How To Figure Out How Much Can You Spend In Retirement

Most people finally reach a point in life when they stop working and retire. Instead of living off their wages, they must start to live off their retirement income. As discussed in the article on sources of retirement income, this usually includes spending down savings.

It may surprise you to learn there is no commonly accepted method of distributing savings in retirement (‘distributing’ means withdrawing and spending).

Let's deal first with the simple approaches, with a brief comment or two about why we don't use them.

The first is the Unplanned approach, obviously not preferred by professional retirement planners such as ourselves!

In the unplanned approach, the retiree takes whatever they need without any regard as to the ability of the portfolio to generate that level of cash flow. This only works for well-off retirees whose portfolio generates income beyond their needs. If this isn't you, don't try this approach at home, folks.

Next is what I will call the ‘quasi-plans’:

Living off dividends and interest - although fixed interest bonds and dividend paying equities are less volatile than growth stocks, there will be some variation in the amount withdrawn because of different market conditions. If this provides sufficient income for you, it is 100% safe because the principal is never spent, but for many retirees, it will be necessary to draw from their principal at some point during the retirement period, which means this method could not be used.

Taking a fixed dollar amount - easy to administer once the amount is chosen, but inflation will reduce the real value as time goes on. As retirees grow older, they may have difficulty making the decision on whether or when to adjust the amount withdrawn. 

Taking a fixed amount and adjusting it for inflation - eliminates the management decision from the method just discussed. This is very popular in the general literature, but it is inflexible and does not allow for any periodic adjustments needed to meet real-life dynamics. Studies show that taking too much money during market downturns will lead to failure of the plan.

Next we have the more sophisticated approaches:

Taking a constant percentage of the portfolio - the amount withdrawn will fluctuate up and down with the portfolio value so this method does adjust to market conditions. The trick is determining the percentage. The 'Safe Withdrawal Rate' is generally thought to be about 4%. The disadvantage of this approach is the unpredictability of the income from year to year.

Taking a varying distribution based on portfolio performance - a percentage of the portfolio is withdrawn in the first year and that amount is increased each year for inflation, but only if portfolio performance warrants it. If it doesn’t, the retiree forgoes the inflation increase. If the amount withdrawn goes above or below certain 'guardrails', then the percentage is adjusted either up or down. If the investment performance is good and money has accumulated in the portfolio, the guardrails allow more money to be withdrawn and spent; conversely if performance is poor , they reduce the income to protect the money remaining in the portfolio.

At Bay Area Planners, we already know the starting point for how much to withdraw - it's based on the constant living standard that our software identifies for each retirement plan. If you are not familiar with the concept of 'economic smoothing' used by our software in designing retirement plans, here's a brief run-through. We look at your savings and other assets, and your sources of income, to identify the underlying 'living standard' they can provide for the rest of your life (or your spouse's life if it is expected to be longer). We can adjust the assumptions to allow you to spend more during the early years of retirement when you are the most active, or for you to leave a legacy amount for others to inherit. We perform a 'what if' analysis of strategies such as delaying taking Social Security, converting from a traditional IRA to a Roth IRA, downsizing the house, etc., to ensure we have maximized the income from your available retirement resources. The software accurately takes Social Security and taxes into account.

We know which accounts to take any principal withdrawals from in order to minimize taxes. And we have a system for which types of investments to liquidate in order to preserve your nest egg. The way we organize the investments is the subject of the Bucket System, and finally we describe the concept of a Retirement Paycheck.

By now you should now be recognizing some of the issues that are involved in retirement planning:

• How much can you withdraw from your savings without running out of money should you happen to live beyond your expected lifespan?
• Which accounts should you withdraw this money from?
• Which investments should you liquidate to provide the money?
• How should your savings be invested so you don't lose out when withdrawing money during a market downturn?
• How will taxes and changes to Social Security affect all these decisions?

There's a lot to consider. Like we say, everybody needs help with financial planning.

To find out your living standard number and how much you should be spending in retirement, call (408) 725-7135 or click here.

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