Not all of your spending is created equal. And it would help if you didn’t pretend like it is.
But it’s distressingly common for people to simply decide they want a certain amount of income each year in retirement and leave it at that. Even leaving aside how our spending changes throughout retirement, it’s essential to think about your spending goals – and specifically how important the different components of our overarching spending goals are.
Not being able to pay for groceries is very different than only being able to fly business, rather than first class, on your third vacation of the year. This matters because how you structure your retirement income plan will depend on how much risk you can tolerate to your income – and especially your most essential income.
Categories of Spending
To think through how important the different pieces of your spending are, there are three big categories:
- Essential Spending
- Discretionary Spending
- Contingent Spending
Before we dig in, let’s define each of these categories.
Essential Spending
Essential spending is pretty much what it sounds like – this is the spending you can’t live without (or aren’t willing to compromise on). You can think of this as how much it would cost to fund your minimum acceptable standard of living. For many, these expenses are things like your mortgage, groceries, and car payments – the spending that would be the last to go.
Discretionary Spending
Discretionary spending is also pretty much what it sounds like – spending you are more flexible on. This is all your planned spending that you would be ok cutting out (though you probably wouldn’t be pleased about it).
Contingent Spending
Contingent spending covers items you aren’t sure about when – or even if – will occur. Examples often include major home repairs or other major one-time expenses. They are unlikely to happen on a regular schedule, so it’s tough to budget for these items specifically, but they are typically pretty important (when you need a new roof, you need a new roof).
People often earmark money for these types of expenses separately from their more “typical” Essential and Discretionary spending.
Spending is a Spectrum
It’s essential to recognize that everyone will categorize their spending differently. One person’s discretionary expense is another person’s essential expense. And, so long as your retirement plan can support it, that’s great.
But more important than whether you officially label an expense as Essential or Discretionary is thinking about just how essential or discretionary that bit of spending is. Within each group, you should be able to rank your spending generally.
You don’t necessarily need to decide whether your mortgage is more essential than your groceries, but you should at least be able to break things into rough bands.
For instance, if you live in a city with good public transportation, you may view your car payment as essential, but it’s probably less essential than keeping your roof over your head. On the other hand, if you live out in the country – where you might be effectively trapped without your car – you may feel differently.
On the discretionary side, the ranking is likely even more apparent. If money gets tight, there are usually certain items that you know you would cut first.
But figuring out how your spending fits this spectrum is essential. Partially, that’s because it’s a good way of being intentional about budgeting and how you want to spend your money, but mainly because of how your spending interacts with your different income sources.
What Income is Backing Your Spending?
Just like there are different types of spending, there are different types of income that you’ll want to consider in your planning. And, coincidentally, they roughly line up with the different types of spending (though you don’t necessarily need to match them up – we’ll get to that in a bit):
- Reliable Income
- Diversified Portfolio Income
- Reserve Assets
To quickly run through these, Reliable Income covers those income streams where you know how much you’ll get and on what day. Typical examples are Social Security, income from a bond ladder, or annuities.
Diversified Portfolio Income is any income you get from your risky assets – typically, this will come from your investment portfolio (as you probably gathered from the name).
And last are the Reserve Assets. These are assets you hold off to the side – those that aren’t earmarked to fund specific expenses – so that you can use them to cover your unplanned (or contingent) expenses without reducing your “normal” spending.
In an ideal world, most people would want to match their essential expenses with reliable income, their discretionary expenses with their risky income, and their contingent expenses with their reserve assets. But this isn’t always possible – and not everyone wants to take this approach.
How Full is Your Bathtub?
A good way to approach this is to consider your spending as a bathtub. You have your most essential spending at the bottom and your most discretionary spending at the top.
And then, we fill the bathtub with our different income sources – starting with our reliable income.
We want to cover our most essential spending with our most reliable income sources. Since those are the ones we are least willing to compromise on, we want to make sure that we cover them with the least risky income.
But it’s pretty unlikely that we’ll completely fill the bathtub with our reliable income. We will likely have to cover some of our spending with our investment portfolio or other risky assets.
A big part of retirement planning is figuring out the balance you want to draw here. How much of the bathtub do you want to fill? In other words, how much of your spending do you want to be covered by reliable income?
Because there is a tradeoff.
All else being equal, risky assets have a higher expected return. And if you are comfortable taking on that risk, that means that those risky assets can support a higher level of spending than if you turned those same assets into reliable income by buying an annuity or building a bond ladder.
So, how high do you want to fill the bathtub? What is the most essential (or least discretionary) spending you are comfortable funding with a risky source of income?
Put another way, you want to understand the risk you are taking with your income in retirement. How much of your income is exposed to risk, and how much is locked in?
Your Answers Will Change
But it’s important to recognize that the relative importance of the different pieces of your spending will change over time – just like your overall level of spending.
Your spending through time will evolve – just like you. You’re not the same person now as you were when you were 35, and you’re not the same person you will be when you are 95. And that’s a good thing. It just means that we need to accept that and work with those changes in our planning process.
What’s Your Approach?
Discovering your retirement income personality by taking the RISA is a good way to start sorting out these different pieces. The RISA can help you identify how you feel about the different types of risk your retirement income might (will) be exposed to and figure out how to structure your retirement income plan to work for you and your situation.
However you approach retirement income, it’s important to think clearly about what you want to spend – and how you value that spending.
You don’t need to be hyper-precise about exactly how essential this piece of spending is or how discretionary that spending is. Trying to be too precise is often counterproductive. But you do want to have a rough order to understand how you are funding your different goals and to ensure you are comfortable with that.
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