A few weeks ago, I gave you six ways to make your nest egg last. It’s an important topic, so here’s a seventh: Dynamic Spending. There’s a growing body of research that shows it can significantly extend the life of your portfolio. What is it and how does it work?
In retirement, like in your working years, your budget will include both fixed and discretionary expenses. Fixed expenses are things like food and your mortgage. Discretionary expenses include things like travel. In retirement, many of your fixed expenses are gone. Your house and cars are likely paid off. The kids are out of college. You’re no longer saving. Fixed expenses make up a smaller portion of your budget than ever. Your discretionary expenses are another story. Most retirees have a long list of travel, hobbies and other things they want to do.
That type of budget—low fixed, high discretionary—is ideal for dynamic spending rules. As the name implies, dynamic spending is simply adjusting your spending each year based on how your portfolio is doing. You establish rules that give you a raise when times are good and cut back a little when times are tough. The adjustments don’t need to be large to be effective and, as we saw earlier, spending adjustments are easier in retirement because a larger portion of your budget is discretionary.
How it works.
Vanguard did some research in this area and found evidence that dynamic spending rules can greatly improve success. What they tested was a hybrid distribution strategy that was basically a percentage withdrawal of the previous year’s portfolio value with adjustments based on certain rules. They would allow the spending to adjust each year based on year-end value, but would limit it to a ceiling and a floor. This allows your spending to rise as high as the ceiling when times are good and adjust downward as far as the floor when times are bad.
Let’s look at a quick example. Assume a $1 million portfolio and a 4% withdrawal rate, so the first-year distribution is $40,000. Now for next year, they would calculate a ceiling and a floor 5% above and 2.5% below that $40,000. So the ceiling is $42,000 and the floor is $39,000. Now let’s assume we have a big up market and the portfolio value is $1.1 million. 4% of that would now be $44,000. That’s above the ceiling, so you limit your withdrawals to $42,000. What if instead the portfolio had a bad year and it dropped to $900,000. 4% of that is $36,000. That’s below the floor, so you take the floor amount of $39,000. Basically, you’re giving yourself a raise during good times or taking a pay cut during bad times, but you are limiting each by predetermined amounts. This strategy had a 92% success rate vs. the 78% success rate of just taking a dollar amount grown by inflation. That’s a huge jump, all because you set a few simple rules that help ensure you don’t overspend (and risk running out of money) or underspend (and risk not living to the full).
“Will my money last?” That’s the biggest concern for most retirees. What can you do to stretch your retirement dollars for as long as possible? A recent article in the Journal of Financial Planning (JFP) analyzed six factors and the role each played in portfolio longevity. (Determinants of Retirement Portfolio Sustainability and Their Relative Impacts, by Jack C. DeJong Jr., Ph.D., CFA; and John H. Robinson). Let’s take a look at each:
Initial withdrawal rate
The less money you take from your portfolio each year, the longer it will last. No surprise there. What is somewhat unexpected, however, is that the withdrawal rate that is considered “safe” is shrinking. Thanks to lower assumed bond rates, the long held 4% rule should probably be renamed the 3% rule for those who need their portfolio to last 30 years. That’s one conclusion reached by the JFP article and it is backed up by other studies from respected researchers like Michael Kitces and Wade Pfau. So if you anticipate a long retirement, and you think bond rates will stay near their historic lows, it’s probably a good idea to dial back your initial withdrawal rate. If, however, you saved more than needed, retire later or have health issues that shorten your retirement (e.g. 20 years instead of 30) the 4% rule will likely hold.
The Fed’s decade long experiment with low interest rates has been great for borrowers, but terrible for retirees. Generating income is harder than ever. When the initial research was done for the 4% rule, mean bond rates were around 5-6%. Now they are much lower. Lower returns mean your portfolio won’t last as long. It looks like rates will stay low for the foreseeable future. Plan accordingly.
