The Fallacies in Today?s Retirement Plan Assumptions: Putting the Hedonic Pleasure Index to Work
Are you dramatically underestimating your clients’ retirement lifestyle expenditures when you use Monte Carlo software? If you stop and look at a number of important assumptions hidden in the current models, you’ll suddenly have a lot less confidence in the retirement plans you’re mapping out for your clients.
Last August, in this space, I took issue with ten "garbage in" inputs that I’ve seen advisors use to analyze client decisions. (You can see the full article here.) The list included future tax obligations, future tax rates, the after-tax allocations in a client portfolio, two different aspects of the so-called "efficient frontier," assumptions about how long clients will live, what clients will pay in future medical expenses, any estimates about the downside volatility of the investment markets, any general estimates about future U.S. equity returns, and – particularly problematic – assumptions about client spending in retirement.
After that article ran, I received a detailed response from Jim Shambo, of Lifetime Planning Concepts in Colorado Springs, CO. Shambo may have thought more deeply about post-retirement spending patterns than anybody in the profession. In a nutshell, he said that the research I cited (Bureau of Labor Statistics CEX surveys) is not really telling us that people spend less in retirement than they did before. The CEX data doesn't follow the same individuals before and after retirement, and it doesn't control for the fact that different age cohorts reported different income levels. Garbage in, garbage out!
Shambo had previously published his own analysis in the November 2008 issue of the Journal of Financial Planning, where he coined the phrase "The Hedonic Pleasure Index" to define real-world spending patterns. His investigation began with a critical look at the Consumer Price Index – which, of course, is a significant input into traditional retirement sufficiency models that advisors sometimes overlook. Safe spending rates are normally defined as a percentage of the portfolio on the client’s first day of retirement (often 4% to 5% of the total), and then increasing that dollar amount by the CPI in each subsequent year of retirement, so client expenditures would keep pace with the cost of living.
Inflation is higher than you think
But, Shambo asked, does the CPI accurately reflect increases in the costs of a client's lifestyle in retirement? He cited his own pre-retirement spending inflation as an example. “In 1973, I made and spent $9,000,” he said. “Using a 3% annual inflation estimate, I should expect to spend $28,500 today. Does anyone think that makes sense?” Relying on the price index means completely ignoring changes in income levels, net worth and spending behavior.
The CPI may also be dramatically understating real-world cost increases for goods and services, for several reasons:
- The Bureau of Labor Statistics has been tinkering with the CPI since 1983, and overall Shambo has concluded that most of us have experienced a full percentage point more inflation than the revised CPI statistics have indicated. Among other things, the BLS tried to take out of the CPI the “investment return” that people get back from owning a home. So the housing expenditure cost increases were reduced to the extent that the BLS assumed you were getting them back in the form of increases in the value of your home. Since 2008, this has been far more of a theoretical than an actual offset for many homeowners. Indeed, the BLS never allowed for the possibility that houses might decline in value. But even if the value of your retired clients’ homes have gone up instead of down these last five years, they still have to write checks for the full cost of their home repairs, taxes, etc. each year, not the hypothetical (lower) CPI estimate.
- In its CPI calculations, the BLS now accounts for the fact that people are able to substitute one product for another when faced with rapid price increases. In his Hedonic Pleasure Index article, Shambo cites the example of a family accustomed to eating a filet mignon steak once a week for dinner. But when the price of such premium beef rises by 5%, the family might decide to eat T-bone steak instead – a lower expenditure that therefore (by BLS logic) results in a much smaller increase in living costs. But will all your clients make the BLS-assumed substitutions? For those who don’t, actual costs will rise faster than the reported CPI.