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If you are designing a retirement income plan, one of the things you'll need is an estimate of how much income you'll require each year, once you've stopped working. But how do you come up with a number?

One way to go about this is to simply select a percentage of your pre-retirement income – called the "replacement rate" – and assume that's what you need in retirement. Another method is to determine a so-called "safe withdrawal rate" as a percentage of your investment portfolio.

In both cases, the yearly amounts are assumed to be adjusted upwards for inflation – meaning the real (after inflation) change in spending from year to year is actually zero, and spending is expected to be flat over your retirement.

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But how realistic is it that retirement spending – for you or anyone else – will remain at the same level throughout your golden years?

The retirement spending smile

Detailed research from the U.S. suggests that spending in retirement doesn't follow a steady decline, but creates a pattern that looks like a smile: it declines slowly in the early years of retirement, then more rapidly in the middle years, and then less slowly in the final years. The report doesn't attempt to figure out in any depth why expenditures change, just notes that it does. (Researchers in Canada have also found that retirement spending gradually decreases with age.)

Going one step further, this same U.S. research suggests that spending in retirement changes based on whether a household's net worth matches its spending rate. That is, households can have both high net worth and high spending, or low net worth and low spending -- or a household's net worth can be "mismatched" between high and low spending rates and net worth.

Matching spending and resources

This table shows what happens to spending in retirement when households are categorized in this way:

Household net worth

Retirement spending

How does spending change in retirement?

HIGH

LOW

increases over time

HIGH

HIGH

decreases over time

LOW

HIGH

decreases “considerably” over time

LOW

LOW

increases over time

Source: David Blanchett, Estimating the True Cost of Retirement (Chicago: Morningstar Investment Management, 2013).

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Here's how to think about the results in the table: Households with "matched" spending and net worth experience fewer changes to their spending in retirement over time. That is, a high spending rate, when coupled with a high net worth, can be maintained over your retirement. Similarly, households with low total wealth experience smaller spending decreases over time compared to other households, as long as their spending rate is low as well.

In contrast, households with "mismatched" spending and wealth experienced spending declines over the course of their retirement – and in the case of the "low" net worth households with "high" spending, they experienced the biggest declines of all.

Start low…so you can increase as needed

The takeaway? The best way to protect yourself against big declines in spending over your retirement is to start with a low spending rate (relative to your net worth). In that way, your spending has room to increase, if you need it to.

The good news, for current and future retirees of all kinds, is that budgeting your spending in retirement is the element of your retirement plans over which you can exert the most direct control.

Alexandra Macqueen, CFP teaches and writes about finance in Toronto. She is co-author of Pensionize Your Nest Egg: How to use Product Allocation to Create Guaranteed Income in Retirement (Wiley 2015). You can follow her on Twitter at @MoneyGal.

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