Retirees typically invest in both stocks and bonds so they can balance out the need for growth with the need for stability. What’s the right mix? Several recent studies seem to suggest that dialing up stock exposure a bit (say from 60/40 to 70/30) might help improve portfolio longevity. Before taking that advice, however, I think there are three important considerations. First, what is the likely future return of stocks? The studies assume a lower return for bonds, but assume future stock returns will be similar to past stock returns. When stocks are as richly valued as they are now, however, future returns are generally lackluster. Second, how will you respond in the face of increased volatility? The studies assume that retirees will calmly ride out any increased volatility from the higher stock allocation. That flies in the face of what we know from both behavioral finance studies as well as the long running Dalbar study on investor behavior. Volatility often causes people to do the wrong thing at the wrong time. Third, how much return do you need? If you haven’t saved enough, it can be tempting to swing for the fences and heavily overweight stocks. If you nest egg is adequate, however, it might make more sense to swing for singles and doubles rather than risk striking out. The takeaway from all this? Don’t take the added risk unless necessary. And if you decide to increase your stock allocation, wait for a good opportunity, such as after a market correction. Stocks will be cheaper and bonds will likely have rallied.
Inflation mutes your investment returns and diminishes your purchasing power. For retirees, low inflation is better and will help portfolios last longer. You can’t control the inflation rate, but it’s helpful to know what it is. We’re currently in a prolonged period of low inflation around 1-2%. That can help improve portfolio longevity and offset the lower expected returns discussed earlier.
Investment expenses act as a headwind against returns, so it’s important to a) keep them as low as possible and b) make sure the people you hire are adding value. In a large study on the value of advisors, Vanguard concluded: “Left alone, investors often make choices that impair their returns and jeopardize their ability to fund their long-term objectives.” This type of behavior often leads to “wealth destruction rather than creation.” Vanguard suggests that advisors can help add value if they “act as wealth managers and behavioral coaches, providing discipline and experience to investors who need it.” Specifically, they say to look for an advisor who can help with things like asset allocation, security selection, behavioral coaching and distribution strategies. According to Vanguard, those things are worth about 3% per year in net returns. In other words, a good adviser creates value, but has reasonable fees. The JFP article found that portfolio longevity is greatly improved when expenses are limited to around 1%, but diminish significantly when expenses rise beyond 2 or 3%.
Distribution strategies come in lots of different flavors, but the goal is usually the same: turn your assets into an income. The JFP article tested 4 different withdrawal strategies: a) spend stocks first, b) constant allocation, c) simple guardrail and d) spend bonds first. Most of those are self-explanatory except the guardrail strategy. With that strategy, withdrawals are taken proportionally from stocks and bonds with one exception. No withdrawals are made from stocks following a down year. Most retirees use the constant allocation strategy (draw from asset classes proportionally and rebalance each year), but the study found that the two strategies with the highest success rate were spend bonds first and the guardrail. Both strategies reduce the likelihood that you’ll have to sell assets for a loss during the early years of retirement which, not surprisingly, will help your money last longer.
When planning for retirement, you need to make a lot of assumptions. How long will you live? What will your investment returns be? How much income will you need? When it comes to that last one, most people just estimate their first year of retirement expenses and then adjust that amount higher each year to account for inflation. This seems like a logical strategy. It’s predictable. It provides a steady income. It gives you a raise each year to account for rising costs. There’s just one potential problem. New research shows it’s not how the typical person spends money in retirement.
New spending research
David Blanchett, Michael Finke and other academics have studied how spending changes throughout retirement and what they found might surprise you. Rather than starting at a certain amount and then moving higher with inflation, people spend more in their early years and then gradually decrease spending as they get older. This trend typically continues until later in life at which point healthcare costs cause spending to rise again.
Why is this important? First, your retirement plan is driven by assumptions and perhaps the most important assumption of all is how much you need to spend each year in retirement. If you have that number wrong, your plan won’t be as accurate as it could be.
Second, most people, planners and software assume a static rate of spending in retirement that needs to increase every year with inflation. If that’s not correct—and real spending gradually decreases instead—then we’re overstating the cost of retirement. That means you might be able to retire sooner, retire with less or take a higher distribution rate. Here’s an example to show you what I mean.
In his research, Blanchett found that a household that needed $50,000 in income at age 65 would decrease real spending by about 15% by age 80 and 20% by age 85. Let’s assume you retire needing $50,000 in income and you plan on getting half of that from Social Security and half from portfolio withdrawals. Even if your spending goes down, your Social Security won’t, so any spending reductions can be used to reduce portfolio withdrawals. So if you want to decrease total spending by 20%, then you can decrease your withdrawals by 40%. That means less strain on your portfolio which, as mentioned earlier, means you might be able to retire sooner than expected, retire with less, or spend a bit more early in retirement when you’re healthy and active, knowing that you’ll decrease spending later.
There are some important ways that you can incorporate this new spending research into your planning.
