Participant Spending Behavior Plays Role in Selecting QDIA, Guaranteed Income Solutions

When providing qualified default investment alternatives and retirement income options for participants, plan sponsors need to consider plan participants’ dynamic and variable spending behaviors before and during retirement, according to J.P. Morgan Asset Management.

After analyzing data from 280,000 households that bank with Chase, J.P. Morgan found three spending surprises, which include a lifetime spending curve, a retirement spending surge and spending volatility throughout retirement.

Spending Curve

As people age, J.P. Morgan concluded in the research, spending patterns change significantly and do not uniformly rise with inflation. Instead, the asset management and banking firm observed a peak in spending at mid-life and then a gradual decline in total spending over time.

However, costs associated with health care were most likely to rise later in life. Older households (age 65 and over) tend to spend more on health care and charitable gifts than younger households—but significantly less on everything else.

Looking across the range of households in the data set, J.P. Morgan found that plan participants are generally spending less than expected. For example, in partially and fully retired households with investable assets of $250,000 to $750,000, the annualized inflation-adjusted change in spending was just 1.65%.

Sharon Carson, executive director of retirement insights strategy at J.P. Morgan Asset Management, says historically, household spending has not kept up with inflation. However, she says it is important to take into account that retirees spend more money on health care, which is a higher-inflating good. But even with taking health care into account, spending growth still tends to lag inflation. As a result, she says it is important for investors to not overweigh their inflation risk.

“You do need to take inflation into account, but it’s important that [plan sponsors] balance their view,” Carson says. “You don’t want people to be super risky right at retirement [because] if there’s a market downturn at that time and they’re spending at that time, it could be very detrimental as they take money out [of their retirement account].”

Carson emphasizes that the “sequence of return risk”—when early and unexpected withdrawals combined with bad returns early in retirement can increase the likelihood of running out of money—is important for plan sponsors to consider when selecting a QDIA, such as a target date fund.

In addition, the report noted that sponsors need to consider the possibility that retirees may opt to liquidate market holdings at the wrong time if they are invested too aggressively just before retirement.

Carson adds that the firm’s spending curve does not completely reflect the impact of long-term care costs.

“Long-term care [is] a very idiosyncratic risk, and it’s hard to plan for because it’s not an annual expense,” Carson says. “Some people have it, some people don’t.”

For those who pay for long-term care, more than one quarter spend less than $25,000, and slightly less than one-third spend more than $250,000. Not surprisingly, families with higher incomes tend to spend even more on long-term care.

Spending Surge

On average, J.P. Morgan’s data showed that post-retirement spending temporarily increased for partially retired households with pre-retirement income of less than $150,000.

When looking at households that started to draw retirement income between the ages of 60 to 69, fully retired households transitioned from work-related income to complete reliance on retirement income. Partially retired households, however, continued to receive some income from employment while drawing 20% or more of their household income from Social Security, pensions or annuities.

J.P. Morgan only classified a household as partially retired if its labor-related income was less than 95% of pre-retirement income.

These partially retired households also spent more in the years preceding retirement and overall had more credit card debt and lower savings balances, J.P. Morgan found.

“But once they go to that partially retired state, [many households] started paying off some of their credit debt and they [started building] up savings,” Carson says. “So not only are they spending more, but they seem to also be using that time to get on better financial footing.”

In addition, partially retired households tended to spend more post-retirement than their fully retired peers.

For those households most likely to experience a surge, the increased spending was largely on health care, apparel, food and beverages. These households were also more likely to have credit card debt and lower cash balances than households that fully retired with the same pre-retirement income. This signals to plan sponsors that participants need help managing their debt and spending at earlier ages to prepare for retirement.

Partial retirement also suggests the need for flexibility in timing for any guaranteed income options that plan sponsors may be considering, as participants vary regarding when they want to start withdrawing retirement income.

Spending Volatility

Six in 10 households experience some form of spending volatility in the first few years of retirement, according to the research.

While volatility lessens somewhat as households move deeper into retirement, it does not disappear, as volatile spending patterns may linger, even for the fully retired cohort, in the years before most long-term care expenses start—often after the age of 80.

An implication of this volatile spending is that it can create short-term liquidity needs and exacerbate long-term funding risks.

As a result, J.P. Morgan argued in the report that plan sponsors should offer solutions that help participants manage risk at the beginning of retirement, when balances are typically highest and sequence of return risk is greatest.

When offering a guaranteed income solution, plan sponsors should also consider that participants may need sufficient liquidity and flexibility to adjust to changing circumstances in retirement.