A lot of expenses are negotiable, but many just aren’t. You have to buy groceries. You have to pay your homeowner’s insurance premiums. You have to go on that golf trip this winter (this one may be open to debate).

As we’ve discussed in the past, it can be very useful to break expenses down into fixed and variable. Another big way to categorize retirement expenses is as essential and discretionary. Where fixed and variable expenses focus on which expenses can be lowered, essential and discretionary expenses are about determining what costs must be paid and what you could go without in case of an emergency.

What Are Essential and Discretionary Expenses?

Essential expenses are the things you really need to pay for – either because they are necessary to live, or they are meaningful to you. Expenses should be classified as essential if they would be among the last things you’d give up if something happened to your retirement income.

discretionary and essential expensesDiscretionary expenses are the things that you want to do, but are willing to sacrifice if something happened to your retirement income.

Everything you’d be willing to sacrifice before you give up your essential expenses would be classified as discretionary. It’s not that discretionary expenses aren’t important to you, but they’re not among the most important.

But, like most dichotomies, this isn’t truly binary – it’s a continuum. Very few things are truly essential – food, shelter, that’s pretty much it. But there are plenty of items that would really hurt to have to reduce or give up entirely. When sorting essential and discretionary expenses, the goal is to figure out what proportion of your spending is in that “really hurts” group, and how much is spent on things that wouldn’t cause you quite as much pain to go without.

Why Do Essential and Discretionary Expenses Matter?

Just like with fixed and variable expenses, identifying your essential and discretionary expenses helps determine where you can be more flexible with your retirement spending. If another 2008 hits two years after you retire, how much can you dial back your spending so the rest of your retirement plan isn’t thrown off-course?

The more essential expenses you have, the less flexible your retirement spending becomes. If a good amount of your spending is discretionary, you’ll be able to make adjustments without feeling it too much.

So What Does That Mean for My Retirement Plan?

This isn’t just a thought exercise in case things go wrong. It has a real impact on how you structure your retirement income plan. You want to be confident that you’ll be able to pay for your essential expenses, so if you have more of them, you’ll want to incorporate reliable income sources into your retirement income plan.

If more of your expenses are discretionary, you can afford to take more risk. More of your income can come from your diversified investment portfolio. Flexibility is a desirable quality in a retirement spending plan because if (ok, when) we run into a bad market situation in the future, you can adjust your spending to match the situation.

If you understand how much spending flexibility you have, you can build your retirement income plan to match up with the right level of risk for you and get on the path to a secure retirement.

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