With increasing longevity and uncertainty about healthcare costs, many retirees find themselves afraid to spend their money during retirement, at a time when they are healthy and can enjoy their hard-earned savings. The same challenges that complicate saving for retirement—such as estimating lifespan, predicting portfolio returns, factoring inflation and accounting for unexpected expenses—also make retirement spending decisions complex.
Fearing they might outlive their savings, some retirees underspend, missing opportunities to enhance their quality of life. In this article, we’ll explore key blind spots that may affect retirement spending and demonstrate how mental accounting can help you anticipate and manage these challenges effectively.
Retirement and Happiness
For new retirees, years of ingrained habits focused on saving could make spending feel unnatural or irresponsible. As a result, retirees may prioritize preserving their nest egg over their well-being, avoiding discretionary expenses like travel or dining out. Economic research indicates that retirees who allocate more money to leisure activities tend to report higher levels of happiness. This type of spending can be particularly beneficial in the early years of retirement, when individuals are healthier and better able to travel or pursue hobbies they enjoy.
What may cause underspending?
Men who turn 65 today can expect to live an average of 17 more years—two years longer than men who reached 65 in 1990. This increase in longevity means retirees may need to be more cautious with their spending than previous generations. In addition, two common blind spots could lead to underspending during retirement.
Loss Aversion: Loss aversion is the tendency to feel the pain of losses more deeply than the pleasure of financial gains. It may lead retirees to be excessively frugal, even when they could afford to spend more. As they adjust to living without a steady stream of income, retirees often see their savings balance gradually decline. Each time they check, the lower balance can trigger a sense of loss compared to the previous time. With loss aversion, each withdrawal feels like a loss and people are therefore tempted to spend little money to reduce their feeling of losing money. In addition, longevity uncertainty amplifies the fear of spending due to fear of outliving savings, causing retirees to hoard their assets "just in case." Consequently, retirees may deprive themselves of fulfilling experiences, even when their savings are sufficient to cover a comfortable lifestyle.
Anchoring:With anchoring, exposure to a number—called the anchor—creates a reference point that influences our judgments. For example, widely circulated guidelines, such as saving 25 times one’s annual retirement expenses, provide helpful estimates but may overlook individual circumstances and needs. As a result, some people may fixate on these high target figures, leading them to work longer than necessary, even when their personal situation might allow for an earlier retirement.
Similarly, adherence to rules like the 4% withdrawal rate can create an artificial ceiling on spending, even when market conditions or individual circumstances permit more. Anchoring bias causes retirees to stick to familiar guidelines without reassessing their applicability, potentially causing them to live well below their means and unnecessarily delay enjoyment of their savings.
How mental accounting can help
According to the theory of mental accounting, people treat money differently, depending on factors such as the money’s origin and intended use. They hold different mental budgets for different categories of expenses (food, housing), and assign a specific budget to each account. Even though this bias can undermine flexibility in face of changing needs, in the case of retirement, mental accounting can be beneficial and empower retirees to feel in control of their finances, making spending a deliberate and psychologically rewarding activity. It bridges the gap between rational financial planning and the emotional reality of managing money in retirement.
- Categorizing Savings into Purpose-Driven Buckets: Assigning specific purposes to different "accounts" or pools of money (e.g., a vacation fund, daily living expenses, healthcare costs) can make spending feel more controlled and less risky. A retiree who earmarks $10,000 annually for discretionary expenses (like travel) may feel more comfortable spending that money because it’s designated for enjoyment
- Framing withdrawals as Income: Retirees often associate regular income (like a paycheck) with security, whereas withdrawing from savings feels like a loss. By reframing withdrawals as "monthly income," retirees may feel more at ease spending. Setting up an automatic withdrawal plan that deposits a fixed amount into a checking account each month mimics the structure of a paycheck
- Prioritizing Guaranteed Sources of Income:Mental accounting encourages retirees to see guaranteed income streams (like Social Security, pensions, or annuities) as a "safe" account for spending, reducing anxiety about touching their investment portfolio. A retiree might decide to use Social Security for everyday expenses and a separate investment account for extraordinary expenses, making spending decisions easier.
Conclusion
Striking the right balance between enjoying retirement and ensuring that your savings last can be challenging. Understanding the psychological factors that influence spending, and leveraging tools like mental accounting, can help you approach your finances with greater confidence during your retirement. Consulting with your financial professional can further help you tailor a retirement strategy that aligns with your goals and circumstances, ensuring you make the most of your retirement years while maintaining financial security.