Meir Statman, PhD
Meir Statman, PhD, professor of finance at Santa Clara University’s Leavey School of Business, California. He is author of Finance for Normal People: How Investors and Markets Behave.
Retirees often are warned not to overspend or they could outlive their savings. Rarely mentioned is that some retirees have the opposite problem—they underspend. Their dramatic underspending detracts from quality of life and, counterintuitively, even can lead to money problems (more on that below). But as far as these underspenders are concerned, they are just being frugal and responsible.
Here’s what retirees and their families need to know about problematic underspending…
We’ve all heard horror stories about retirees reduced to scraping by on modest Social Security checks. But when you dig a little deeper and investigate why these retirees ended up in dire financial straits, you almost always discover that postretirement overspending was not the issue. More likely they were poor throughout their lives…made poor investment decisions…were defrauded by scammers…had massive medical or long-term-care bills…and/or never had much saved for retirement.
You almost never hear about retirees who saved diligently and successfully for retirement but who ended up broke anyway, primarily because of excessive discretionary spending. Yet it’s this unlikely danger that causes some retirees to pinch their pennies.
The retirees most likely to make this underspending mistake are, ironically, those who made few money mistakes during their working lives. These people paid off their credit card balances in full every month and maxed out their retirement contributions. These people are cautious and savvy—in short, they’re the last people you would expect to have a bad financial habit.
But shifting from the working world into retirement requires people to make a challenging mental transition—the shift from saving to spending. They struggle to escape the sense that taking money out of retirement savings is wrong, so they withdraw much less than they could and harangue their spouses to do the same.
Many decide that it’s OK to spend the income generated by their investments but not to draw down the capital. But with today’s low interest rates, the income produced by a typical retirement portfolio often is not enough to finance even a frugal retirement, so these underspenders seek out investments that pay higher yields. They tell themselves that this is the safe play because it lets them preserve their capital and spend only income—but they are focusing on the wrong danger. The real risk is investing a significant portion of retirement savings in assets that are riskier or pricier than is appropriate, which is exactly what they are doing—high-yield investments often come with excessive risks or fees. Ironically, for retirees, the drive to be financially responsible can lead to investment losses. Examples: There’s a reason that high-yield bonds often are referred to as “junk” bonds—they are issued by companies or governments that might not be able to pay the money due, meaning these bonds can be very risky. “Income-focused” mutual funds that emphasize high dividends often have high fees and might generate higher-than-necessary tax bills.
Most underspending retirees also are loath to tap their home equity, either by selling their home or by taking a reverse mortgage. They do everything they can to pass the family home to the next generation debt-free—even if that next generation is just going to sell it.
Among the options for overcoming retirement underspending…
Set up automated monthly transfers from retirement investment accounts into a bank account or money market fund. When money appears automatically, it tends to feel like income, not like tapping into savings.
Bonus: Setting up these preset monthly withdrawals also helps overcome stock-sale-timing regret. If you pull money out of a stock fund today and the stock market rallies tomorrow, you are likely to feel pangs of regret about the profits you missed. For some retirees, these concerns are such a significant psychological hurdle that they cannot bring themselves to tap into their retirement capital at all. Automated monthly withdrawals reduce these feelings of regret because there’s less of a sense of personal responsibility—the money was withdrawn by an automated process.
Historically, it has been safe for retirees to withdraw 4% of their savings early in retirement—although some experts suggest 3% to be extra safe—and adjust that amount upward to keep pace with inflation as the years pass. Invest in “managed payout” funds. These distribute a small percentage of their value in the form of monthly payments that seem like income, so they are another effective way for retirees to overcome psychological hurdles about tapping into capital. Examples: Vanguard Managed Payout Fund targets a 4% annual distribution rate (Vanguard.com)…Schwab Monthly Income Funds pay 1% to 8% annually, depending on the fund selected and market conditions (Schwab.com).
Treat “required minimum distributions” as required minimum spending. If you have money in a tax-deferred retirement account, such as a 401(k), traditional IRA or SEP IRA, you typically are required to start withdrawing money starting the year you turn 70½. These withdrawals start at 3.65% at age 70½ and increase over the years. (These rules do not apply to Roth IRAs.)
Underspenders sometimes make these required withdrawals but then reinvest the money. Instead, tell yourself, I’ve paid taxes on these withdrawals anyway, it’s my money, so I might as well enjoy it rather than reinvest and face more taxes later. Underspenders as a group are perturbed by taxes, so framing spending around tax avoidance such as this can be effective. The required withdrawal rate is very conservative, so it is safe to spend this money.
Investigate what forms of spending bring you the most joy. These might not be the classic retirement activities…and it might not be the things that you splurged on during your career. Example: Retirees often discover that keeping-up-with-the-Joneses, status-oriented purchases such as luxury cars bring them less joy in retirement.
The good news is that retirees have time to try different things until they stumble upon something that does bring them joy. If spending on yourself does not do the trick, consider making gifts to your kids (or to a charity). They’re the ones who will get this money if you don’t spend it, and giving gifts now means you get to see the recipients enjoy it.
Stop postponing splurges until later in retirement. Retirees often reason that if they might live 25 years in retirement, they shouldn’t spend more than ½5 of their retirement savings in any year. But retirees actually spend significantly less as the years pass by. After around age 70, they travel less, splurge on fewer creature comforts and pour less money into home improvement. Retirement spending falls off even more sharply after one partner in a couple passes away. People inevitably derive the greatest joy from retirement spending early in retirement, while they still are relatively young, healthy and energetic.
Don’t let the possibility of a long stay in a long-term-care facility ruin your retirement. It’s true that some retirees eventually face staggeringly large medical or long-term-care–related bills—but that doesn’t mean that the prudent move is to hang on to as much savings as possible to pay those costs if they do come. If someone lived very frugally in retirement, perhaps he might have $300,000 remaining in his savings when he needed an extended nursing home stay versus $200,000 if he enjoyed his retirement—but the average cost of a nursing home stay is around $100,000 per year and rising fast. At that rate, he is likely to have to turn to Medicaid to pay the bills eventually anyway (unless he has purchased a long-term-care insurance policy). Medicaid won’t pay for his care until he has run through virtually all his savings anyway, so the sensible option is to enjoy retirement so that he qualifies for Medicaid a bit sooner.
And while it is worth budgeting for the Medicare deductibles and co-pays you are likely to face based on your typical health-care spending, there really is no feasible way for the average retiree to save enough to be able to pay the massive medical bills that sometimes occur—those are likely to eat up their savings no matter how frugally they have lived. The smart move is to sign up for a Medigap plan or a Medicare Advantage plan that limits out-of-pocket medical costs as much as possible and then enjoy your retirement.
