Helping pre-retirees choose a retirement spending limit

A key step when helping clients transition to retirement is preparing a tax-efficient income plan, including any necessary investment adjustments, as they begin retirement account withdrawals. (See “Building a Tax-Efficient Retirement Income Plan for Clients,” JofA, May 12, 2022.) A related step in the planning process is estimating how much they can comfortably spend in retirement.

For this purpose, one of the first things an adviser requests of a pre-retiree is typically a reliable estimate of monthly or annual expenses. While this may seem like a simple request, the reality is that most clients don’t have a solid handle on exactly how much they need to fund the basics of their lifestyle, even before factoring in changes to spending in retirement, such as increased travel or decreased commuting costs.

For many experienced CPA financial planners, one of the most challenging aspects of planning for pre-retirees is helping them create a realistic and accurate retirement spending limit. The stakes are high: Getting this number wrong can lead to clients either running out of money too soon or else underspending, leading to an unnecessarily thrifty retirement lifestyle.

Retirees’ need for a spending number

It’s been said that the goal of living on a budget is to get to a point where you don’t need to budget anymore, due to a combination of sound spending habits along with a savings buffer to cover unexpected expenses and larger purchases.

Typically, cash-flow planning, or budgeting, is associated with basic financial literacy, and most education and information on the topic is geared toward people who are just getting started on their individual financial journeys. By the time clients are reaching the end of successful careers, any skills or knowledge they may have had around budgeting are likely to be outdated at best, or completely unfamiliar in many cases. In retirement, however, having a spending number is important.  

Studies show that travel, time with friends, and dining out bring the most life satisfaction to retirees. Yet this is the area clients are most likely to cut out if they don’t have an accurate idea of how much they can afford to spend each month. When CPA financial planners rely on clients’ best guesses as to how much they are accustomed to spending rather than looking at the actual data, they may create financial and investment plans that unnecessarily limit “fun money,” which is arguably the most important category and also the most discretionary.

Similarly, if you ask a client their anticipated cash flow needs and they simply estimate a number or use the amount they have been earning on a monthly basis, it’s highly likely they are underestimating. For example, most clients have an idea of their housing costs, but retirees who have recently paid off mortgages commonly forget to budget for property taxes and insurance if they’ve been used to those amounts being paid through escrow for many years. Additionally, home maintenance and repairs are challenging to predict, particularly on older homes where roofing, plumbing, and appliance replacements may be looming sooner rather than later. One suggestion to overcome this uncertainty would be to use the common rule of thumb of setting aside 1%–5% of the home’s value as a repair reserve.

How to help clients find their number

Here’s how to help those clients arrive at a more accurate retirement spending number, ideally with the least hassle possible.

Have your clients start by answering a simple question: What is your monthly take-home pay from all sources and where does it go?

If that doesn’t feel specific enough, or if they are in the habit of regularly drawing down savings to pay for things like holidays or home projects, drill down a little more by asking for a list of fixed monthly expenses, which can typically be assessed through a checklist of common expenses and a glance through the last full month’s bank transactions.

Then have them add up the monthly statement balance of any credit cards that they used (assuming they pay it off each month) over the past 12 months, then divide by 12 to get an average monthly spend.

These steps can provide a good baseline estimate of cash flow needs to start from, before layering in changes that are expected in retirement due to lifestyle choices.

A more in-depth analysis

For clients who find that their spending will need to be cut back from their working days’ habits, a more in-depth analysis of where money has been going is a good starting point for the conversation of where they want it to go in retirement, as well as where they will limit spending.

To do this spending analysis, I find it most helpful to download all digital transactions from the past three to six months into one spreadsheet, then sort the list by merchant before assigning a spending category to each item. The sorting step makes it easier to quickly label common expenses such as groceries or gas, while also offering insight into merchants that they frequent that may need to be monitored or deprioritized in retirement.

You may provide a list of common labels, such as housing, transportation, food, etc., but also encourage clients to make their own categories. A common label that often leads to a desired change in habits is the Amazon/Costco/Target category. While it’s unreasonable to expect clients to cancel their Prime membership or give up the joy of a good Target run, seeing the total expenditures at merchants that tend to have a high element of impulse spending can encourage a level of intention that may not be as strong if they label that spending as simply household or groceries.

Sorting transactions in a spreadsheet may not appeal to all clients. One alternative is to have clients deposit the amount they think they need (or their spending goal) into their checking account each month and put everything else in savings, then evaluate: Did they need to move money from savings? Did they have funds left over?

When it comes to budgeting, clients tend to go to one of two extremes. They either view a budget as a dreaded exercise in restriction and annoyance due to the need to track expenses and therefore avoid it altogether, or they overanalyze things to the point of stress by trying to categorize every penny they spend. Both approaches lead to procrastination and can delay the process of financial planning. By recommending a middle ground, advisers can overcome this resistance to budgeting while also helping clients create accurate plans that will work with the reality of their retired life.

For further information, listen to the podcast series Retirement Drawdown Strategies. Members of the AICPA Personal Financial Planning Section can consult the resources in the Broadridge “Nearing Retirement/Retirement” life event center.

— Kelley C. Long, CPA/PFS, CFP, is a personal financial coach and consultant in Arizona. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.