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Kitces: Are retirement bucket strategies half empty?

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Retirement bucket strategies have recently been developed with an eye toward connecting portfolio allocations to specific expenditures. These strategies commonly call for tying expenses a retiree cannot outlive to guaranteed income streams, or at least highly conservative portfolios with low withdrawal rates. Meanwhile, discretionary expenses are supported via more volatile portfolios, recognizing that if the portfolio performs poorly, the expenses can be cut.

Yet from client to client, it’s not always easy to determine what constitutes essential and what can be deemed discretionary. Because of that ambiguity, planners run the risk of identifying an expense as discretionary when the client may view it as vital to their well-being.

A defense against this is to attach specific portfolio buckets to core vs. adaptive spending types, making it easier for retirees to see not only the security of their core spending, but also to gain an appreciation of a resource bucket earmarked for discretionary consumption. This in turn opens the door for retirees to decide how much they want tied to each of the associated retirement buckets.

A planner who’s capable of doing this for retirees can not only provide peace of mind, but another way they add value to the client relationship.

Fundamental to the process of budgeting is to separate needs from wants.

Needs are the essentials, i.e., food, clothing and shelter costs, and also perhaps basic transportation and healthcare. Meanwhile, wants are generally viewed as more discretionary and flexible, i.e., travel and entertainment. From the retirement planning perspective, making these distinctions is crucial.

Yet the fundamental challenge of this approach is that while expenses like travel and entertainment may be discretionary inasmuch as they are not critical to preserving the retiree’s life, they do form the core of a household’s lifestyle. Consequently, losing out on the ability to cover those discretionary expenses could be quite traumatic for the household.

The key takeaway is that discretionary expenses often relate directly to our social commitments and support the social aspects of our well-being.

If we consider Maslow’s classic hierarchy of needs, essential expenses may tie to the bare necessities for survival, but discretionary expenses aren’t merely optional. Instead, those expenses typically just fund higher-level psychological needs. Put another way, some non-essential discretionary spending may not support our physiological needs, but it may still be essential spending to support our psychological needs.

On the flipside, not all essential expenses are actually essential to the project of survival.

For instance, while shelter is vital, living in a home of reasonable quality and safety doesn’t necessarily mean a client’s current home is essential. It may represent a substantial upgrade above what is truly necessary for physiological safety and survival, and for those who can afford a more upscale home, there’s nothing wrong with indulging that impulse.

Still, it’s important to note that for some, the core amount they may need to maintain the essential housing component could be 10%, 25% or even 50% less than they currently spend.

And while food is obviously essential, high-end organic groceries may best fit in a discretionary bucket. That also applies to the decision to eat out frequently instead of having friends over for a potluck dinner.

Clothing offers another illustrative moment. You may want blue jeans, but there’s a difference between spending $1,300 for a pair from Gucci versus $130 for three pairs at the Gap — let alone paying a fraction of the Gap price at a thrift store.

Simply put, at least some discretionary spending on entertainment and travel may be essential for our personal fulfillment, while at the same time only some “essential” spending is truly essential.

The real issue lies not in classifying essential and discretionary expenses, but in defining a core lifestyle cost, on top of which discretionary spending may be layered.

Through this lens, core spending constitutes the true essentials of the household’s entire lifestyle, recognizing that most people would not want to drastically curb spending on those things but that — according to the strictures of a traditional bucketing strategy — may be considered frivolous.

Clarifying what is core versus the discretionary expenses that stack on top is crucial to understanding how much the household really needs to fund their retirement, and how much risk the household can and should take on in a portfolio to satisfy those spending goals. The key distinction is that segmenting a household’s budget into core versus non-core expenses means separating out core expenses within each category.

Imagine a relatively affluent retired couple that spends almost $80,000 per year. Almost 40% of their budget, $2,500 per month, covers the home they’ve lived in for the past 25 years, including the mortgage and property taxes, along with home furnishings. They additionally spend $1,000 per month on healthcare — Medicare Part B and Part D, plus a Medigap supplemental policy for each of them — about $700 per month on food and $3,000 per year on clothing, all of which forms a core of about $53,000 per year in essentials.

On top of this they spend roughly $500 per month on entertainment, another $400 per month in car payments, $6,000 per year for vacation travel, $3,000 per year in charitable donations and about $500 per month on miscellaneous expenses, bringing their discretionary total to almost $26,000 per year.

The challenge is that many of these so-called essential expenses may not be essential at all. And if the retiring couple’s advisor created a portfolio strategy that secured essential expenses but had a material risk of failing to sustain the couple’s discretionary expenses, this would not be deemed an acceptable retirement plan because this couple cannot envision a life in which travel, entertainment and other traditionally discretionary expenses went down to zero.

So what’s the alternative? Rather than segmenting each category of spending into essential versus discretionary tiers, the advisor should segment the spending within each category into the core level of spending that would sustain the household, and then the discretionary spending the couple would like to preserve on top — but realistically could live without.

For instance, the couple might decide they are unwilling to relocate, but they could scale back on landscaping and home furnishings expenditures. They could envision trimming their food and entertainment budgets by about 40%, selling one car, dialing down to just one vacation per year to see the grandchildren and making cuts to most other spending categories — save for healthcare, as their Medicare Part B and Part D and Medigap supplemental policy premiums are entirely fixed, and they can’t control their out-of-pocket expenses any further if/when a health event should occur.

