Spending Strategies in Retirement – Which is Best?
Which strategy identifies with your preferences?
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 heard the old saying, “if you don’t know where you’re going, then, any road will get you there”. Having a plan of action will provide direction and purpose. Otherwise, a haphazard approach may lead to unfortunate results.
What are spending strategies?
A spending strategy is a rule you can use to determine how much you can withdraw from your accounts. There are two extremes to consider. Anything else will fall somewhere in between.
Example #1 - Fixed Amount
You may take a specific (fixed) amount every month until your money runs out. For example, you begin spending the account at age 62 and withdraw $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 for price increases for normal expenses such as food, gas, utilities, taxes, medicine, insurance, etc, so you will need to budget your monthly expenses and potentially cut some of the “fun money” activities when necessity prices have risen. Your life expectancy should also be considered when determining the fixed amount to take.
Example #2 - Variable Amount
You may take a fixed percentage (variable) amount every month. Taking only a percentage of the remaining balance helps protect against the risk of spending to a degree which drops your assets below a comfortable level. For example, you begin spending .75% monthly from your portfolio’s year end value of $500,000.
You now have $3,750 to spend during month 1, $3,725 in month 2, and $3,697 in the 3rd month, etc. The withdrawal amount will vary based on your account value, which will depend on the investment performance.
Note: This strategy does not consider how reasonable your withdrawal rate actually is. You could end up spending your accounts down too fast which will leave less money for your later years.
How do you figure out which spending strategy to use?
A spending strategy should be customized to your 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 fixed spending strategy) to provide a specific amount to cover basic 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. Some people will want a strategy that allows them to spend more early in retirement when they are healthy and active.
Of course spending more at the start of retirement means you run a greater risk of having less to spend later. 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 start 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 associated anxiety the comes with a transition from saving money to spending the money it took you so many years to save.
Once you have developed a projected spending plan, you should start using it as soon as you retire, and update your projections each and every year to determine if your withdrawal plan continues to be sustainable through life expectancy.
What do the experts say?
Experts who are into number crunching and estimating returns will recommend retirees follow what is called a decision-rule method. This rule assumes the spending strategy withdrawal rate comes out of a diversified portfolio of investments which will fluctuate up and down over a 30 year period. The investment mix contains between 50-70% to stock allocations. The popular 4% withdrawal 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. By being more conservative, investment returns may have less upside potential but more stability. As the account values fluctuate retirees spend more in the “good” return years and less in the “below average” ones. The IRS’s Required Minimum Distribution calculations follow this actuarial method.
It will take an impressive spreadsheet to factor in all of the variables which go into evaluating spending strategies "just exactly perfect." Retirement planners can help with the coordination involved with multiple income sources and varied tax treatments.
All in all, the important and pressing issues to be considered include your attitude on spending flexibility, feelings about investment fluctuation tolerance, desired spending pattern (up, down, constant), time period included, and any legacy wishes. A great resource on more of the technical approaches outlined by Professor Wade D. Pfau can be found online at Making Sense Out of Variable Spending Strategies for Retirees.