The number one fear for those who are retired or planning for retirement is running out of money. Will there be enough funds to support your desired lifestyle?
As with the desire for stability with investment returns, individuals also want a stable cash flow to last during their retirement lifetime.
Determining how much we can spend every year during retirement would be simple arithmetic if we knew our life expectancy and the market returns. That is the beginning of the problem.
We don’t know how long we will live and market returns vary year to year. The arithmetic may appear to be simple but in reality it isn’t. Life expectancy and market returns are random.
Also, investors can choose a different asset allocation of stocks and bonds which will also affect investment returns. Add to this the uncertainty that financial emergencies may occur when a lump sum of cash is needed for costly medical issues or unanticipated home repairs.
William Bengen, a retired financial advisor published the “Four Percent Rule” in the Journal of Financial Planning in October 1994. The article states that a retiree should spend four per cent of their investment capital annually over a 30 year retirement period.
He assumed an allocation of 60 per cent stocks and 40 per cent bonds. Based on historic market performance data that was his conclusion as a successful approach to retirement spending.
Unfortunately life is not so predicable; therefore, selecting just one method to determine retirement spending is not recommended. Recent research has shifted to withdrawing funds based on the performance of your investment portfolio.
Spending money based on how much money was coming in to the household has been our practice for decades. Pay raises and bonus cheques most often are spent. You spend what you have.
Our opinion is that a middle position is most useful. Do not just blindly spend a specific amount regardless of having the need or ability to spend.
At the same time don’t adjust your retirement spending based on how your investments performed last year. That roller coaster method of stopping and starting spending would be chaotic.
The best method is to base retirement spending on a long-term financial plan. How much do you want and can afford to spend?
The guiding tool for determining spending amounts and to ensure you stay on track is doing a retirement cash flow estimate at least once per year. Predict what you need to spend during your lifetime and see if your financial resources are sufficient.
It may be useful to make an estimation based on different assumptions. The variables include market returns, life expectancy and asset allocation.
One benefit of this exercise is to see the role of asset allocation in your current investing approach. This is the one variable that is completely within your control.
For example, a risk adverse investor is fearful of outliving their money. They want to avoid risk at all costs. They only are comfortable investing 30 per cent of the investments in stocks.
Owning a 70 per cent weighted bond portfolio will likely result in a very low return on investment. Avoiding investment risk by owning mostly bonds means there is a higher risk of running out of capital.
The risk adverse investor may be better off taking more investment risk and owning more stocks to earn a higher rate of return. The higher return will produce more funds and those additional funds will reduce the risk of outliving their capital.
The solution to combating the fear of outliving your capital is to do a retirement cash flow estimate at least once a year.