Thoughts on Financing Retirement I--Beware Rules of Thumb
It is natural that many readers of investment sites are shooting for a retirement goal. You want to achieve a comfortable, secure retirement, with confidence that they can live at a lifestyle of your choosing without running out of money.
I have been retired for nine years. I was fortunate to be able to retire early (age 55) and turn more of my attention to one of my passions, which is helping other people through my writing about stock investing. Other passions include my wife and activities with her, golf, gaming (poker and blackjack), and the Buffalo Bills (don’t ask).
When I was planning to retire—or more correctly, exploring whether I would be able to retire—the first step was to learn more about financing retirement. One thing that I decided quickly was that in retirement, it’s all about income. I mean that when you are retired, you need income—money coming in—that covers your expenses. You will need that income for the rest of your life, which may be a long time, potentially longer than you worked at your principal career. So when you are exploring retirement, the first two questions become, how much will you need, and where will it come from?
On the first question, I quickly decided that conventional rules of thumb, like “You will need 70% of your final year’s income,” are worthless. That particular canard fails on at least two levels. First, it presumes that you were spending all of your income in your last year of work. But more likely, you were saving a good portion of your income as you came into the home stretch prior to retirement. So the amount you were making in that final year probably bears little relationship to what you will actually need. Second, your expenses can change significantly the day you retire. I had a position that required formal business clothing. Since the day I retired, I have not worn a suit, and I only wear ties to weddings and funerals. That entire expense category disappeared. The “savings” category disappeared. On the other hand, I spend more now on golf equipment and greens fees.
So instead of scaring yourself silly with the 70% rule, create a retirement budget. We like to travel, so that’s part of the budget. I don’t care about having a new car every few years, so that’s gone, along with the business clothing. We paid off our house, that expense is gone. Senior discounts make a little dent. You may be surprised that your retirement budget comes in at far less than the 70% rule would have led you to believe. The point is, everyone’s circumstances are different. You cannot rely on a crude rule of thumb to estimate your expenses. You’ve got to sit down and work them out yourself.
The second question is, Where will it come from? Here, you need to list all the sources at your disposal:
• A pension. Many baby boomers, who are just starting to retire, have traditional pensions. The percentage goes down as you move back to younger people.
• Social Security. There are lots of options on when to begin taking SS, and there are tradeoffs between waiting longer versus taking a smaller amount sooner. Remember that SS is indexed to inflation these days.
• Part-time work. Many retirees don’t fully retire. They make some money through consulting, contract work, part-time jobs, or by converting a hobby into an income-producing little business.
• Your investments.
I wrote an article in February, “Why I Love Dividends,” that appeared on an investment Web site called Seeking Alpha. There, it spawned a lively discussion (over 110 comments to date), and one of the branches of the discussion is directly on point here. The debate was whether it is better to derive your retirement income from income-producing investments, or to create it by selling off part of your investments each year.
The rule of thumb on selling part of your investments to finance retirement is that the “safe” thing to do is to calculate 4% of your investments when you retire, and that’s the amount you can sell each year with confidence that you will never run out of money. You are supposed to increment that amount each year to account for inflation—commonly by increasing it 3% each year. The rule of thumb presumes that you have a well-diversified portfolio under the standards of Modern Portfolio Theory, and I believe the 4% “safe” figure has been validated by millions of Monte Carlo tests to about a 95% confidence level that your money will never run out.
Once again, I find the rule of thumb wanting. For one thing, you may not need 4% per year to round out your retirement budget. That doesn’t create a problem. But you may need more, in which case the experts I’ve read disagree on what you should do (delay retirement, lower your budget, get part-time work, withdraw 5% or 6% per year, etc.). But something must be done. I just heard of a study that found that many retirees blow through their 401(k)'s in five years or less. Clearly that is unacceptable.
A second disconnect for me is the 3%-per-year inflation adjustment. As discussed earlier, your retirement budget is unique to you. Your personal “basket of goods and services” probably bears little relationship to the government’s basket when they are figuring inflation. The costs of travel have gone down, not up, since I have been retired. Furthermore, the automatic adjustment ignores the performance of your investments. I think that’s a big flaw. What I have been doing is adjusting the 4% base amount not by inflation, but by how our investments have actually performed. I withdraw 1% per quarter of what’s actually there. If the total value of our investments has gone up, the withdrawal amount goes up a little. If the investments have declined, the withdrawal amount goes down. The change is at the margin and has been no trouble to absorb. But over time, I think it makes the 4% rule a lot safer to adjust it by how your investments are actually doing than to just automatically bump the withdrawal amount up each year and ignore what’s happening in the real world.
Frequent readers who know my appreciation for dividend investing may be wondering why I just don’t take my dividend money directly. I see this article as the first of an occasional series on retirement realities. In a future article, I will explore my reasons for using a quarterly-withdrawal system. Hint: The dividends help fuel it.
