Can you see into the future? It’s likely that you cannot. Can you use the present as an indicator of the future? Certainly you can. You can choose to justify that you won’t need to spend much in retirement because you’ll be too old to do anything, but that is not realistic. You’ll realise that retirement will one day be “tomorrow” and living expenses will be a reality that you must face.
Determining how much you will spend in retirement is critical in estimating how long your savings will last. This knowledge will help you to save now, so that you can cover your future retirement expenses easily. You can realistically determine how much you spend in retirement by modelling your retirement needs mathematically with the following factors:
a) Replacement income
b) Retirement lifestyle
c) Projected annual rate of withdrawal
d) Inflation
e) Pre-retirement income
The first step to making an assessment of how much you might spend in retirement is to gauge what your current expenses are and project them as future expenses with a given inflation rate. If you have an account of your monthly expenditure, this would be a great start. You can discount costs or expenses that would be absent by the time that you retire.
As part of the principle of prudence in financial management, you should project a higher living expenses total. This could act as a buffer in case the assumptions used are not met. The simplest way to determine your retirement spending would be to project current expenditure to a pre-retirement level (using inflation and the years left until retirement). This would not be the end of the process, since you can assume that you wish to maintain your standard of living 9and therefore spending level) throughout retirement.
You will have to use the pre-retirement expense figure as the base spending amount. You can then calculate retirement spending in two ways:
i) As a percentage of pre-retirement income
ii) Adjusted for inflation with the assumption that spending levels are maintained
Ideally, your spending should be a percentage of your retirement income. However, you can anticipate and restrict your spending levels by setting a spending limit. This limit will be in the form of an annual rate of withdrawal from the balance of your savings. This can be used alongside the percentage of income that is projected to be spent, to calculate what the nominal and real spending would be in retirement.
Any determination of how much you will spend in retirement should include inflation, withdrawal rates and retirement income. How much you will spend must be governed by how much you can afford to spend also. Whether your retirement income is fixed or variable should act as a spending limitation. While this aspect of planning is speculative, it will ensure that you are aware of the effect of longevity risk, inflation risk and purchasing power risk on your retirement spending and lifestyle.