Spending Your Retirement Money 101
How do you decide how much money you can afford to spend in retirement?
Are you worried about running out?
There are several general guidelines floating around cyberspace (and possibly your 401k provider’s website) that purport to answer this question for you. Let’s look at a few in detail.
1-Percentage of Income Approach
Many “experts” say you should aim to replace 70-80% of your pre-retirement salary in retirement. This is an overly simplistic solution to a complex question that deserves more attention. When you log into your 401k account, you likely see some type of retirement “readiness” score which is based partially on this kind of assumption. The question should be: Do you really want to leave your ability to fund retirement to an online calculator? Probably not. It might be easier for now but is not sustainable down the road.
No two people have an identical financial situation. This generalization assumes your expenses will go down significantly in retirement, however, that may not be the case for you. If you plan to travel, have expensive hobbies, or end up with healthcare challenges, your expenses could be higher in retirement. Real retirement planning requires a realistic assessment of how much you are spending now, what will go away, and what new expenses you might incur when you no longer have to work, and have more time for leisure and hobbies.
2-The 4% Rule
One frequently used guideline for retirement spending is the 4% rule: It says, withdraw 4% of your assets each year (adjusted for inflation) and you probably won’t run out of money. Another way of stating this rule is save 25 times your pre-retirement salary by the time you retire. While this rule is probably better than not limiting your spending at all, it has some limitations.
First, it applies to a very specific hypothetical portfolio and assumes you continue to earn historical market returns. Many analysts are projecting below historical returns in the future so basing a sustainable withdrawal rate on these assumptions could be risky.
It also assumes a long (30-year) time horizon. If you are over age 65 today, this rule may not fit your situation.
Lastly, it assumes a very high likelihood of probability (close to 100%). We will talk about probability in a moment but planning for a 100% probability of meeting your goals may cause you to scrimp more than needed and miss out on life experiences that you can afford.
4-The Monte Carlo Simulation
Since when did retirement planning become gambling? You may have seen something called a Monte Carlo analysis if you’ve worked with a financial planner or advisor. A Monte Carlo simulation is a decision-making tool that you can use to determine how likely you are to meet a retirement goal of not running out of money during your lifetime. In a Monte Carlo simulation, the planning software runs many projections with randomized outcomes (some years of losses, some of gains), and produces a probability of meeting your goals expressed as a percentage.
If you google “What’s a good Monte Carlo result?”, you’ll see anywhere from 70-90% and many advisors use 90%+ as a threshold, which means there is a 10% probability you may need to course correct at some point in order to meet your goals and NOT run out of money. The reality is that you may be comfortable with a lower probability level (with course corrections if needed) if you are someone who wants to enjoy your hard-earned savings while you can still lead an active lifestyle. Therefore, a reasonable threshold requires a thoughtful discussion with your financial planner and ongoing monitoring and corrective spending levels as needed.
So, what CAN you rely on?
Retirement planning is less about your asset allocation, or getting a little extra return, than it is having a realistic income and spending plan.
Getting granular on how much you will need to live on is the foundation for successful retirement planning. You will need to track your expenses ideally over a year, understand and identify what additional expenses you might have after you stop working (think healthcare, travel, hobbies), and then figure out how you will get income in retirement (a future blogpost!).
As, always, reach out if we can be of help and check out our Retirement Planning Services.
Sources:
Adjusting Monte Carlo Success Thresholds By Tolerance For Spending Volatility, October 20, 2021, Kitces.com.
Beyond the 4% Rule: How Much Can You Spend in Retirement? August 23, 2021, Schwab.com