I have been retired for nine years. I was fortunate to be able to retire early (age 55) and turn more of my attention to one of my passions, which is helping other people through my writing about stock investing. Other passions include my wife and activities with her, golf, gaming (poker and blackjack), and the Buffalo Bills (don’t ask).
When I was planning to retire—or more correctly, exploring whether I would be able to retire—the first step was to learn more about financing retirement. One thing that I decided quickly was that in retirement, it’s all about income. I mean that when you are retired, you need income—money coming in—that covers your expenses. You will need that income for the rest of your life, which may be a long time, potentially longer than you worked at your principal career. So when you are exploring retirement, the first two questions become, how much will you need, and where will it come from?
On the first question, I quickly decided that conventional rules of thumb, like “You will need 70% of your final year’s income,” are worthless. That particular canard fails on at least two levels. First, it presumes that you were spending all of your income in your last year of work. But more likely, you were saving a good portion of your income as you came into the home stretch prior to retirement. So the amount you were making in that final year probably bears little relationship to what you will actually need. Second, your expenses can change significantly the day you retire. I had a position that required formal business clothing. Since the day I retired, I have not worn a suit, and I only wear ties to weddings and funerals. That entire expense category disappeared. The “savings” category disappeared. On the other hand, I spend more now on golf equipment and greens fees.
So instead of scaring yourself silly with the 70% rule, create a retirement budget. We like to travel, so that’s part of the budget. I don’t care about having a new car every few years, so that’s gone, along with the business clothing. We paid off our house, that expense is gone. Senior discounts make a little dent. You may be surprised that your retirement budget comes in at far less than the 70% rule would have led you to believe. The point is, everyone’s circumstances are different. You cannot rely on a crude rule of thumb to estimate your expenses. You’ve got to sit down and work them out yourself.
The second question is, Where will it come from? Here, you need to list all the sources at your disposal:
• A pension. Many baby boomers, who are just starting to retire, have traditional pensions. The percentage goes down as you move back to younger people.
• Social Security. There are lots of options on when to begin taking SS, and there are tradeoffs between waiting longer versus taking a smaller amount sooner. Remember that SS is indexed to inflation these days.
• Part-time work. Many retirees don’t fully retire. They make some money through consulting, contract work, part-time jobs, or by converting a hobby into an income-producing little business.
• Your investments.
I wrote an article in February, “Why I Love Dividends,” that appeared on an investment Web site called Seeking Alpha. There, it spawned a lively discussion (over 110 comments to date), and one of the branches of the discussion is directly on point here. The debate was whether it is better to derive your retirement income from income-producing investments, or to create it by selling off part of your investments each year.
The rule of thumb on selling part of your investments to finance retirement is that the “safe” thing to do is to calculate 4% of your investments when you retire, and that’s the amount you can sell each year with confidence that you will never run out of money. You are supposed to increment that amount each year to account for inflation—commonly by increasing it 3% each year. The rule of thumb presumes that you have a well-diversified portfolio under the standards of Modern Portfolio Theory, and I believe the 4% “safe” figure has been validated by millions of Monte Carlo tests to about a 95% confidence level that your money will never run out.
Once again, I find the rule of thumb wanting. For one thing, you may not need 4% per year to round out your retirement budget. That doesn’t create a problem. But you may need more, in which case the experts I’ve read disagree on what you should do (delay retirement, lower your budget, get part-time work, withdraw 5% or 6% per year, etc.). But something must be done. I just heard of a study that found that many retirees blow through their 401(k)'s in five years or less. Clearly that is unacceptable.
A second disconnect for me is the 3%-per-year inflation adjustment. As discussed earlier, your retirement budget is unique to you. Your personal “basket of goods and services” probably bears little relationship to the government’s basket when they are figuring inflation. The costs of travel have gone down, not up, since I have been retired. Furthermore, the automatic adjustment ignores the performance of your investments. I think that’s a big flaw. What I have been doing is adjusting the 4% base amount not by inflation, but by how our investments have actually performed. I withdraw 1% per quarter of what’s actually there. If the total value of our investments has gone up, the withdrawal amount goes up a little. If the investments have declined, the withdrawal amount goes down. The change is at the margin and has been no trouble to absorb. But over time, I think it makes the 4% rule a lot safer to adjust it by how your investments are actually doing than to just automatically bump the withdrawal amount up each year and ignore what’s happening in the real world.
Frequent readers who know my appreciation for dividend investing may be wondering why I just don’t take my dividend money directly. I see this article as the first of an occasional series on retirement realities. In a future article, I will explore my reasons for using a quarterly-withdrawal system. Hint: The dividends help fuel it.
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