Notably, the relative breakdown of how much constitutes discretionary spending is substantively similar, with about 2/3 of the couple’s annual spending, $54,000, as core and the other 1/3, or $25,000, as discretionary. But unlike the prior budget, the couple could actually abide this one.

Once expenses are segmented into a relatively unchanging core and a more flexible discretionary portion, an interesting phenomenon emerges: Many expenses that retirees ultimately label as discretionary above the core also tend to decrease with age.

In fact, recent retirement research has increasingly documented that retiree spending tends to naturally decline, at least in real dollar terms, throughout retirement, as even with a moderate rise in healthcare expenses in later years, discretionary spending tends to decline in a manner that more than offsets rising healthcare costs.

That’s not because retirees eliminate entire categories of discretionary expenses in retirement. Rather, their previously scaled-up discretionary lifestyle is dialed back toward a lower-cost core as age and deteriorating health reduce the retiree’s activity levels.

Retirees in their later years tend to reduce their transportation costs, travel and dining out, and spending on clothing and entertainment. This means those non-core discretionary expenses aren’t just discretionary, they’re also adaptive — i.e., declining in step with age and lifestyle factors.

And for many retirees, a significant portion of retirement spending, and core expenses in particular — may already be covered by Social Security. This arguably is a plus, as it more directly ties the most essential and core expenses to a stable and lifetime-guaranteed income stream, while the portfolio itself remains tied to the already naturally adaptive expenses left over.

Continuing the prior example, the retiring couple may already be anticipating $40,000 per year of Social Security benefits, which means their portfolio only needs to sustain a net of about $15,000 per year of core expenses. At a 4% initial withdrawal rate — conservatively chosen given that they must continue for what could be a 30-year time horizon — that would necessitate a roughly $360,000 allocation.

Meantime, the adaptive expenses that naturally wind down only need to be sustained for the next 20 years, meaning the couple may accept a 7% initial withdrawal rate because the plan anticipates that this portion of the portfolio will be spent down over time, resulting in another $350,000 allocation.

Accordingly, if the retiree started with a $1 million portfolio, approximately $360,000 would be earmarked for the core portfolio, the next $350,000 would be allocated to the adaptive portfolio and the last $290,000 could simply be held as long-term reserves for future use.

Of course, a key caveat is that depending on exactly when the couple actually retires, Social Security benefits that cover the bulk of their core expenses might not actually be available right away.

If the couple were to retire at age 65 as Medicare becomes available, but only planned to take the lower-income spouse’s $1,250 monthly benefit while delaying the other spouse’s benefit for five years until it rises to $2,100 per month with delayed retirement credits, the couple would need another $125,000 — at a pace of roughly $25,000 per year for the next five years — to bridge spending needs until the rest of those Social Security payments begin.

Consequently, the couple would allocate $125,000 of their reserves to a bridge portfolio, which must be allocated differently — and likely ultra-conservatively, given the very short time horizon — with the remainder then available to continue holding as reserves.

It’s important to properly categorize retirement expenses to ensure retirement assets are allocated to cover them, and that withdrawal rates from those assets are reasonable given both the time horizon involved and the relative flexibility or adaptive nature of the expenses.

Thus, as noted earlier, core expenses might be tied to guaranteed income streams — e.g., Social Security, a pension or an inflation-adjusted immediate annuity — or at most an appropriately conservative safe withdrawal rate from a long-term portfolio. Meanwhile, discretionary expenses might be tapped with a substantially higher withdrawal rate and a more growth-oriented portfolio, given expenses can be reduced if necessary or may naturally reduce over time. The key difference being that this portfolio would be constructed for the couple to enjoy the upside potential of a favorable sequence of returns, which would allow even more flexibility in their spending.

Bridge expenses, meanwhile, will generally be the most short-term and fixed in nature, and would therefore be allocated to the most conservative (e.g., fixed-income) investments appropriate for the shorter time horizon.

And to the extent not all of the retirement portfolio is needed for those three buckets, available reserves can simply be held or reallocated to one of the other buckets to lift spending.

For example, a retiree who finds themselves with substantial excess reserves could also simply chose to allocate them to their adaptive bucket, and actually spend it by increasing their more flexible lifestyle expenses. Alternatively, the retiree could also allocate the reserves to their core expenses, lifting up their core lifestyle — for instance, buying a nicer primary residence.

However, because the withdrawal rate will by necessity be lower with the core bucket than the adaptive, the same dollars allocated out of reserves won’t have the same spending impact. Moving $100,000 of reserves to the core portfolio increases spending by just $4,000 per year. Allocating it to the adaptive bucket would lift it by $7,000 per year, albeit for a shorter period of time.

On the other hand, when carving up spending within each category into core vs. adaptive expenses, it becomes clearer where retirees really do have spending flexibility to cut back.

And in turn, clarifying the relative amount of core vs. adaptive spending also makes it easier to determine how much in retirement assets should be allocated to each bucket, how the buckets themselves should be invested and whether the retiree actually has more than enough and could allocate some additional reserves to support even higher spending.

Perhaps the greatest benefit to a clear separation of core vs. adaptive expenses — and the creation of separate buckets to support each — is simply that it clarifies for retirees exactly how much room they have left to spend, and allows them to see more directly the impact market volatility may have on their adaptive spending ability.

Ultimately, labeling expenses as core across essential and discretionary categories, then layering adaptive expenses on top, isn’t just a matter of semantics. Clear words and labels help retirees stay on board with the plan, the truest indicator of a planner’s value.

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