Coping with Spending Shocks
As we saw in the last chapter, the Thompsons encountered three spending shocks after retirement. They cut back a little on other spending to offset the impact, but the shocks nevertheless made an already difficult situation even worse. Below, we help them come up with a better method of handling spending shocks.
In general, a spending shock is any significant expenditure that you could not reasonably predict and cannot ignore once it happens. Hence, refinishing your basement after it has flooded would be a spending shock, while renovating that same basement just because you feel like it falls under regular spending.
Not every expenditure is so black and white. For instance, if your grown-up children continue to live at home after you retire, you might consider the higher bills for groceries and utilities to be a spending shock. On the other hand, perhaps you anticipated this unhappy event and gradually built it into your budget. In that case, it is just another item in your regular spending basket.
To inject a little (actuarial) science into the matter of spending shocks, I will turn to a study that was conducted by the Society of Actuaries (SOA) in 2015. In the study, the SOA enumerated the various different types of spending shocks encountered by Americans and how they actually cope with them.a I will focus on the middle-income survey respondents.
The 2015 study was not the first time the SOA surveyed retirees and pre-retirees, but it was the first time the SOA focused specifically on older retirees. The real-life experiences of people who have been retired for 10 or 15 years provide useful insights that cannot be gleaned from theory.
The SOA report listed the various financial shocks that retirees reported. When I looked at the list, the shocks seemed to fall into two major categories. The first category consists of supply shocks in the sense that they all involve a sudden loss of assets and the belt-tightening actions that must follow from such a loss. Using the wording from the report, supply shocks include:
Notice that the supply shocks all relate to investment risk in some way. I will look at investment risk separately, in the next chapter.
By contrast, the spending shocks all required a sudden, unavoidable increase in spending. Table 4.1 shows the list of spending shocks compiled by the SOA. The table also shows what percentage of retirees experience these shocks according to the SOA’s findings.
|
Shock |
Frequency |
|---|---|
|
Major home repairs or upgrades |
35% |
|
Major dental expenses |
26% |
|
Significant out-of-pocket medical or prescription expenses |
8% |
|
A family emergency |
6% |
|
Significant damage to the home due to a fire or natural disaster |
2% |
|
Divorce during retirement |
2% |
Copyright © 2016 by the Society of Actuaries, Schaumburg, Illinois. Reprinted with permission.
In reviewing Table 4.1, three observations come to mind. First and foremost, the financial impact is not that large for the most part. Consider major home repairs, for example. These repairs could include things like re-shingling the roof or replacing the furnace, which could cost as much as $20,000 but, more often that not, will be just a fraction of that. While a $20,000 bill is distressing, it doesn’t arise that often. With a little bit of planning, this is something that retired couples like the Thompsons should be able to handle.
Home upgrades, as opposed to repairs, can cost a lot more, but they are less frightening than repairs for the simple reason that you can opt not to make them. In my own definition of shocks, I didn’t include the expense of an upgrade because you can see it coming and you can change your mind about it if you think you can’t afford it. It’s not as if you walked into your kitchen one morning and discovered workers setting up scaffolding.
Hence, the second observation is that many of the events on the list are not even shocks in the true sense of the word. Even most home repairs should not come as shocks. Roofs and furnaces last only so long and homeowners should not be surprised when they eventually have to be replaced. The oxymoron “foreseeable shock” comes to mind.
Moving on to major dental work, the cost is once again going to be in the low thousands. This might cause you to delay or cancel some discretionary spending — like your next holiday — but it is not going to bankrupt a well-heeled retired couple.
As for medical situations, the chances that the cost will be catastrophic are exceedingly slim in Canada because our universal health care system covers most of the big-ticket items. One study shows that healthcare expenditures of Canadian households at the 90th percentile are about $4,000 a year.b This means that nine times out of ten, such expenditures will be less than $4,000. Now, $4,000 is an inconvenience, but it is not going to lead to financial ruin for a couple that is otherwise well prepared for retirement. Besides, you have to assume that anyone who is spending this much on healthcare will be curtailing other activities, so total spending should rise by less than the cost of the healthcare expenditures.
One of the few truly expensive healthcare expenditures that might not be covered are certain new drugs that can cost $1,000 a month or more. There is some real exposure here, though fortunately the need does not arise very often.
