Got Enough for Retirement?

As the baby-boom cohort nears retirement, an army of financial advisors is selling the service of predicting:

• how much money you can spend in retirement in order to make your money last until death (spending spreadsheet), and
• the corollary decision – how much money you must save to live the lifestyle you want in retirement (saving spreadsheet).

Neither you nor the advisor can know the answers because the future is unknown. All answers will depend on:

• assumptions that will change over time,
• assumptions about normality that don’t reflect real-life’s abnormalities, and
• small probabilities of extreme outcomes you must consider.

You need to model the situation for yourself, with variables you can change.

• You adjust the model as your actual experience differs from it.
• You adjust the assumptions as the world changes.
• Best of all, you see year-by-year the value of the model: So much better than being given ‘a $number’ by the advisor.

Assumptions To Make

1. Income Tax Rates.
   Taxes you pay will have a huge impact on the cash you can spend. Don’t mistakenly use the ‘marginal’ tax rates commonly quoted for financial decisions. Calculate your anticipated ‘average’ rate using the bottom box of this tax-rate spreadsheet. Beware of Minimum Tax. Don’t calculate tax as a percent of your anticipated spending. Calculate it on portfolio returns or the required withdrawal rates from tax-sheltered accounts. If you plan on dying broke, you will spend more than your portfolio returns. Otherwise, you will spend at lot less, especially at the start when you reinvest protection for future inflation.
2. Government Subsidy To The Elderly.
   Because of the population bulge, this model assumes only that government benefits will offset your higher healthcare costs for drugs, physio, eyeglasses, hearing-aids, etc. It is better to err on the downside. It removes two unknowns from the model.
3. Inflation
   is a variable input. Long-term history indicates 2.5% is reasonable, but real-life can vary drastically. Both the saving and the spending spreadsheets (links above) correct for inflation. The inflation adjustment is applied to only the $$ left for spending AFTER taxes are paid. Most commentary on investment returns quotes returns ‘after inflation’. This implies that stock markets will have higher returns in periods of high inflation and that you need not worry about inflation. But history shows there is NO correlation between returns and inflation. Look at the graph on Sheet 17. Yes, over time businesses correct their pricing to compensate for inflation, but that correction takes time to implement. Keep your assumptions of investment returns separate from inflation assumptions. Gold-plated pensions are indexed to inflation, but few people have those. Annuities that you buy personally from trust companies can be obtained in a version that also adjusts with inflation, but they cost a lot more. Most people do not feel the trade-off is worth it. Just because your annuity payments are flat does not mean you cannot deal effectively with inflation’s erosion. You simply do not spend all the income of early years. You set aside and investment a portion. You gradually build up a portfolio of value that will later be drawn down to cover your growing cost of living. This spreadsheet converts a flat payment to an amount you can spend that grows with inflation. Owning your own home is a great hedge against inflation. The value of the rent saved will grow with inflation and the principal value of the home will also grow with inflation. Even better if you have a rental suite to cover the increasing cost of your other bills.
4. Long-Term Care Costs
   for the last few years of your life can wipe out your savings. They cannot be ignored. There are four ways to deal with it.
   1. You can depend on family caregivers and/or friends to provide the care for free.
   2. You can set aside the value of your home (with no mortgage) from your other retirement calculations; understanding that its eventual sale will fund the nursing home costs.
   3. If you maintain the inflation-adjusted value of your investment portfolio (see the spreadsheet), it will be available to run down over that last few years of your life in a nursing home.
   4. You can buy long-term care insurance. How much you should spend on it comes from the spreadsheet. Compare the spending allowed between the two options (die-broke or maintain principal value). The extra cash available in the ‘die-broke’ scenario is the maximum you should pay.
5. Investment Returns
   are a huge unknown. The variability of returns will greatly impact the portfolio’s sustainability. ‘Dollar-cost-averaging’ will be working in reverse. Draws after a market decline will remove a greater portion of the portfolio, than draws make at market highs. Computer models that incorporate thousands of possible returns, called MonteCarlo simulations, have all shown that poor returns at the start of retirement destroy its sustainability. Returning to work might be the best decision if this is your reality. So do not burn your bridges behind you when you retire. Experts disagree on what to do to mitigate the risk of early poor returns. Most advise either: taking your spending money from debt assets first, or taking it from the best performing asset class (Spitzer,Singh paper), or reducing your spending for those years. Some advisors use the term “buckets”. This refers to the strategy of owning safe debt that matures in each withdrawal period such that draws are taken only from that debt.
6. Longevity Risk
   is the risk of out living you money because you did not correctly predict the age at which you would die. The spending spreadsheet (link above) includes a section for “die broke”. The all-important variable will be your expected life span. The probability of living different lifespans can be found at this website. Remember though, that you may be the 1% that lives to 102.There are five ways to deal with longevity risk.
   1. If you are lucky enough to have a defined benefit pension plan that is sufficient to cover your necessary costs, you have no worries. By the time you reach an advanced age, your discretionary costs will be minimal. The Canadian Pension Plan (CPP) and Old Age Security (OAS) continue until death, so they cover off some longevity risk.
   2. Owning your own home provides you with free rent until you die. Even better if there is a rental suite with income to cover your property taxes.
   3. Otherwise, you must buy longevity insurance. The most effective way is to buy a deferred annuity. You get the most benefit by waiting to make the purchase until you are over 60. Defer the benefits until the time you expect your portfolio to have run down. In the mean time, the cohort with whom you are lumped by the insurance company will have died away – leaving all their money to you, along with what it has earned in the interim. This concept is called a tontine.
   4. You can get a reverse mortgage on your home. This too, assigns your longevity risk to another party. But in the process, you destroy your home equity and reduce the eventual sale’s proceeds that can be used to fund a retirement home.
   5. You can presume a lifespan that is long in the exteme, that adds (say) 10 years to the actuaries’ predictions today, that adds 20 years to your grandparents’ age at death. The point is that you cannot use any kind of average.
7. Die Broke
   or maintain your wealth? This is the biggest decision to make. ‘Die broke’ allows you to spend more, but leaves you more exposed to the risk that you outlive your savings (longevity risk). Investment returns may be lower than expected, tax rates or inflation may rise and your lifespan may be longer than predicted. What, exactly, do you plan to do then? Milesvky (paper) has found that outliving your expected death ranks with poor initial market returns as by far the biggest risks facing retirees.
8. Maintain Your Wealth
   is a far less risky strategy because it removes the lifespan risk. Essentially you can spend only what is left from your investment returns after taxes are paid and after the amount of inflation in retained and reinvested.
   • You can leave a legacy to your kids or charity.
   • You can self-insure against unknown investment returns.
   • You maintain the ability to make large purchases like real-estate.
   • You can self-insure against unknown health costs.

