Do you daydream about spending long, sunny afternoons in retirement, mesmerized by the waves as they roll onto the beach? Maybe a lake house is more your style, along with a boat for skiing, fishing, or just relaxing on the water with friends and family. Or are you a mountain person who envisions a cozy cabin, tucked onto a forested hillside with a view of the valley below? For some, a vacation home in retirement that can offer opportunities for both restorative personal time and a venue for memory-making with children and grandchildren is a longed-for lifestyle feature.
Others dream of extended travel: spending weeks at a time touring the world’s great cities or enjoying adventures in more natural settings like an African photo-safari or a tour of America’s national parks.
Naturally, though, dreams like these come with a price tag (or several). So, for those planning retirement and also wishing to create “fun” experiences for themselves and others, it’s important to build major lifestyle expenditures like these into the retirement spending plan.
What is lifestyle inflation and how does it affect retirement?
Even if we’ve never specifically labeled it, we’re all familiar with lifestyle inflation: the phenomenon where discretionary expenditures tend to increase as income grows (and, too often, the former grow at a faster rate than the latter). During much of our lives, a certain amount of “lifestyle creep” is unavoidable; when children come along, for example, household expenses almost always rise (and that’s before education expenses are accounted for). Much of the time, we can compensate by achieving promotions and raises or exploiting additional sources of income. But in retirement, when budgets tend to become more “locked in” as we begin spending down retirement savings, lifestyle inflation can be more problematic.
The challenge can be especially steep during the “go-go” years of early retirement, when healthy, active retirees often spend significantly more on travel and other activities. Additionally, “ordinary” inflation, combined with rising healthcare costs (which historically exceed general inflation) mean that purchasing power can deteriorate by thousands of dollars each year. So, in addition to budgeting for the increasing costs of everyday expenses like housing, food, transportation, and healthcare, retirees who intend to include “fun” lifestyle spending may need to build in significantly more to their retirement spending plans (and the earlier they can start, the better).
Can I afford a vacation home in retirement?
The strong runup in vacation home prices that occurred during roughly the same period as the pandemic has eased over the last several years, most notably due to rising interest rates and increased insurance costs. Those with the means may be seeking to secure property in an ideal location during this period of lower demand. But there are several matters that deserve careful consideration.
Remember that second homes don’t receive the same type of consideration by lenders that primary homes do. Because they are viewed as more risky, mortgage interest rates for second homes tend to be higher (and in today’s uncertain interest rate environment, that’s something to think about). It’s also not unusual for lenders to require a down payment of 20–25% for a second home, as compared with the 3.5% required for FHA primary home loans.
If, for example, you decide to purchase a $500,000 property, you’ll need to put down at least $100,000 to get started. If you get a 30-year fixed-rate mortgage at the current average interest rate of 6.61%, that puts your monthly principal and interest payment at $2,557; you can probably figure another $700–900 per month for taxes and insurance.
But the costs don’t end there. If you want to use the property to generate income, you’re probably going to need the services of a property manager who can help you advertise the property and deal with renters. Also, unless you live nearby and have good plumbing, electrical, and carpentry skills, you’re going to need someone to look after basic upkeep, just as you do with your primary home. A property management service is likely to charge 8–12% of monthly rental income, and perhaps a somewhat reduced fee if the house is vacant, depending on the particulars of your agreement. That typically doesn’t include the cost of any repairs or maintenance, which can run another 1–4% of the home’s value, each year, or anywhere from $5,000–$20,000 in our example.
Of course, you also have to consider the flipside: the property’s appreciation in value. Though real estate prices have cooled off from their recent blistering pace—largely due to the increased costs imposed by higher interest rates mentioned earlier—real estate is likely to continue to rise in price for the long term, especially in the types of desirable areas where vacation homes would likely be situated. Especially for those in or approaching retirement who have a good understanding of real estate investing, this prospect can easily offset the expense considerations above. For those who don’t necessarily plan to pass the second home on to their children, the opportunity to reap a tidy profit—net of expenses—after five to ten years of ownership and enjoyment can make the picture even rosier. You will need to keep in mind, however, that the capital gains exemptions that apply to the sale of primary residences are not the same when selling a second home.
How do I know if a big purchase will derail my financial plan?
So, if you’re planning a major “fun” expense in retirement, whether it’s a vacation home or a more modest purchase like a boat or extended travel, it’s important to do some careful analysis and forecasting, along with taking a realistic look at your retirement budget, both before and after the purchase. With the help of your financial advisor, you may want to conduct a spending stress test to evaluate the impact of your purchase on the sustainability of your desired retirement lifestyle.
The first step is to identify your variables: Which expenses are baseline costs (housing, food, other essentials), and which are discretionary expenses that can be cut back during periods of poor market returns or other reductions to income? Ask yourself:
- How much is my regular monthly income (sources like Social Security, pensions, or annuities), and what percentage of my baseline costs does it cover?
- How large is the gap between my regular income and my regular expenses (the amount that must be covered by withdrawals from the portfolio)?
- What is the anticipated effect of inflation on my baseline expenses (don’t forget about healthcare), and how will that affect the gap to be covered by portfolio funds?
Next, you may wish to run several simulations (likely with the assistance of your financial advisor) to help you forecast the sustainability of your basic retirement budget under various market, economic, and personal scenarios (such as various lifespan projections or an unexpected change in health). The simulation can allow you to plug in the anticipated cost of your lifestyle purchase to see how it affects the likelihood of your ability to continue funding your retirement lifestyle.
At Optima Asset Management, we place our highest value on having real-world conversations with our clients about important financial decisions. If you’re wondering about the sustainability of your retirement plan or considering a major lifestyle purchase, we can help you do the analysis that can give you more confidence in your decision. Just let us know how we can help.