If the retiree insists on going out of the country for medical treatment (especially to the United States), then yes, the bills can quickly lead to financial ruin. This is a matter over which the individual has control, however, and it is seldom done voluntarily except by the especially affluent. If medical treatment is needed while travelling out of country, well, there is no excuse for not having out-of-country emergency medical insurance.
Then there is the matter of significant damage to, or loss of, a home. The emotional shock is real, of course, and some items of sentimental value can be lost, but it should not result in significant financial loss; this is what home insurance is for.
My third observation is that the biggest spending shocks are ones that tend to involve other family members. Divorce after retirement is one of those events. It is not so much the legal costs that set you back, but rather the fact that your assets drop by half while your living expenses drop by only 30 percent or so. I confess I have no solution for this unfortunate eventuality other than to oversave if you feel it is a real risk.
The crises of other family members can also cost you money. One common situation will be a grown-up child coming to you with an urgent need for money — due to business loss or job loss, for example — and needing financial help. If you feel it is your role to be your adult children’s financial backstop well into your retirement when your own resources are limited, it is not my place to tell you differently. Just be prepared to deal with the consequences. I know of retirees who have taken out sizeable mortgages on their homes to bail out a child, even though they have no way of repaying the amount.
You might think I am being a little cavalier in brushing off the impact of the various spending shocks, but the retirees in the SOA survey will back me up on this. When asked about their ability to manage within new constraints (following a shock), 93 percent of the retirees in the top third of the income scale said they managed “very well” or “somewhat well.” Based on their assets, Nick and Susan would comfortably be in this top third. So would most of the target audience for this book. As for the middle third of retirees, 85 percent said they managed “very well” or “somewhat well.”
What we are witnessing here is a widespread phenomenon that is not usually appreciated by pre-retirees or retirement experts who are opining on the needs of retirees. Retirees are amazingly resilient in difficult financial circumstances. They have a great capacity to “get by” when their income suddenly drops or when they encounter a spending shock.
My guess is that if the same survey was conducted in Canada, an even higher percentage of retirees would say they were managing very well. Not only are Canadians better savers and more prudent spenders (at least that is my impression), we have the Guaranteed Income Supplement (GIS) as a backstop. In addition, our so-called socialized medicine is much less likely to result in a major bill to the patient.
What do we do with this information? It appears that most retirees muddle through reasonably well, in spite of the odd retirement shock. They do so even without an elaborate strategy for dealing with spending shocks. They should do even better if they approach the matter a little more scientifically. I suggest that retirees like the Thompsons should set aside somewhere between 3 percent and 5 percent of their spendable income each year, specifically to deal with spending shocks.
This reserve might not totally cover all the shocks that people like the Thompsons might encounter, but it will definitely soften their impact. It would certainly place the Thompsons among the better-prepared retirees. I should add that this is a strategy best suited for middle-income retirees. Those who qualify as “high net worth” should rarely have a problem covering their spending shocks.
If you do set up a reserve, I would strongly suggest using the money only for rainy-day situations. To avoid the temptation of treating it as mad money, you might want to keep it separate from other assets. In the original scenario, Nick and Susan didn’t build a reserve to handle spending shocks. In the makeover, we will assume they set aside 3 percent of their retirement income until age 75 (a little under $2,000 a year, plus inflation). This may not turn out to be enough, but it will at least mitigate the pain of any spending shocks they encounter.
The idea of holding a reserve also helps to explain a mystery. I used to think it strange that retirees would bother saving any money at all and stranger yet that so many of them save as much as they do. They were originally saving for retirement, but now they are retired, what is all that saving for? It appears that many retirees sort of back into the idea of holding a reserve against future spending shocks, whether they know it or not.
The SOA survey did not consider long-term care as a spending shock. Long-term care is a complicated issue that deserves more space than there is room for here.1 Let me say, though, that it tends to be a real financial problem for only a small fraction of the population. Most people will never need long-term care, and many of those who do will need it only for a relatively short period of time, like one or two years.
As for the rest, the very affluent can handle the extraordinary costs as they arise. Those of modest means will have to rely on family members and community care access centres in any event. It is only the people in the middle-income group who need to make some hard decisions. Those with substantial equity in their homes might choose a more expensive option, such as home care with outside caregivers.