What is the Retirement Smile Expense Curve?

by Evan

I have been in the financial services industry for a really long time, so I am always shocked when I hear a new term, especially when it doesn’t seem that the term is all that new! As the title foreshadows, I heard about the “retirement smile expense curve” for retirees recently (past couple of months) and am shocked how intuitive it seems.

What is the Retirement Smile Expense Curve?

The origins of the term in the main stream seem to come from a 2014 article titled, “Exploring the Retirement Consumption Puzzle” by David Blanchett from Morningstar. Using consumption data from 2001 to 2009 Mr. Blanchett made the argument that instead of the normal consumption rate that most financial professionals use (i.e. spending habits indexed for inflation), there is actually a curve to the expenses wherein it starts at $X dips and the increases towards the end of retirement/life.

The often quoted retirement guru, Michael Kitces sums up the data succinctly,

The chart above shows the “retirement spending smile” of Blanchett’s research – or what was actually a “mini-smile” from age 65 to 75, and a broader smile that spans all the way from age 60 to age 90, based on the best-fit regression equations that fit the available data (the blue dots). Notably, the horizontal orange line represents the 0% line for real (inflation-adjusted) spending growth; if the assumptions of the safe withdrawal rate research were correct, the blue spending dots (and the associated best-fit regression) should hover around this horizontal line. Instead, the results show not only a “curve” to retirement spending (rather than just a flat or declining line), but the smile also spends virtually all of its time below the 0% line; in other words, the reality seems to be that retirees actually decrease their real retirement spending throughout almost all of their retirement, with annual decreases of 1%/year that accelerate to 2%/year through the “slow-go” years before turning upwards (but not positive!) to ‘mere’ 1%/year declines again by the end of retirement.

What are the Ramifications of Retirees and Financial Professionals using a Constant Need versus a Smile Based Approach to Retirement Spending?

The assumption of constant inflation-adjusted spending, according to Blanchett’s article, will lead individuals to two issues. The first is absolutely minor in my opinion and that is some may over-save for retirement. This is happening because of the gap between the actual need and the projected need (at an amount indexed for inflation) is wide for a number of years. To be frank, I just don’t see this as a huge problem. Oh you just have too much money? You are too prepared? Consider the alternative!

The other issue raised is a much more interesting one. Specifically, Mr. Blanchett states,

The fact that spending tends to decrease in real terms during retirement may lead to suboptimal retirement consumption. Retirees may be better served by planning on spending more early in retirement (and saving more for later in retirement) than assuming some constant inflation-adjusted amount. Spending more early in retirement also allows retirees the ability to spend money on things they may be unable to enjoy later in retirement as health declines.

Reductions in real spending also have important implications for optimal guaranteed income. Inflation-adjusted single premium immediate annuities (SPIAs) are often noted as “risk-free” retirement income assets, because they hedge both inflation risk and mortality risk. If retiree spending does not increase annually by inflation, though, it may be that some combination of a nominal annuity and inflation-adjusted annuity would be a more optimal combination of guaranteed income. This possibility is worthy of future study. 

This seems like a much more interesting “problem” to me. Of course, if the Retiree is receiving that income and doesn’t use the money it isn’t like it is being burned. There should be an assumption that it is being saved/invested somewhere. Notwithstanding, there could be an interesting planning technique using deferred income annuities with a cash refund in a way that turns on later on in life providing life credits with more of a safety net then the market.

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