Plan for Unexpected Expenses in Retirement in Three Steps: Addressing the Systematic Underestimation of Accumulation Levels
Author: Mathew Greenwald
In the extensive interviewing I’ve done with financial professionals, pre-retirees, and retirees, I have very rarely heard people mention including unplanned expenses in estimates of how much to save for retirement. Because unexpected and unplanned expenses can be considerable over a long retirement, an estimate that doesn’t incorporate them will lead to an underestimation of how much should be incorporated, leading to unfortunate consequences. This lack of a careful approach to estimating retirement expenses represents a systematic error in retirement planning.
In this blog post, I’ll provide a recommendation for how financial professionals, pre-retirees, and retirees can adequately prepare for retirement.
Considering Unplanned Expenses in Retirement
Greenwald Research has conducted multiple studies on the unplanned expenses retirees encounter. These are the ones we hear about most often:
- Repair and replacement of major household systems, such as a furnace and roof
- Unexpected medical, pharmaceutical, and dental expenses, including hearing aids and other devices
- Unexpected family needs, especially grown children needing money because of a loss of job, a divorce, or mental illness
- Death of spouse
- Long-term care expense
- Major unexpected (yet controllable) luxury expenses, such as the wedding of a child, or a second home or yacht
An unplanned luxury expense is controllable. However, in speaking to financial professionals who’ve worked with these clients, we often see retirees who are unable to withstand the desire to finance the luxury purchase that threatens their retirement budget.
The Consequences of Not Planning for Unexpected Expenses in Retirement
Studies we’ve conducted indicate that people tend to react to an unexpected expense in three ways:
- Pay for the expense and reduce spending to recover from the cost.
- Pay for the expense and then go on with their financial lives, but with a reduced asset level. In some cases, this can result in running low or out of assets prematurely.
- Refuse to make the expenditure.
Refusing to make the expenditure is fine in some instances, but the consequences can be tragic. For example, the Kaiser Family Foundation found that while the need for hearing aids, dental care, and vision care are common among older people, one in six of the elderly are not getting the care they need because they cannot afford it.
Reacting to unexpected expenses in this way can have costly, dangerous implications, including:
- Increasing the risk of dementia.
- Increasing the risk of poor nutrition and other health issues
- Increasing the risk of having a fatal auto accident at night
For many Americans, planning for retirement is focused on saving enough to be able to have a stream of income throughout retirement. But for about half the population, who have a net worth of less than $200,000 at age 65, planning for unexpected expenses in retirement must be the main priority. This group will not be able to generate much of a recurring income from their retirement investments. However, they must have enough money to meet unexpected expenses so they can meet their basic needs and avoid poverty when a spouse dies. For this group, planning for unexpected expenses is all the retirement planning they can do. Retirement plan providers must focus more effort on helping this group of people plan for unexpected expenses.
How to Plan for Unexpected Expenses in Retirement
A useful strategy for dealing with a complex problem is to break it down into constituent parts. The approach I recommend involves three steps that will help retirees and their plan providers think through these issues and come up with an adequate estimate.
Step One: Identify Risks That Are Highly Unlikely or Will Be Manageable
The first step should be to start with the risks that research has shown to occur most frequently. Retirees may add others based on their unique experiences and situations. After compiling this list, retirees can identify those risks they believe won’t occur or will be manageable if they do.
Some people have no risk of having a family-related need develop because they have no spouse or children, or because their children are well-established and there is almost no risk of them needing financial help. No further planning is needed for these risks.
Some people may feel that if their spouse predeceases them, they may suffer the loss of Social Security income. Expenses will decrease in this instance, and the overall impact will likely be manageable. This first step will reduce the list of risks that retirees should consider further.
Step Two: Develop a Plan for Other Unexpected Expenses
Each of the most frequent causes of unexpected expenses has a different impact and needs to be planned for accordingly. Addressing expenses one at a time is the most effective method for having a clear understanding and developing a reasonable plan.
- Major Home Repairs and Replacements
Roofs, furnaces, and air conditioners usually last for a predictable period of time. Businesses depreciate equipment and people should as well. Saving money over a long period to be financially prepared when the need arises is a great place to start.
If you have a roof that’s expected to last 25 years, save up 2-3% of the expected cost every year for the next 25 years, with investment returns making up for inflation and underinvestment. For repairs, purchase warranties, or insurance. Throughout retirement, the cost of repairs and replacements can be considerable. But these are some of the most predictable unexpected expenses and are the easiest to estimate and prepare for.
- Healthcare Costs
Healthcare, including pharmaceutical and dental costs, can be estimated to a considerable degree based on data. The level of risk can be managed to some degree by choosing Medicare Advantage versus traditional Medicare insurance and the use of drug insurance and dental insurance. Financial firms and financial professionals need to provide their clients with the information they need to predict these costs.
- Long-Term Care
A variety of strategies can be developed for financial consequences related to long-term care. These include different levels of long-term care insurance, plans to use home equity to fund long-term care and different levels of dependence on family. The task here is to consider the alternatives and risk tolerance, then use the strategy that fits best.
Most people would prefer to have care at home than to be cared for in a shared room in a nursing home. Yet, many end their lives in nursing homes. People should think this issue through when they’re working and have choices, rather than not addressing it until the need for long-term care has arisen.
- Supporting Children Financially
To a considerable extent, the risk of children needing financial support can be estimated. After all, almost all parents have a deep understanding of their children. A significant proportion of parents can be fairly certain that their children won’t need financial assistance.
Unfortunately, a significant proportion of parents have children who have a significant risk of needing financial support during their adult lives. Most people, perhaps 70%, can make a reasonable estimate of the extent to which the need to financially support their adult children will occur.
- Luxury Gifts
When it comes to luxury gifts, every individual has to make a judgment about how much money, if any, they want to set aside for this expense. Most, of course, do not have the “luxury” of setting aside any money for this purpose. It’ll be hard enough for them to meet their regular expenses.
The best time to think about this is during working years when many people can save more or work longer and build a bigger emergency fund for expenses that might be unplanned at the start of retirement, but will likely be irresistible during retirement.
- The Death of a Spouse
The death of a spouse has a financial impact that can be calculated fairly easily, but it’s still an important consideration. For many, there won’t be a major financial impact because the loss of Social Security income will be more than offset by lower expenses. Women outlive their husbands by a wide margin, and some end their lives in financial insecurity.
In many cases, this risk can be mitigated through more effective Social Security claiming strategies. When the higher-paid spouse dies, the surviving spouse gets the higher of the two benefits. Delaying claiming leads to a higher monthly benefit which is going up with inflation. A higher-earning spouse who delays claiming Social Security from age 66 to 70 will provide a benefit that is 33% higher. That can make a big difference.
Step Three: Finalize the Plan
After going through the first two steps, each individual will have a much better understanding of the levels of risk they face for unexpected expenses and can formulate a plan. The plan won’t inoculate them from the risk of unexpected expenses, but it will give them a better sense of the costs that may arise. More importantly, it will help them decide how much to save for these emergencies. The planning I’m suggesting isn’t time-consuming and won’t cost anything. But the payoff for this level of planning will contribute to a more financially secure and enjoyable retirement.
I welcome any conversations around the approach I’ve suggested for addressing this common omission to retirement planning that has led to a systematic underestimate of how much should be saved to gain financial security throughout retirement.
If you’re interested in discussing how to help your clients better plan for unexpected expenses in retirement, contact us.
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