In planning for retiring clients, it’s crucial to get an understanding of what the client’s goals are in the first place – so that recommendations can be made about how to financially secure those goals. In the context of setting a spending goal, a popular delineation is to separate retirement spending into "essential" versus "discretionary" expenses – not unlike "needs" versus "wants" for accumulators – with the idea of using guarantees to secure the essential expenses, and less certain growth assets with some risk to fund the discretionary expenses (since they’re ‘only’ discretionary and not essential, by definition). Yet in reality, even discretionary spending still constitutes an important part of a retiree’s overall lifestyle – the loss of which could be very psychologically damaging. As a result, merely securing the essential expenses of retirement and leaving the rest at risk still, in the eyes of most retirees, would constitute a failure of the overall retirement goal. Instead, clients often choose to ensure that all their spending can be sustained – by continuing to work as long as necessary (as health allows) to secure all of their goals. Does that mean the distinction between essential versus discretionary retirement expenses isn’t necessarily helpful after all?
The inspiration for today’s blog post was a recent discussion I had with a retirement researcher with AARP regarding the "essentials vs discretionary" approach to retirement planning, where spending needs are separated into two categories, each of which may have their own funding and investment strategies. Yet in practice, the approach can be more problematic than its simple elegance suggests. To understand why, it’s necessary to understand the basic "wants versus needs" framework upon which it is built.
Wants vs Needs
In most ways, the separation of essential versus discretionary retirement spending is not unlike the separation of wants versus needs for any individual’s general levels of spending. As the theory goes, there are basic needs that everyone has – food, shelter, and clothing – but no matter how much we really think we need it, an iPad is not really a "need" but is simply a want.
In fact, even within the classic need categories of food, shelter, and clothing, there are still wants. For instance, while we need clothing, we don’t need fancy designer clothes; similarly, while we need shelter, we don’t need to have an apartment to ourselves when roommates will do, or a huge 5,000 square foot house when 1,500 square feet would still be more than enough to provide a roof over our heads.
This framework can be highly effective in helping people to establish appropriate spending behaviors. Where there is no clear delineation between needs and wants, it becomes difficult to control impulse purchases and make rational spending decisions. When there’s no difference between needs and wants, the only constraint to spending is the amount of money available to spend – leading to the unfortunate outcome where spending on needs and wants-as-needs rises to fill all the available income until there’s simply no money left at the end of every month (or potentially not even enough money to make it to the end of the month!).
Accordingly, by separating the wants and the needs, spending on needs is done because it has to be, and spending on wants occurs as a trade-off to saving, with the opportunity to apply constructive thought and a proactive decision about whether the next dollar should be spent or saved.
Essential vs Discretionary and Wants vs Needs
In the retirement context, the basic idea is that needs are essential and wants are discretionary. Accordingly, we can extend the needs versus wants framework into retirement, and then plan to fund it accordingly: guarantees can be tied to the client’s essentials, ensuring there will always be food on the table, a roof overhead, and clothes on the back, while discretionary spending – the wants of retirement – can be funded with the excesses, if/when/as the portfolio provides. Thus, as with the working years, we secure the essential needs first, and then allow for greater discretionary spending on the wants as income allows.
As the strategy is typically applied, a prospective retiree’s "essential" expenses are secured with a guaranteed stream of income like Social Security, pensions, or by purchasing annuities (or TIPS) to the extent necessary, while "discretionary" expenses are funded with less certain investments (e.g., a diversified portfolio) where the spending can be adjusted in light of the ongoing returns.
Yet in practice, it seems there is one major flaw in the approach: prospective retirees often have the flexibility to choose to treat discretionary expenses as being "essential" in the first place! Because in the end, if you’ve only guaranteed a part of the goal and fail to achieve the rest, isn’t that still an overall failure of the goal?
"Essential" for Retirees vs Needs for Accumulators
In the general case of spending, where people are ultimately are constrained by income and must make spending and saving decisions with the income they have, it is valuable to distinguish between needs and wants. In the case of retirees, however, the situation is somewhat different – for the simple reason that if retirees are not satisfied with the total level of spending available, the retiree can choose to spend less and save more before retirement, and/or can choose to work longer to accumulate more before retiring (at least to the extent health allows). Thus, in the case of the retiree, there is an interaction between "essential" needs in retirement and the decision to retire at all: if your accumulated savings can afford only the bare essentials and not the full amount of the "discretionary" desired lifestyle, the prospective retiree keeps working until the entire lifestyle they feel is "essential" is affordable!
As a result, in all but the situations where retirement is forced due to external circumstances, the distinction between essential and discretionary spending appears to be less relevant. If there are only sufficient assets to afford essentials but not the desired discretionary spending, the prospective retiree keeps working until they can afford their entire lifestyle, including the essentials and a desired amount of lifestyle discretionary spending. From there, if returns are even better than anticipated, lifestyle can always be upgraded further. But from the perspective of someone considering the retirement decision – who has a choice about whether to retire or not – the goal rarely is to secure essential spending and take the risk that the rest won’t be affordable because it’s just "discretionary" – instead, the typical goal is to afford the entire retirement lifestyle.
In fact, retirees are often willing to work longer specifically to ensure that their later retirement years aren’t stripped of enjoyment (no more eating out, no more visiting the grandchildren) because there wasn’t enough money to afford the desired "discretionary" spending. Or stated more simply, the psychological impact of losing one’s discretionary expenses – those not required for food, shelter, and clothing, but still deeply tied to life enjoyment, personal satisfaction, social and family ties, etc. – can be so severe, that it’s not really clear whether we can fairly call them "discretionary" at all, until/unless there are absolutely no other choices available and we have to.
In practice, I believe this is why an essentials vs discretionary discussion is often difficult to have with a retiree, especially a prospective retiree. If the answer is "you can afford the essentials in retirement, but not the discretionary expenses that also constitute lifestyle you are accustomed to" the typical answer is not "let’s guarantee the essentials and hope returns carry us to the rest" but instead is "I’ll keep working until I have reasonable certainly my entire lifestyle goal can be accomplished" – and if there’s upside from there, all the better. In turn, this is why approaches like tying total spending to an amount sustainable under a safe withdrawal rate approach seems to be far more popular with planners and their clients than buying an annuity to secure "essentials" and investing for the discretionary expenses that remain.
So what do you think? Is the essentials versus discretionary distinction really meaningful for a retiree who can just work longer to ensure their entire lifestyle is affordable? Does the psychological impact of being unable to afford the discretionary expenses that constitute a lifestyle still make them somewhat essential? If the essential versus discretionary approach only meaningful for people who can’t afford their lifestyles in the first place?
(Editor’s Note: This article was included in Carnival of Personal Finance #364 – The Art of PF Blogging Edition – on One Cent At A Time and also Economy Freak.)