Client Memo: Afraid To Spend In Retirement

Retirees hate to spend money in retirement.  It’s not a big revelation as we are told for two decades during our childhoods and then are taught for decades working to only spend what you make and save the rest.   

Dipping into savings is inculcated into us, almost from birth, as a bad thing.  This is true even if it is a one-off expense in many cases.   

I get it.  I hate it too.  And if you are retiring or have retired, I can’t imagine the feeling knowing that your last paycheck has come in for the rest of your life (outside of social security).   

 The fear of running out of money is typically the greatest fear, but health care, including long-term care, is a large fear as well.

One of our goals at Noble Wealth is to prevent this from happening.  We have annual reviews (at the least) to reiterate your financial plan and make sure that outliving your money isn’t probable.   

Our plans are extremely conservative.

Financial planning, at its core, is built on three key inputs: 

1. Assumed rate of return of invested assets 

2. Spending each year 

3. Inflation Rate 

 We model plans under very conservative assumptions such as a lower rate of return than we anticipate you’ll actually get, higher inflation rate than what we anticipate will actually occur (adjusting over time when needed) and continued increased spending each year.  If the investor makes it to age 95 under most scenarios, then the likelihood of outliving assets is very low. 

Additionally, if just one of these inputs is made more baseline (lower inflation), tiered spending, or more likely rate of return, the ending assets after 20-40 years of time, will be substantially higher.    

Tiered spending is a key one.  We often break down retirement into three distinct time periods:  the go-go years, which is typically from the day of retirement to age 75.  The slow-go years from age 75-85, and the no-go years from 85+.   

To assume you will spend the same amount on your lifestyle at the age of 90 as you did at the age of 65 is not likely.  The one caveat to that is if your health care spend or a long-term care event (with the absence of LTC insurance) offsets the reduction in lifestyle spending.   

Additionally, sequence of returns risk is a key risk for retirees in the 50s and 60s.  Rates of returns in financial plans are assumed to be linear (except in our Monte Carlo simulations but that’s for another memo).  In other words, we assume the portfolio gains ~5% (*some exceptions for outliers in age or risk) per year each year until death.   

However, we all know that’s not how the markets work.  They can be up 40% in a year and down 30% in the next.  The market rarely returns the assumed 5% or 7% in any given year, let alone over a series of years. 

Sequence of returns risk is the risk that your account suffers a decline early on in your retirement that lowers the value as you are taking money for lifestyle spending from it.  In other words, you are selling down and taking out your principal at the same time that the value falls. 

Some of you may remember that we visualized this with our Calvin and Hobbes slide (see below). 

In the chart below, both Calvin and Hobbes retire at 65 with $1,000,000, both take out 4% of their initial account value adjusted for inflation each year, and here’s the key, each get a 6% average rate of return. 

Calvin dies at age 94 and his ending balance is $1.32m while Hobbes runs out of money at age 89.   

What happened?   

They both had the same amount of money, got the same return on that money, and took out the same amount of money each year.   

What happened was the order of their returns over roughly three decades.  For Calvin, he had mostly positive years early on in his retirement while Hobbes had three years of negative returns.   

Hobbes’ ending balance fell below one million and never recovered thanks to the withdrawals when the portfolio was down.   

This is the hidden risk early on in retirement.   

At Noble, we offset this risk with income production.  Our goal is to have clients live off the income (i.e. bond dividends) their portfolios produce, much like an endowment or pension.   

By recreating the paycheck through yield on portfolio assets we can avoid sequence of returns.   

In the same realm of income production as a key metric for rate of return, we also look at spending trends.  One of the benefits of our financial planning software is that it can calculate a withdrawal rate.  

The most well-known withdrawal rate is the 4% rule.  This rule states that one could withdraw 4% of their portfolio each year and not outlive their assets.   

But, here’s the rub. If you’ve combatted the sequence of returns risk and mitigated that risk, then the ‘safe withdrawal rate’ is actually above 6%, according to academic studies.ⁱ  The 4% rule was built on the worst investing environments of the past hundred years (think Depression) AND poor sequence of returns.    

Sincerely,  

Mark J Asaro, CFA 

Scared To Spend? (You're Not Alone) - The Retirement Manifesto 

[1] What Returns Are Safe Withdrawal Rates REALLY Based Upon?