So, we all know that life style inflation can kill your savings rate. If you increase your expenditures at the same rate as your income, then you’ll likely never increase your Net Worth to where you need to be to retire. However, life style inflation does not only impact you in the accumulation phase. People tend to forget its impact on your post retirement phase. This is Life Style Inflation’s less talked about downside.
Net Worth and Safe Withdrawal Rates
Early Retirement Now has a great series of articles released a few weeks ago on what withdrawal rates are safe to maintain your financial solvency throughout your lifetime. In general, it is somewhere between 3-4% depending on your time horizon. We talked previously about how to calculate whether your Net Worth would cover these withdrawal rates as well as the pitfalls of putting your trust in those calculations. The key takeaway from those posts is the question of what happens to your expenditures over time and will your nest egg cover those expenditures.
Life Style Inflation’s Less Talked about Downside
If you haven’t guessed by now, the issue with Life Style Inflation is with the amount of expenditures you must cover. If my pay were to increase 5% a year and I increased my expenditures by 4% a year, my savings would rise by 1%. However, the amount I need to retire would also raise by 4% assuming I maintained my expenditure rate into retirement. That 4% increased need may take a long time to cover with the 1% increased savings depending on what your overall savings rate is. Here you would be patting yourself on the back for increasing your savings rate by 1%, but you may have just added years onto your working life.
The Take Aways of Life Style Inflations Impact on Retirement Requirements
On its own what this means is you should cut out all life style inflation. However, we’ve discussed previously the aspects of marginal utility. I.E. that your existing savings rate should define the value of increasing that additional 1% in savings. There are points on the curve, say you are already saving 55% a year, where reducing savings to 50% or increasing it to 60% is probably a pedantic exercise. Sure, there might be a year or 2 difference between 50-60%, but when you are talking about 15 years to retirement it’s not that huge a deal. This is of course provided you are enjoying the money you spend in those 15 years. After all retirement doesn’t bring happiness, it brings more options to indulge in the things that make you happy. It does however mean that you should not increase expenditures simply because you increased your income. Always consider the value of that expenditure.
The second takeaway I noticed was referenced by Route to Retire a few weeks ago. Just because you spend what you do today does not mean that will be your spending rate in retirement. Studies have shown that normal retirees tend to decrease their expenditures after taking the leap. There is a possibility you are not average. Say you plan on retiring early and traveling the world or moving to your dream location. In those cases expenses might increase in retirement. That means when calculating when is enough to stop working, you need to determine and plan what your expenditures will be post retirement.
My Retirement Needs
Take me for example. My wife and I plan on traveling the world once we finally retire. The current plan has us using travel trailers to crisscross various countries for 6 months at a time. However, given we have children, I also expect that we will maintain a base of operations somewhere. That base of operations will likely be a downgrade in size from our current home. Also, I doubt we’ll be staying at the Ritz Carlton for these types of trips. Still, I do expect costs will rise from where we are today by as much as 10 percent. As such my net worth goals consider a need for 10 percent more funds than my current expenditure rate.
Now I’m honestly still at least a decade away from any planned retirement. My plans could change or I could let lifestyle inflation creep in which would change my end Net Worth Target. It’s ok if that were to happen, but I realize if either does I need to adjust my plans per everything I’ve spoken to above. That realization will allow me to make those types of decisions fully aware of their impact. After all, if I want to live a more expensive life now or live a more extravagant life in retirement in exchange for a few more years of work that is my families’ decision to make.
Have you accounted for any change in potential expenditures either from lifestyle inflation or retirement plans in your Net Worth Targets? If so by how much did you adjust and how did you determine the adjustment amount?