Why Does My Spending Matter?
I am reasonably confident that discussions around spending are not our clients’ favorite thing, and will tend to be avoided, when possible. But those discussions are critical to the planning we do, which is why so much time is focused on cash flow during client meetings. Identifying a client’s spending levels and patterns helps us set realistic goals for saving and more accurately predict a client’s future spending needs.
It is also crucial for us to understand how average spending patterns—and spending growth rates—change over time. JP Morgan has been at the forefront of research in this area. We use their research, along with our in-depth knowledge of each client’s patterns and preferences, to perform more accurate financial projections.
As we prepare a personalized financial projection for a client, we need to incorporate spending assumptions into our modeling and forecasting tools. In doing so, we focus on three key areas:
1. Spending Changes
2. Spending Growth
3. Spending Profiles
Please continue reading below to understand a bit more about each of these areas and how they impact the planning we do for you.
How Spending Changes As We Age
Data from the U.S. Bureau of Labor and Statistics (BLS) shows that average spending for U.S. households peaks at age 45 (see chart below). After that time, there is a spending decline in all categories except health care and charitable giving. Further studies show that this trend is consistent across generations and wealth levels.
Housing is the largest expense during all time periods and health care expenses become a large component of overall spending in older ages due to its higher utilization and a much higher rate of inflation (as discussed in the next section).
Spending Growth Rates
In addition to analyzing how spending changes over time for the average U.S. household, we also pay close attention to spending growth rates and their impact on our financial projections. The chart in the previous section shows a decrease in overall spending, but it is not adjusted for inflation. This means that while the average household sees an increase in the number of dollars they spend as they age, the rate of increase is less than the overall inflation rate. We factor this into our planning by setting the overall spending inflation rate at 2% before retirement (to match our overall inflation assumption) and at 1% post-retirement (to reflect a decrease in the acceleration of overall spending for the average retiree).
As previously stated, health care spending rises as one ages and therefore becomes an increasingly large component of a person’s overall spending. Based on government-provided data on health care spending, JP Morgan estimates health care inflation to be 6.5% for retirees. In our financial projections, we use this 6.5% rate as our post-retirement health care inflation assumption and use a slightly lower 4.5% rate before retirement. This “pre-retirement” rate reflects a typical defrayment of healthcare costs through employer-provided group coverage.
Common Spending Profiles
The discussion up to this point has been around averages and, similar to all of the children in Lake Wobegon, we know that our clients are above average! Kidding aside, while averages are a helpful starting point for establishing policy around key planning assumptions, each person has a unique spending profile that is bound to deviate from the averages in certain areas.
In 2015, JP Morgan dug deeper into the spending data of 613,000 households with members over age 55 and found that over 75% of them fit neatly into four categories:
Foodie – a higher level of food, beverage, and retail spending, but lowest overall spending (due primarily to low housing costs relative to other retirees).
Homebody – higher housing-related expenses and typically lower discretionary spending (eating out, travel, etc.).
Globetrotter – higher travel and entertainment expenses and the highest overall spending level throughout retirement.
Healthcare spender – on average spends nearly 30% of income on health care.
The remaining households affectionately referred to as “snowflakes” in the study, had a distinct spending pattern different from the others.
Whether you fit in one of the categories above or identify as a snowflake, the key takeaway here is that only through deep discovery of your preferences and proclivities can we understand your unique spending profile and effectively incorporate it into our planning assumptions and financial projections.