An estimated 10,000 people are retiring every day, and this unprecedented surge of new retirees is expected to last for the next 17 years. Many, perhaps most, will roll their retirement plan assets into an IRA account, and that money--plus Social Security and any taxable retirement accounts they may have--will provide their living expenses for the rest of their lives.
This is different from retirees in the past, who often received regular payments from their defined benefit plans--their equivalent of a retirement paycheck. Millions of new retirees are being required to make a new kind of calculation: how do I translate a lump sum retirement account into sustainable income over the rest of my retirement? For those of us who are accustomed to receiving income throughout our lives, this is not an easy calculation to make.
Suppose, for example, a 65-year-old couple retires (also in our preferred language known as reaching their 'financial freedom' years), and when their pension assets are rolled into the IRA, they have a total of $4 million between the IRA and their retirement accounts. They can start receiving $1,750 a month from Social Security. With so much money in the bank, they feel comfortable joining an expensive country club, traveling around the globe, and before long, a large recreational vehicle is parked in their driveway. They remodel the kitchen. By age 68, they still have $2.5 million in the bank and back down to spending $170,000 a year. Are they all right, or not?
This is the kind of calculation that financial planners who serve retiree couples wrestle with all day long, and there are few definitive answers. Some of the pioneering research into safe spending in retirement, takes into account what is called "sequence risk"--meaning that some unlucky retirees will experience a severe market drop in their early years, which will make it more likely that they'll run out of money before they die. The research assumes that the retired couple wants to raise spending, each year, at exactly the inflation rate, so they maintain spending power. Then it looks at the historical market returns, and identifies a spending level that would have survived even the worst sequence risk scenarios. The answer is between 4% and 4.5% of the retirement portfolio in the first year, with that dollar amount rising with the inflation rate each year.
In our hypothetical retiree example, Social Security is paying for $21,000 of the couple's living expenses, meaning the portfolio has to come up with an additional $149,000, indexed to inflation, for the next 30 or so years. That comes to almost exactly 6% of the remaining portfolio. The couple feels financially solvent, but they are really highly at risk if the market turns down in the next few years.
Other research has factored in the possibility that a retired couple will be willing to forego inflation increases in years when their retirement portfolio has lost money. This so-called "adaptive withdrawal" strategy allows a retiree couple to raise spending to 4.8% of the initial portfolio. Once again, under this other scenario, our hypothetical couple is in the spending danger zone. And this only covers a 30-year period. People who live longer would need to live on somewhat less--but how do you know how long you'll live?
At Pauley Financial, unless we have convincing evidence otherwise, our default planning age is 100. The point of all this analysis is to balance living for today and saving for tomorrow, all-the-while responsibly addressing the desire to not outlive your means. Thirty years is a long time to live off of a portfolio.
Of course, all of this research focuses on surviving the worst-case scenario--the times when the markets are least favorable to a comfortable retirement. If the market climate is, instead, sunny during the early years of retirement, if our hypothetical couple happened to retire in the early years of a bull market, then their current spending won't be a problem, and they may actually be able to increase their lifestyle expenditures.
We believe the only way to stay in the safety zone is to establish a realistic plan and then run the numbers as "life happens" to adjust to market activity, life changes and goal re-prioritization. Converting a portfolio into a paycheck is a surprisingly complex exercise. We stand by ready to assist.
The information herein represents the opinions of the author. Much of the material is based on data gathered from what are believed to be reliable sources. It is not guaranteed as to accuracy. It should not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.
Posted on Wed, February 13, 2013
by Kimberly Pauley filed under