Make a Core/Discretionary budget: Not all spending changes equally during retirement. Certain core spending on things like food and housing will be with you throughout retirement and are more likely to increase with inflation. It is your discretionary spending—such as travel and entertainment—that will likely decrease as you move through retirement. To better predict how your spending will change, make a budget that itemizes core spending (e.g. grocery money) and discretionary spending (e.g. travel or a new car).
Shrink core expenses: Once you know how your spending breaks down, get rid of as much core spending as possible before entering retirement. Housing is the largest retiree expense and more and more people are retiring with mortgage debt. This is especially easy to justify in a low rate environment. But the downside of servicing a mortgage in retirement is that you’re not servicing it from your paycheck, you’re servicing it from your investment portfolio. If your portfolio drops, you still need to pay your mortgage. That means selling into weakness and increasing your odds of running out of money. Core spending is riskier because there’s little flexibility. Discretionary spending, however, tends to decrease as you move through retirement and you can adjust it if necessary (e.g. postpone your vacation if the market drops).
Rethink your distribution rate: In Blanchett’s research, he found that a 4% initial withdrawal rate over 30 years under the constant spending model has the same approximate probability of success as a 5% initial withdrawal rate if spending changes as discussed earlier (assuming $50,000 in initial spending). If you can take 5% instead of 4%, then you would need 20% fewer assets when you retire. For example, a 4% withdrawal from a $1,000,000 portfolio gives you the same dollar amount as a 5% withdrawal from an $800,000 portfolio.
Stay healthy: Obviously you can’t prevent all illness, but do everything you can to be healthy. This will improve your odds of a long, active retirement and can delay or even eliminate some of the health costs that cause spending to rise later in retirement.
Insure against rising costs: You might be asking, “Why do health costs rise later in retirement? Doesn’t Medicare cover those expenses?” Medicare covers a lot of things, but with very few exceptions, long-term care—where you need help caring for yourself—is not one of them.
What are the chances you’ll need this type of care? Seventy percent of the people who reach age 65 eventually require some form of long-term care. Those are good odds. It reminds me of the time I picked up a rental car in Dublin. I found out the car was a stick, the steering wheel was on the right, you drive on the left, and the place we were going only had single lane roads. The guy behind the counter asked <insert Irish accent> “Are ya gonna be wantin’ the insurance today then?” “Yeah,” I said. “Better give me everything you got. There’s a good chance you won’t be seeing that car again.” The lesson? Insure against bad things that are likely to happen.
Enjoy life: There’s a good reminder embedded in the research we’ve been discussing. If spending decreases as you move through retirement, then for whatever reason, the typical retiree is doing less—either by choice or necessity—at 75 than at 65 or at 85 than at 75. If you retire at 65 and stay healthy and active until 75, then you’ve got 10 years to do everything you’ve been putting off for the last 40. That’s not much time. Be ready to hit the ground running when you retire. Yes, that means the early part of your retirement will be a little more expensive, but if incorporate this new spending research into your plan with the help of a competent adviser and the results hold up, then you should be in good shape.
Not long ago, most people worked as long as they were able and eventually either “died in harness” or relied on younger family members to care for them in their old age. And then along came this idea of retirement where through hard work, shrewd investing and some help from a pension (if you’re lucky) and Uncle Sam, you could hang up your work boots a little early and spend your golden years enjoying a bit of leisure and fun. But for most people, the math of retirement only works if they’re able to earn some interest on their savings. That is a challenging task in a world where Central Banks the world over seem to have declared war on savers. What does this mean for the long term viability of your retirement? In other words, are low interest rates ruining retirement? More importantly, what can you do to keep your plans on track?
The 4% Rule
Back in the early 1990s, a financial adviser by the name of William Bengen did research on sustainable portfolio withdrawal rates. Assuming an asset mix of half stocks and half bonds, he back tested withdrawal rates against historical 30 year periods in the market. His conclusion was that if you wanted your portfolio to last 30 years, the maximum withdrawal that you should take each year is 4%. That rate has worked well for millions and many assume it will continue to work great unless future returns are significantly worse than past returns. Enter the Central Banks.
