Why your retirement spending rate should vary over time based on individual and market circumstances.
In this episode, you’ll learn:
- What are the unknowns that make determining a retirement spending rate so difficult.
- What are some issues with the 4% retirement spending rule.
- What is Monte Carlo analysis and what are some of its potential flaws.
- What is sequence of return risk.
- Why is it better to start with a low equity allocation in the early years of retirement and then increase the allocation to stocks over time.
- What is the probability of 65 year olds reaching the age of 85, 95 and 100.
- The advantage of waiting until age 85 to buy a single premium immediate annuity.
The Still Alive By 85 Bucket
One of the most daunting challenges facing new retirees is determining how much they can they spend each year in retirement without depleting their retirement savings.
This is not an easy task because there are two large unknowns:
1. How long the retiree will live.
2. What rate of return the retirees will earn on their investment portfolios.
Sequence of Return Risk
The second unknown is especially challenging because the issue is not so much about the average annual return retirees will earn on their portfolios, but the sequence of those returns.
In other words, a retiree that has negative returns in the first decade of retirement but then has positive returns in subsequent years has a higher probability of retirement ruin than a retiree who has positive returns in the first decade of retirement followed by some negative return years later on.
A study by Michael Kitces and Wade Pfau highlighted in the American Association of Individual Investors Journal found that retirees have a higher probability of making their retirement savings last by starting with a lower allocation to stocks in the early years of retirement and then increasing the equity allocation as they age.
This is counterintuitive to traditional financial advice to reduce stock exposure as one proceeds through retirement.
But the advice is sound because the sequence of return risk I mentioned above.
A lower equity allocation in the early years of retirement when balances are large and life expectancies are long helps to avoid catastrophic portfolio losses.
Later in retirement when the balances are smaller and life expectancies are shorter is a time when higher stock exposure makes more sense.
The advantage of this approach is if market returns are poor during the first half of retirement, the retiree is able to avoid much of that portfolio pain while at the same time systematically increasing their allocation to stocks at more favorable entry points when valuations are lower. This is known as dollar cost averaging.
Reducing Longevity Risk
There are also ways to mitigate the uncertainty of not knowing how long one will live in retirement.
I have previously written and spoken about single premium immediate annuities (“SPIAs”).
A SPIA is a contract with an insurance company where the retiree gives the insurance company a lump sum (i.e., the premium) and the insurer promises to pay a specific periodic dollar amount, usually monthly, for the rest of the retiree’s life and depending on the contract the lifetime of the surviving spouse.
SPIAs are a form of risk pooling as premiums paid by participants who die young are used to pay the monthly benefits for those who live well beyond the average life expectancy.
Retirees are often hesitant to purchase SPIAs because they don’t want lose control of their money, and they are afraid they will die early and not get their money’s worth.
Still Alive By 85 Bucket
One way to address these concerns is to use a strategy I call the “still alive by 85 bucket.”
The older one is when he or she purchases a SPIA, the higher the monthly payout.
For example, according to scenarios I ran on immediateannuities.com, an 85-year old couple who purchases a SPIA today would receive a monthly benefit that is twice as high as a 65-year old couple who purchases a SPIA.
That’s because 85 year olds have a much shorter life expectancy.
The “still alive by 85 bucket” strategy involves new retirees setting aside a portion of their retirement nest eggs in a separate bucket to be used to purchase a SPIA at age 85 if they actually live that long.
That bucket is invested conservatively with the aim of keeping pace with inflation.
The amount in the bucket would be sufficient to purchase a SPIA that is large enough to cover one’s retirement living expenses in today’s dollars after deducting social security and other pension benefits.
The premise is that if the amount in the bucket grows by the rate of inflation, there will be sufficient assets to purchase a SPIA to cover most of a retiree’s living expenses in the future even though prices of goods and services will be higher due to inflation.
The advantage of this approach is the remaining retirement nest egg only needs to last twenty years for retirees retiring at age 65. That potentially means higher annual withdrawal rates.
Of course, much of this is simply mental accounting, but as irrational humans with strong emotions, adjusting our mental paradigm often leads to less stress and better decisions.
To get an idea of how much you would need to set aside to eventually purchase an annuity, you can run scenarios for 85 years olds on immediateannuities.com.
One thing to consider is with interest rates at historically low levels, annuity payouts are also historically low.
In a more normal interest rate environment, annuity payments would be higher requiring a lower premium payment to generate sufficient annuity cash flow to meet expenses.