Another Take on Retirement Withdrawal Strategies
I’ve long argued that we need to account for inflation with our retirement income plans. Many disagree arguing that we spend less as we get older. Retirement income planner, Daryl Diamond, argues that both extremes are wrong in his book Your Retirement Income Blueprint. He plans for retirement income purchasing power to drop by 25% at age 75.
I don’t see much sense in arguments that we can plan retirement spending based on constant dollars. Even at 2% inflation, why should we expect a retiree to want to spend 10% less only 5 years into retirement? An elderly couple in my extended family have seen inflation triple prices since they retired. They are struggling with trying to live on only one-third of their former consumption.
Daryl Diamond says “retirement income projections that do not adjust at all for inflation or that are fully indexed through retirement are both in error.” He indexes spending plans up to age 75, then drops spending by 25%, and resumes indexing thereafter.
I’m not convinced that most retirees will want to spend 25% less when they reach age 75, but at least this is a more sensible strategy than ignoring inflation entirely. Unfortunately, this 25% drop is self-fulfilling if it gets planned in. Retirees on Diamond’s plan will have to reduce spending whether they want to or not. Otherwise they risk running out of money.
Diamond’s preference is to start with a 5% withdrawal rate rising with inflation with the one-time 25% reduction at age 75. He says this “has proven to be quite resilient in the face of negative markets over the last 25 years.” He goes on to show some 22-year scenarios (riddled with small calculation errors) based on real market returns starting in 1992.
How can experience over 25 years give much insight into whether retirees will run out of money over 30+ years of retirement? Diamond says “I know this example does not go back and review a hundred years of data.” Unfortunately, it doesn’t even cover a full retirement for a typical 60-year old couple.
For some reason, none of Diamond’s scenarios include the 25% spending reduction at age 75. So, they are testing a 5% withdrawal rate indexed to inflation with no reduction. As an experiment, I reordered the returns in one scenario to begin in 2008 and after 2013 wrap back to 1992. At an indexed 5% withdrawal rate, the retiree ran out of money in the 23rd year.
Diamond has not persuaded me change my conclusions from recent withdrawal rate experiments. Anyone retiring at 60 or 65 who pays typical investment fees is taking a chance even withdrawing initially at 4%. As for the 25% spending reduction at age 75, it may make sense to let each retiree decide whether to include this as long as the question is framed in a way they can truly understand.
This whole business of withdrawal rates reminds me of times when my boss wanted me to collect information to make some important decision. In reality, my boss knew which choice he wanted and this was really an exercise in justifying that choice no matter the truth. With withdrawal rates, retirees play the role of my boss, and advisors play my role. Retirees want as much retirement income as they can get. Advisors have to justify higher withdrawal rates somehow or risk losing clients. After all, will you pick the advisor who says you can spend $5000 per month or the one saying $3000 per month? Fortunately for advisors and unfortunately for their clients, the result of over-consumption won’t be obvious for many years.
I don’t see much sense in arguments that we can plan retirement spending based on constant dollars. Even at 2% inflation, why should we expect a retiree to want to spend 10% less only 5 years into retirement? An elderly couple in my extended family have seen inflation triple prices since they retired. They are struggling with trying to live on only one-third of their former consumption.
Daryl Diamond says “retirement income projections that do not adjust at all for inflation or that are fully indexed through retirement are both in error.” He indexes spending plans up to age 75, then drops spending by 25%, and resumes indexing thereafter.
I’m not convinced that most retirees will want to spend 25% less when they reach age 75, but at least this is a more sensible strategy than ignoring inflation entirely. Unfortunately, this 25% drop is self-fulfilling if it gets planned in. Retirees on Diamond’s plan will have to reduce spending whether they want to or not. Otherwise they risk running out of money.
Diamond’s preference is to start with a 5% withdrawal rate rising with inflation with the one-time 25% reduction at age 75. He says this “has proven to be quite resilient in the face of negative markets over the last 25 years.” He goes on to show some 22-year scenarios (riddled with small calculation errors) based on real market returns starting in 1992.
How can experience over 25 years give much insight into whether retirees will run out of money over 30+ years of retirement? Diamond says “I know this example does not go back and review a hundred years of data.” Unfortunately, it doesn’t even cover a full retirement for a typical 60-year old couple.
For some reason, none of Diamond’s scenarios include the 25% spending reduction at age 75. So, they are testing a 5% withdrawal rate indexed to inflation with no reduction. As an experiment, I reordered the returns in one scenario to begin in 2008 and after 2013 wrap back to 1992. At an indexed 5% withdrawal rate, the retiree ran out of money in the 23rd year.
