Note: This is a work in progress. In this post I’m trying to balance the competing aims of making a technical discussion widely accessible, while not over-simplifying the key points.
The majority of financial information that’s available online is about building wealth. However, when you get to retirement, the next part of the equation is how to spend that wealth to support your retirement lifestyle. (We’re talking about “decumulation” rather than “accumulation”.)
Most people want to become financially independent, and get to the point where passive income exceeds the cost of their lifestyle. (Better yet is to “live off the interest of the interest”. We can dream.)
The reality is that not everyone can get to that place. I won’t go into the mathematics of it, but the economy doesn’t work that way.
If you don’t think you’ll get to a position where your passive income exceeds the cost of your lifestyle, cheer up! Only a small minority of people do. And it doesn’t stop you from enjoying a good quality of life during your retirement.
Think of it this way. Even if you accumulate a significant nest egg by the time you retire, deciding to live only off the returns of your investments means that you’ll have a much lower level of consumption during your retirement than if you spent some of the capital.
If you insist on not spending capital, then you’re committing to spending less than you can get away with. Your children might get a larger inheritance when you die – if your priority is making sure your children fly first class, that’s great. But you could get more out of life.
A simple example: Let’s say you have $1 million, and you generate a constant, after-tax and -inflation return of 3% per year. If you live off your returns, you get to spend $30,000 per year. You could, however, enjoy a lifestyle of $40,000 per year, and you’d still have $200,000 left over after 40 years.
The trick when it comes to spending in retirement is to find a balance between spending too much (and depleting your capital) and spending too little (letting your children fly first class).
For some people, the goal is to spend your last dollar on the day they die.
However, this isn’t simple to do. It’s not something you can “set and forget”.
As I’ve discussed before, there are many uncertainties when it comes to retirement planning – whether you’re planning before retirement or during retirement. For example, you don’t know how long you’re going to live, and you don’t know what will happen to your health.
You also don’t know how your investment assets will perform. Consider this chart from www.firecalc.com, which I discuss in my recent blog post. The short explanation is that each of the lines represents the historical performance of the same investment portfolio over a time period of 30 years – with the only variable being the year the portfolio began.
Each of those lines represents a different retirement experience. As much as I’d love to tell you what your experience will be, I’d be guessing.
All of this reinforces the importance of calibrating your plan over time to fit your changing circumstances.
How much can I spend?
As you can probably gather, I’m not going to give you a figure. But I’ll discuss some ways of thinking about how to spend your money during retirement.
Some people like to think in terms of simple rules of thumb (heuristics). These are discussed in a recent publication by the New Zealand Society of Actuaries.
4% (or 3.5%) withdrawal rate (adjusting for inflation)
The most common heuristic is the 4% withdrawal rate. (Returns have been fairly muted in recent years, so some people have tweaked this to be a 3.5% withdrawal rate.) The idea is that you look at the size of your portfolio when you retire, and withdraw 4% (or 3.5%) of that figure each year of your retirement, and adjust each year for inflation. This gives you a constant amount to spend each year throughout your retirement.
Many people still use this heuristic. It certainly benefits from simplicity. In most historical periods it succeeds in terms of capital not being depleted by the end of a person’s life.
The problem is, sometimes following this heuristic will see you run out of money. Also, it doesn’t accommodate for the fact that most people like to spend more in the earlier years of their retirement. Retirement spending is often thought of being “U-shaped” to reflect higher spending at the start – and higher spending at the end, as health becomes a major factor. (Although as I discuss elsewhere, the end-of-life costs aren’t as high as many people think.)
6% withdrawal rate (not adjusting for inflation)
Another heuristic is the 6% withdrawal rate. The advantage of this over the 4% (or 3.5%) withdrawal rate is that it front-loads spending, to reflect the fact that people tend to spend more in the early years of their retirement.
Using this approach, you don’t adjust for inflation. So you keep withdrawing the same amount, but inflation eats away in terms of what this can buy you. Assuming a 2.5% inflation rate, $100 in 10 years’ time will only buy $78 in today’s dollars, and after 30 years it will only buy $47 in today’s dollars.
Another disadvantage of the 6% withdrawal rate is that you’re more likely to spend all of your capital sooner than you would by, say, withdrawing 4% and adjusting by inflation.
Divide your retirement savings based on your life expectancy
With this approach, you take the value of your retirement savings at the start of the year, and divide this figure by the number of years left until your life expectancy
Stats NZ has a good “How long will I live?” resource. If we consider Stats NZ’s data, a 65 year old female might expect to live to 89.9 – another 24.9 years. Once that female gets to 70 years, she might expect to live to 90.6 – another 20.6 years. Once she gets to 75 years, the expectancy is 91.4 years (another 16.4 years); at 80 years, 92.3 (12.3); 85 years, 93.7 (8.7); 90 years, 95.7 (5.7); 95 years, 98.7 (3.7); and so on.
So basically, a 65-year-old female will look at how much she has, and divide that figure by 24.9, and commit to spending this amount over the next 12 months. When she’s 70, she looks at what she has and divides by 20.6 to get her spending for the year ahead. And so on.
This isn’t a bad approach, but it doesn’t provide much of a buffer if you live longer than you expect or have unexpected costs. In most cases, it also means you won’t leave much of an inheritance to your loved ones.
(You can also simplify this calculation by simply selecting a set age, and dividing your retirement savings by that age. If you live longer than that – you’re relying exclusively on NZ Super. The NZ Society of Actuaries report discusses the pros and cons of this option, but I am not a fan of this at all.)
Dynamic withdrawal approaches
In recent years, approaches have been developed to more effectively link withdrawal rates to the performance of their retirement savings portfolios. There is no definitive approach that is obviously better than all of the others, and I don’t think whether there ever will be. This goes back to all of the uncertainties associated with planning for retirement, not least being investment returns.
The easiest way of thinking about these approaches is that they set some rules, and create “guard rails”. If your investments don’t perform as well as you were expecting, you reduce your expenditure to preserve your capital. If your investments perform better – you can spend more.
I won’t go into different strategies (such as Bengen’s floor-and-ceiling rule and Guyton and Klinger’s decision rules, canvassed briefly in this New York Times article) in detail, but I’ll mention some rules/aspects I like:
- If you’re updating the amount you withdraw for inflation, do not adjust for inflation in any year where your portfolio does not meet a specific benchmark (for example, a positive inflation-adjusted return).
- Calculate your withdrawal rate – ie, the amount you’re withdrawing relative to the value of your investment portfolio – each year. If your withdrawal rate goes outside of an established range, increase or decrease expenditure as appropriate.
(On this note, another strategy some people use is a constant withdrawal rate. This means your income goes up and down in line with the performance of your investments. I’m not a big fan of this approach but it’s worth mentioning.)
I’ll almost certainly come back to this post in the future. But if you want to discuss this, feel free to contact me via my business, Fairhaven Wealth.
- Long-term retirement planning and the uncertain future (speculative)
- How much do I need to save for retirement?
- A journey through three web-based retirement planners
- Retirement planning and whole-of-life planning
- New Zealand Society of Actuaries papers: “Decumulation options in the New Zealand market: How rules of thumb can help“
Retirement Manifesto etc
- Early Retirement Now (blog) – “The ultimate guide to safe withdrawal rates” series (This gets very technical, very quick, and questions many of the sacred assumptions many people use when it comes to withdrawal rates. Parts 9 and 10 on the Guyton-Klinger Rules were influential to me).
- New York Times article – “New math for retirees and the 4% withdrawal rule”