Our Thinking

A Retirement Spending Parable

July 30th, 2015

Three 60 year old retirees, each with $4 million, and each wanting to spend 4% of their portfolio, or $160k a year, are at dinner debating the merits of their retirement spending plans. They have invited a finance professor to judge whose plan is best.

Mr. Cash starts off first, proudly stating that his money is under his mattress. He argues that the only person worth trusting is himself, and that by his calculations, he will have 25 years of guaranteed spending cash.  He doesn’t figure to live past 85 anyway, so 25 years is all he needs, and he won’t have to take any risk to get there.

Mrs. Bond says that she puts her money into a 30 year 4% US Treasury Bond. She states that this is the safest way to get a return, without having to worry about interest rates, default risk, or touching her principal. She will simply live off the 4% annual income ($160k) from the bond, which will give her 30 years of $160k income, and then $4 million left over when she is 90.

Mrs. Moneywise has invested her money into a globally diversified portfolio of equities and bonds that she thinks will average 7% a year. She argues that she will be able to leave some money for her heirs, and provide for a lifetime of spending cash.  Needless to say, Mr. Cash and Mrs. Bond are surprised that she wants to take on the risk of being in the “markets”.

After hearing the plans, the professor renders his verdict, suggesting that Mrs. Moneywise should buy dinner, since Mr. Cash and Mrs. Bond need to save every penny they can. “You see”, he exclaims, “Mrs. Moneywise is the only one who has any chance of living past 84 without running out of money.”

Let’s take a deeper look at the professor’s conclusion, to see why this is.

Mr. Cash, has forgotten about inflation. Dating back to 1913, the average historical rate of inflation per year is 3.22%. At that rate, Mr. Cash’s cost of living will increase 37% in the first 10 years, and by year 20, it will be 88% higher. Thus, Mr. Cash is actually losing 3.22% per year in purchasing power, which will exhaust his $4 million portfolio in just 18 years, leaving him 78 and penniless.

Mrs. Bond has forgotten to factor in not only inflation, but also taxes. Using the 3.22% inflation rate, and an average income tax rate of 22%, she will run out of money in 24 years, leaving her 84, broke, and far away from her goal of being 90 with $4 million left over.

Mrs. Moneywise has taken all factors into account, and thus correctly decided that she needed to get an average return of 7% on her portfolio in order to provide for her retirement spending. Factoring in the inflation rate of 3.22%, investment tax rate of 15%, and income tax rate of 22%, Mrs. Moneywise will almost certainly make it to 95 with some money left over. (Most likely $1 million or so.)

Thus, Mrs. Moneywise, while seemingly taking the most risk, is actually taking the least amount of risk, since she is the only one who has any chance of providing for more than 24 years of income. By correctly deducting that longevity, inflation, and tax risk are her biggest risks, she was able to build the “least risky” retirement spending plan. Unfortunately, many retirees, regardless of wealth, have defined risk incorrectly, and are currently exposing themselves to the greatest risk of all, which is outliving their money.

A successful retirement spending plan has a spending rule that dictates how much will be taken from the portfolio per year, and how the investments will be managed in order to provide for such an annual withdrawal. Then, the spending and investment plan should be tested, using a variety of inflation, tax, and investment performance rates to provide a better idea of how successful the plan will be under a variety of circumstances.

**This parable is clearly over simplified in order to best illustrate and highlight the three most important risks that a retiree’s spending plan faces.**