The Fallacies in Today?s Retirement Plan Assumptions: Putting the Hedonic Pleasure Index to Work
November 20, 2012
by Bob Veres
- The BLS also measures changes in the quality of consumer items from year to year and tempers adjustments to the CPI accordingly. So, for example, when car manufacturers added air bags, pollution controls and anti-lock brakes to the next year’s model and raised the price by $1,000, the BLS only included $250 of the increase in its CPI price index. In the real world, however, you can't go to the dealership and ask for those items to be ripped out of your new car in return for a discount. Those costs, and many others throughout the consumer sector, still have to be paid, even if you’re getting more for your money.
When Shambo looked at various analyses, including some conducted by the BLS itself, he found that, on average, the CPI understates actual out-of-pocket cost increases by about one percentage point per year. A 2% inflation rate, in other words, would actually translate to a 3% increase in out-of-pocket costs for the average consumer. Shambo’s actual client experience suggests that the CPI understates spending inflation from .25 percentage points to 1.50 percentage points, depending on the individual’s behavior in the early years of retirement.
Another two faulty assumptions
But that's only part the story. There are two other assumptions built into the spending models that advisors are using. First, most spending models assume that clients will maintain a constant lifestyle in retirement. But do the various surveys and statistics bear this out? And, even if they do, isn’t it likely that at least some of your clients will deviate from this one-lifestyle-forever assumption?
Second, models tend to assume that retirees’ purchasing patterns are the same as those used to calculate the CPI. But is that true? Is it possible that the things retirees tend to buy more of exhibit more or less inflation than the expenditures of younger consumers? If the cost of health care goes up much faster than the inflation rate, for example, and retirees are spending a larger percentage of their income on medical care, then their overall spending might go up faster than any of the models are predicting.
Both of these assumptions turn out to be problematic. When he looked at the BLS spending statistics, Shambo found that people between the ages of 65 and 74 tended, on average, to increase their annual spending levels between 1.11 percentage points and 1.78 percentage points more per year than the inflation rate. That means that over the course of that particular decade of their lives, they were spending between 11.28% and 18.69% more than a simple CPI-based assumption would predict. People age 75 and older were spending between 13.20% and 22.07% more than the inflation statistics suggest.
Some of that increase is undoubtedly due to the chronic CPI underestimation of real cost growth, but some may also owe to the fact that retirees were simply spending more – rather than less – in their retirement years. Shambo speculates that when older people make spending decisions they don’t use what they spent last year as a guideline. Instead, they are influenced by how wealthy they feel; they tend to adjust their consumption according to the rise and fall of the value of their assets and the income generated by those assets.
Indeed, when Shambo looked at more recent data, he found that people across all age groups tended to reduce their spending in the wake of the 2008 global financial crisis. The CPI in 2009 was 2.72%, but people age 75 and older, on average, spent .05% less than they did the year before. In the face of a 1.50% CPI increase in 2010, they reduced their spending, again on average, by .46%. That same year, the average spending of people age 65-75 declined a remarkable 3.55%. It appears that many retirees instinctively spend less when their wealth decreases.