ZIRP and NIRP
The global economy has been stuck in slow growth mode since recovering from the near death experience of the 2008 financial crisis. To stimulate growth, Central Banks around the world lowered rates to pretty much zero and engaged in endless rounds of quantitative easing. When that didn’t work some of them started adopting negative interest rates. That’s right, zero apparently wasn’t low enough. Now they’re moving to negative. ZIRP (zero interest rate policy) has given way to NIRP (negative interest rate policy) in countries such as Denmark, Sweden, Switzerland and Japan. The logic is to force banks to lend, weaken currencies to help exports and stimulate economies. Not surprisingly, there are a lot of people who think these policies could come with some pretty significant unintended consequences, not the least of which being that it will be pretty tough for savers, pension funds and governments to meet those future withdrawal needs if large portions of their bond portfolios are earning zero instead of the 4%-5% that history has taught us to expect.
The $64,000 question (more like $64 trillion) is whether or not these low interest rates will derail retirees and the portfolios, pensions and Social Security program that they rely on to fund retirement. I can say with certainty that…it depends. If these low rates are an anomaly and they eventually return to normal, then the 4% rule of thumb that retirees rely on and the return assumptions that pensions rely on can continue to work. But if they stay this low for a long time, then retirement as we have come to know it is at significant risk. Which will it be? My gut tells me that rates will eventually rise and the 4% rule will continue to work, but it makes sense to plan for the worst even while hoping for the best.
What to do
There are several levers you can pull in order to improve your odds of success. Some are better than others. One side effect of ZIRP has been to force people into riskier investments in search of returns. That works great until it doesn’t as we saw recently when markets rang in the New Year by plummeting. Another side effect of ZIRP has been to encourage individuals, companies and countries to take on more debt. That can also work for a while, but debts eventually needs to be repaid. Are there better options?
Draw less. If a 4% withdrawal rate is too high, the most obvious way to protect yourself is to take less than 4%. I have some clients that are taking 2%-3%. Some are even taking 0% because their pension and Social Security cover their expenses. There is an extremely high probability that those taking less than 4% will be fine even if rates stay low for a long time. Of course drawing less only works if the amount you’re taking is enough to cover your expenses. That might mean you need to…
Cut retirement expenses. Examine your retirement budget for items you can reduce or eliminate. Housing and transportation are often major expenses. Consider downsizing to a smaller home or sharing a car with your spouse. Staying active and healthy can save on health care co-pays and prescription costs. Substituting planned hobbies or activities with less expensive alternatives also can trim costs without significantly changing the quality of your retirement. Taken cumulatively, these adjustments to your retirement budget can help reduce the strain on your nest egg and still provide a meaningful retirement.
Save more. Spending less is one option, but you could also improve your chances if you save more (assuming you’re not already retired). Recent research by Aon Hewitt and others shows that a person will need Social Security plus savings worth about 11-12 times their annual income in order to fund their retirement. If interest rates stay low, that multiple will be higher. If you are still working, make saving a high priority. Both 401(k)s and IRAs have higher contribution limits for people over 50. Take advantage of those limits by putting away as much as possible. The maximum 401(k) contribution for 2016 is $18,000 plus an additional $6,000 if you’re over 50. IRA contribution limits are $5,500 plus an additional $1,000 if you’re over 50. Extra additions to your portfolio could significantly improve your financial position in retirement.
Pay off debt. As I mentioned earlier, one of the unfortunate side effects of low interest rates is that the Fed is punishing savers and encouraging debtors. Debt can make sense if it’s used to purchase an asset that generates income such as a new computer for the office or a college education. Last I checked, however, a $60,000 SUV or a gourmet kitchen aren’t income producing asset for most people. When used unwisely, debt adds risk and reduces cash flow. Those things are especially troublesome to someone in retirement. By retiring debt free, you can greatly reduce the amount of savings necessary to fund your retirement.
Work longer. Working longer may not sound fun, but neither is running out of money. If low rates reduce the viability of your retirement plan, one option is to keep working and earning a paycheck. This strategy has multiple benefits: it allows you to save more, it gives your portfolio more years to grow, it could help boost your potential Social Security benefits and it decreases the overall amount of income you need to draw over the years. Of course this assumes that working longer is an option. Don’t put all your eggs in that basket in case your health doesn’t cooperate or your job skills don’t translate well in a changing world.
Delay Social Security. If you delay collecting Social Security until after your full retirement age, you will get a permanent increase in your benefits. The increase is based on the year you were born. For example, those born after 1943 will get an 8% credit for each year they wait. The increase caps out at age 70, but waiting until then will increase your benefits significantly.
