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.
This week is National Retirement Planning Week, so I thought it would be good to give everyone a quick reminder of what it takes to get ready to retire. Sure, saving enough money is important, but retirement is more than just a math problem. There are plenty of other things involved as well. With that in mind, I made a handy retirement readiness flow chart that will give you an idea if you’re ready to retire or if you still have some work to do. To see the chart, just click on the image below.
If you find yourself on the “No” side of the chart and you’ve still got some work to do, visit the Archives Page where you’ll find dozens of articles on every topic mentioned in the flow chart. A few additional free resources you might find helpful are A Brief Guide to Retirement Bliss and the Financial Checkup Checklist.
Thanks for reading and touch base if I can ever help.
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.
“When can I retire?” I get that question a lot. If you’re curious about the answer, look no further than your retirement budget. The more money you want to spend during retirement, the more you’ll need to save before you get there and the longer you’ll likely need to work. It stands to reason then, that you can probably retire sooner if you can figure out a way to spend less during your golden years. What are some ways to downsize your expenses without downsizing your dreams for retirement?
It has almost become dogma over the last decade that financial security comes by giving up things like your daily latte. That advice can certainly help you sock away a few extra dollars over the years, but if you’re getting close to retirement and find yourself tens (or hundreds) of thousands of dollar short of your goal, drinking Folgers instead of Starbucks isn’t going to solve your problem. It’s just not a big enough line item in your budget. If you want to make a big impact, you need to focus on big expenses.
According to a recently released report by the Social Security Administration, the two biggest expenses for most retirees are housing (35 percent) and transportation (14 percent). Said another way, almost half of your retirement budget will go to pay for the roof over your head and the vehicles in your garage. Let’s look at an imaginary couple to see how cuts in those areas can make a big difference.
John and Linda would like to retire next year. They decide to hire an adviser to look over their plan and, much to their dismay, the adviser tells them that they need to save another $300,000 to adequately fund their retirement. At the rate they are saving that would mean delaying retirement for another 10 years. Instead, they look at their retirement budget for ways to cut back.
With the kids gone, they have more space than they need, so they sell the house for $250,000, move into a $150,000 condo and pocket the extra $100,000. With carpooling and soccer games a thing of the past, they trade in their SUVs on two smaller cars (net gain $20,000) and even kick around the idea of sharing a car once neither of them is working. The smaller house and more fuel-efficient cars also means that they’ll be spending about $500 less each month ($6,000 per year) on taxes, utilities, gas and maintenance. Assuming a 4 percent withdrawal rate, that $6,000 annual savings means that they can get by with $150,000 less in their nest egg.
The total benefit, then, from cutting back in just those two areas was $270,000 (or 67,500 lattes). Not bad. They still have $30,000 to go, but at the rate they’re saving they should be able to set that aside and still retire next year as planned.
[Note: To consider ways to trim your own budget, you can download a free retirement budget worksheet at www.intentionalretirement.com/budget.]
Another way to increase retirement security and perhaps even retire sooner than expected is to eliminate debt. It used to be common for people to enter retirement with little or no debt. Unfortunately, that is no longer the case. According to a recent study by the Employee Benefits Research Institute, 65 percent of American families with a head of household age 65-74 had debt. The age group with one of the biggest spikes in debt was 75 and older.
Not surprisingly, debt makes it harder to fund your retirement. It cuts into your cash flow and increases the risk that you will run out of money. Again, let’s assume that you can draw 4 percent per year from your assets during retirement. That means that for every $1,000 in annual income that you want during retirement, you’ll need $25,000 in savings.
Look at your current budget. How much do you spend each year on debt payments (e.g. mortgage, car, credit cards)? Multiply that number by 25. How much is it? $250,000? $500,000? More? That’s how much you’ll need to save in order to service that same amount of debt in retirement. As you can see, retiring will be much easier if you retire your debt first.
So as you plan, don’t think of retirement as a particular age or work status. Think of it as the time in your life when you can afford to pay your bills through means other than your job (e.g. personal savings, pension, Social Security).
When you look at it that way, it becomes clear that you can reach your retirement goals from two different directions. “Save more for retirement” is certainly one way, but “spend less in retirement” can be just as effective.
Note: I first published this article in the Omaha World Herald.