Spending Strategies in Retirement

Which strategy best identifies with your preferences?

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Whether you are in retirement now or planning ahead, you'll need to use a guideline, or spending strategy, to determine how much you can withdraw each month. You've probably heard the old saying “If you don’t know where you’re going, then any road will get you there.” Those words apply here. Having a plan of action will provide direction and purpose; a haphazard approach may lead to less than stellar results.

What Are Spending Strategies?

A spending strategy is a rule you can use to determine how much you can withdraw from your accounts after you retire so you won't run out of money. There are two main types of strategy that involve taking out either a fixed amount or a fixed percentage from your account each month. An ideal strategy might be a hybrid of the two.

Example #1: Fixed Amount
You may take out a specific (fixed) amount every month until your money runs out. For example, you begin making withdraws at age 62 and take out $3,333 each month. If you are playing it safe and have kept $500,000 in easily accessible safe investments earning 1%, you will completely utilize your savings in just over 160 months (or 13 years). 

Note: This strategy does not allow for increased withdrawals to cover price increases in normal expenses such as food, gas, utilities, taxes, health care, insurance, etc. That means you will need to budget your monthly expenses and potentially cut some of the “fun money” activities when prices of necessities have risen. Your life expectancy should also be considered when determining the fixed amount to take.

Example #2: Variable Amount
You may take out a fixed percentage of the balance each month, which results in a variable amount. Taking only a percentage of the remaining balance helps protect against the risk of spending to a degree that drops your assets below a comfortable level. For example, you begin spending 0.75% monthly from your portfolio’s year-end value of $500,000. You now have $3,750 to spend during month 1, $3,722 in month 2, and $3,694 in the third month, etc., not including gains or losses in the account value. The actual withdrawal amount will vary based on the amount of money that remains in your account, which will depend on investment performance.

Note: This strategy does not consider how reasonable your withdrawal rate actually is. You could end up spending your account down too fast, which will leave less money for you in later years. 

How Do You Figure Out Which Spending Strategy to Use?

A spending strategy should be an ideal fit for your own situation, which means neither of the two examples above will be optimal for most people. With a customized spending strategy, you coordinate other income sources such as Social Security, pensions, and income annuities to achieve optimal results.

Some people buy an immediate annuity (a type of fixed spending retirement account) to provide a specific amount to cover basic monthly living expenses while using a variable withdrawal strategy to take funds from their investments to cover discretionary expenses like travel, clothing, dining out, and entertainment.

Who Should Use a Spending Strategy?

Everyone who plans on withdrawing from their savings and investments in retirement should have a spending strategy in place. Some people will want a strategy that allows them to spend more early in retirement when they are likely to be more healthy and active. Of course, spending more at the start of retirement means you run a greater risk of having less to spend later or running out of money.

A strategy can help you determine the right trade-off amounts for you. Failing to choose a spending strategy may mean having to make significant cutbacks later due to living longer or experiencing poor account performance.

When Should You Start Your Spending Strategy?

You should begin running projections that provide an estimate of retirement spending many years before retirement. These projections should consider factors such as your health and life expectancy, portfolio risk and return estimates, economic factors such as inflation and interest rates, and your attitude toward leaving a legacy. Planning ahead can reduce the anxiety that comes with a transition from saving your money to spending the money it took you so many years to accumulate.

Once you have developed a projected spending plan, you should start using it as soon as you retire. And you should update your projections each and every year to determine whether your plan will continue to be sustainable as you age.

What Do the Experts Say?

Some experts who are into number crunching and estimating returns will recommend retirees follow what is called a decision-rule method. This method assumes the withdrawn money comes out of a diversified portfolio of investments that will fluctuate up and down over a 30-year period. The investment mix contains a stock allocation of 50% to 70%. The popular 4% rule is a decision-rule method of withdrawal.

In contrast, other experts who are more conservative will recommend retirees follow what is called the actuarial method. With this method, as you age, the draw rate will increase. This method is often paired with a lower-risk portfolio with less stock market exposure. When you are more conservative, investment returns may have less upside potential but should be more stable. As account values fluctuate, retirees spend more in the years with higher returns and less in the years with lower returns.

The IRS’s required minimum distribution calculations follow the actuarial method.

In Conclusion

It would take an impressive spreadsheet to factor in all of the variables that can go into perfectly evaluating your spending strategy. Retirement planners can help you account for those variables and with multiple income sources and varied tax treatments.

All in all, the vital issues to be considered include your attitude on spending flexibility, tolerance for swings in investment returns, chosen spending pattern (fixed, up, down), length of retirement period, and desire to leave money to others after your death.