Diamond has not persuaded me change my conclusions from recent withdrawal rate experiments. Anyone retiring at 60 or 65 who pays typical investment fees is taking a chance even withdrawing initially at 4%. As for the 25% spending reduction at age 75, it may make sense to let each retiree decide whether to include this as long as the question is framed in a way they can truly understand.
This whole business of withdrawal rates reminds me of times when my boss wanted me to collect information to make some important decision. In reality, my boss knew which choice he wanted and this was really an exercise in justifying that choice no matter the truth. With withdrawal rates, retirees play the role of my boss, and advisors play my role. Retirees want as much retirement income as they can get. Advisors have to justify higher withdrawal rates somehow or risk losing clients. After all, will you pick the advisor who says you can spend $5000 per month or the one saying $3000 per month? Fortunately for advisors and unfortunately for their clients, the result of over-consumption won’t be obvious for many years.
People got to know some informations about their spending habits before and after retirement. Tha financial advisor cannot help about this.
ReplyDeleteIf you spend a lot on clothing, car (comute) and other expenses related to your job, these expenses should drop a lot afer retirement. If you intend to travel more in retirement, it's increasing your spending. The same for housing, if you keep your big house after the kids are gone, this may be the luxury that sink your future compared to someone moving for a smaller/cheaper place.
To me 40-50k$ is more than enough for a retiree couple in Canada. I see a lot of Boomers spending 75-100k$ while carrying a mortgage balance on a big house, 2 car loans (I mean 1x SUV loan and 1x F-150 loan), a second home and traveling overseas regularly...they will be surprised when the advisor tell them they got to reduce their spending by 25% at 75?
I may be wrong but at the other end of the spectrum
@Le Barbu: No doubt an advisor could help with figuring out your spending needs, but it would definitely take input from you. If you've analyzed your needs and $40k to $50k is enough, then you've got a number to plan with. But remember that this figure has to grow with inflation or else your purchasing power will decline over the years.
DeleteWithdrawal rate hand wringing is a rich man's problem. The typical Canadian 2 income family makes $78K a year; they spend half of that on mortgage/kids/taxes/work expenses. When they retire, these expenses go away. To maintain their lifestyle, most of their income will come from CPP/OAS which is fully indexed and backed by the good people of Canada. The best way to ensure the vast majority of Canadians have the same standard of living in retirement is to encourage them to find work they enjoy and are more willing to keep doing until age 65 (full or part time), buy their own house (possible source of income if absolutely necessary) and pay off all debts before retirement.
ReplyDeleteLarry
@Larry: I guess you and I have different definitions of rich. I don't want to try to get by in retirement on just CPP and OAS with no lump sum on the side. Even the poorest in my extended family have some amount of money on the side to go with their CPP and OAS. This lump sum gives rise to the challenge to make it last.
DeleteLet me reword what I'm trying to say. It's much easier to decide to set aside more for retirement when you are in the 4th or 5th quintile of family income because the family still gets to take the yearly vacation down south and the kids can still play rep. sports. If you are making 78K/year, by saving 15% for retirement, you may not be able to give your family these experiences. You will have more "freedom money" in retirement than you had when raising a family. My question is: was it worth the sacrifices you had to make while the kids were young?
DeleteLarry
@Larry: There are people who genuinely make so little that they make good choices but can't save. However, $78K/year is not a small amount of money. For an Ontario couple with one earner and 3 kids, the available spending after a 15% RRSP contribution, federal tax, provincial tax, CPP, and EI, is over $4400 per month. People who can't get by on this likely have overspent on their house and cars. I see this all the time.
DeleteWhen a townhouse costs $600K in a decent GTA neighbourhood, it's pretty easy to go through $4400/month, but I get your point. If you have some time, please check the math on my website. Give me your honest opinion. I'm a high school adult teacher and I'll be showing this info to my students in the Fall. I'd appreciate your feedback. smarterinvesting.ca
DeleteLarry
@Larry: In the GTA right now, the best option for many people is to rent, even if they need something with some space for a family. Prices are just too high relative to rents.
DeleteI read your piece on saving 15%. For the rare family that manages to work consistently for 35 years without interruption, saving a smaller percentage makes sense. The reality, though, is that people have periods where they lose jobs and can't save, or may even dip into retirement savings. This is why it makes sense to save more during good times. If you see your retirement savings building up to more than you'll need, then by all means cut back on savings. It can be tempting to decide that you're not in good times just because you're having trouble making ends meet. But the reality is that if you're employed, you may have times as good as you're going to get and you should be saving some money in case they get worse. This is unwelcome advice for anyone who has already created cash drains with houses and cars, but it is true nonetheless.
Thanks Michael
DeleteLarry