Obviously, we have to deal with the world as it is, not how we want it to be. When I started my career, you could buy a 1 year CD yielding 7%. That made retirement planning much easier. Now you’re lucky if you can get 1% on that same CD. That’s just the world we live in and there’s a chance that it could persist for some time. Plan accordingly and you’ll greatly improve your odds of retirement success.
Some people have the time, temperament, knowledge and discipline to handle their own finances, while others could use a little help. Regardless of which category you fall into, you should seriously consider hiring an adviser to help you when it comes to retirement. Why? Because the financial issues facing a retiree are very different than the financial issues facing a pre-retiree.
Whether we do it or not, most of us are at least familiar with the concept of saving. Saving is a pre-retirement issue. We’re usually less familiar with concepts like cash flow management, determining how much we need to retire, pension payout options, retirement plan distributions, estate planning, maximizing Social Security, researching and obtaining health insurance and the tax consequences of certain distribution strategies. Those are post-retirement issues. Those are issues that most of us don’t deal with very often, so getting a little help is probably a wise move.
To help people evaluate their retirement knowledge, The American College of Financial Services recently developed a retirement literacy quiz. They gave the quiz to 1,019 Americans ages 60 to 75 who had at least $100,000 in assets. How did they do? Eighty percent of the people failed. Ouch! Fourteen percent got a Gentleman’s D. Less than one percent got an A. Those results reaffirm the point I was making earlier. Most people aren’t familiar with the types of financial issues that they will be dealing with in retirement and could benefit from some help.
I’d encourage you to take the retirement quiz and see how you do (Full Disclosure: I got 100%, but hey, this is what I do for a living!). Hopefully long time readers will do better than most since I’ve written on many of the topics before, but if you miss your fair share, consider reaching out for some help. Maybe that means hiring an adviser. Maybe it just means browsing past articles in our Archives or picking up a resource from our Store like The Ideal Retirement Design Guide. Bottom line: get some help if you need it. Don’t let mistakes derail your retirement.
Will retirement be cheaper than you think? Maybe. A lot depends on your income replacement ratio. What’s that you ask? It’s the percentage of your current income that you will need during retirement to maintain your standard of living.
Some people will need 100% of their current income. Others will be able to get by on less. Ironically, the more money you make now, the lower your income replacement ratio will likely be. That’s because you probably aren’t using all of your current income for expenses that will still exist during your retirement years.
Here are three major expenses that will likely disappear from your retirement budget:
Savings: Retirement is a shift from the accumulation phase to the distribution phase. That means no more 401(k), IRA or savings account contributions. How much are you saving now? Five Percent? Ten? Fifteen? Once you’re no longer saving, you won’t need that income.
Payroll taxes: Looking at the glass half-empty, retirement means no more paycheck. Looking at the glass half-full, that also means no more Social Security and Medicare taxes on your earned income. Right now you’re paying a 6.2% Social Security tax on your first $114,000 in income and a 1.45% Medicare tax on all your income (7.65% total or twice that if self-employed). And if you’re a high-wage earner ($200,000 for singles, $250,000 for couples) you’re paying an additional 0.9% Medicare surtax. Those taxes go away when your earned income goes away.
Work expenses: Think of all the expenses you have that relate to your job: commuting, dress clothes, expensive lunches, a second car. Most of those expenses can be reduced or eliminated in retirement, which is probably the equivalent of hundreds of dollars each month that you can cut from your budget.
If I apply those three items to my own budget, I could eliminate more than a quarter of my expenses. How about you? How much could you get rid of? I’m guessing the amount is significant. If you’re able to pay off your house and retire debt free, you could eliminate even more. To be fair, you’ll also have some expenses that get added to your budget during retirement (e.g. travel, hobbies, etc.), but those likely won’t outweigh the cuts.
A common rule of thumb for your income replacement ratio is 85%. David Blanchett, head of retirement research at Morningstar, thinks that most people will be able to get by on less. Whatever the number, it is the primary driver of how big your nest egg needs to be. Shave 20% from your income replacement ratio and you’ll be able to shave 20% from your nest egg, which means you could save less and retire sooner.
One of the benefits of the exercise above is that it shows the direct link between expenses and retirement. The less you need, the sooner you can retire. Remember that your ideal retirement is not about age or work status. It’s about control. It’s a gradual shift from doing what you have to do to doing what you want to do. One way to speed that shift is to save more, but equally effective (and often overlooked) is to need less.