Why your retirement income doesn’t need to keep pace with inflation

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It is natural to assume that our spending after retirement keeps pace with inflation for the rest of our lives. This is why the federal government increases Canadian Pension Plan and Old Age Security payments on a regular basis and why all public sector pension plans try to provide pensions that are indexed to inflation. But is this assumption valid?


The basket of goods we buy changes rather dramatically with age. The accompanying table gives an idea of just how much. With the contents being so different, there is no particular reason to think the two baskets will always cost the same. Why should the amounts that retirees spend on lawn bowling, bingo nights and hearing aids magically add up to what they used to spend on rock-climbing, pub crawls and designer suits?


Certainly there is no end of anecdotal evidence that people spend less at older ages. My own parents stopped buying durable goods like furniture and even cars after age 75, and it was not for lack of money. Spending dropped even further after 80 when they no longer drove, rarely went to restaurants and stopped travelling. Since their doctor visits and prescription drugs were paid for, their only visible spending other than groceries, utilities and basic home maintenance was on health-related items that are not covered by our health care system.


The challenge is in trying to quantify the rate at which spending declines. An attempt was made by German researchers in the early 1990s. As was expected, the personal account balances of German retirees shrank in their 60s as they applied their savings to produce income. Then something surprising happened: those account balances started to grow again around age 70. After testing various hypotheses, the researchers concluded that people eventually spent less because of physical limitations or lack of interest, not because of a lack of money.


A very recent study shows the same phenomenon is at work in Canada. Statistics Canada’s Survey of Household Spending (SHS) contains detailed data on the spending habits of households by age. McKinsey & Co. has sifted through the SHS and found that household spending drops by more than 40 per cent between ages 54 and 72. Some of that is due to child expenses dropping off, but most of it reflects reduced personal consumption.


In a separate study, a research team in the United States used some very robust data from government sources and found essentially the same thing: spending of retirees rose a little in real terms up until age 66 and then fell steadily from 66 until past 80. How fast it fell depended on education level and marital status, but even in the best-case scenario, spending fell by about 30 per cent in real terms over that period.


Finally, a separate and more recent German study using government statistics found the same thing again: average household spending dropped by 30 per cent between age 55 and 80.


The degree of consistency between these three recent, totally independent studies was uncanny given that they were conducted in different countries by different teams using different methodologies. This consistency makes it possible to propose one set of rates that reflects the spending patterns of middle-income retirees in all three countries. Roughly speaking, spending in real terms falls by about:

  •  1.25 per cent per annum between ages 65 and 70,
  • 1.75 per cent per annum between ages 70 and 80, and
  • 2.75 per cent per annum from age 80 to 85.

For some households, spending did rise eventually if the retiree needed long-term care, but note that (a) fewer than half of all retirees will ever need long-term care; (b) if they do, it tends not to occur until age 85 or later and the stay in a long-term care facility usually lasts two years or less; and (c) not everyone chooses the most expensive long-term care option. Moreover, the cost of long-term care is largely offset by the fact that all other spending ceases.


The important takeaway from these studies is that personal consumption diminishes with age. Provided some conditions are satisfied involving mortgages and grown-up children, my advice is to convert your personal retirement savings into a level stream of income when you retire, rather than an income stream that rises with inflation. This reduces the amount of money you need to save by retirement.

Note that your overall retirement income will still rise each year because the portion of your income that comes from government pensions is fully indexed to inflation. While the rise in overall income will not match inflation, past history suggests it should be enough to meet your evolving needs, as long as inflation remains in the two per cent range.