The 4% Solution : It is important to understand some of the details behind the 4% withdrawal rate frequently promoted. This was the result of work done ten years ago (“Determine Withdrawal Rates” by William Bengen). He found that a 4% withdrawal (that grows with inflation) would almost certainly not deplete the portfolio before 30 years. It was the ‘big events’ that caused portfolios to shrink prematurely – the Great Depression and the 1970’s inflation. Since these big events only occur infrequently, you may not want to be THAT certain. Then again, his time frame for study was only 30 years. If you are retiring early, 40 years would be more appropriate.

Spitzer clarified that over 30 years, a 4% draw rate on a portfolio of 70% or 80% equities would only run out 2% of the time, if the draws were taken first against the bonds portfolio. He also showed that the average remaining portfolio at the end of 30 years will be more than 7 times its original value. So if the sky does NOT fall, the 4% draw rate allows your portfolio to grow for your survivors.

A problem with this solution lies in its treatment of inflation. Their 4% must be used to pay not only living expenses, but also taxes on investment earnings. While it is reasonable that the living expenses increase over time, income taxes will most probably remaing at the same percentage of income.

100 Minus Your Age Solution : There is widely repeated advice that a retired person’s portfolio allocation in common stocks should equal 100 minus his age. (Or his percentage allocation in debt should equal his age.) The debt percentage increases with age. But this advice dates back to an era when men retired at 65 and died 10 years later. The unstated presumption is a die-broke situation where living expenses come from maturing or selling bonds, and so their value must be predictable within short timeframes.

But retirement now stretches out 40 years. It is much more important that portfolios grow to compensate for inflation and longevity risk. When you plan to live off a portfolio’s income instead of its principal, the certainty of liquidation values becomes less important.

Even the research that considers a 30 year retirement has found that you have the best chance of not outliving your wealth if you deplete your debt holding first. In other words, you increase your common stock percentage over time (paper by Spitzer,Singh).

The Flexible Solution : A lot of problems are solved when retirees keep their spending habits flexible. They take an extended trip after market returns have been good, and cut back to basics in down markets. They put aside into near-cash investments 1% or 2% in years of good markets, and draw down those savings in the periodic poor markets. By doing so, the reverse-dollar-cost-averaging effect is not triggered. They budget for ‘normal’ health without touching the inflation-adjusted principal of their portfolio, so that a pot of value is available for end-of-life care.

Each year (or on a 5-year-moving-average) they calculate their spending limits
starting with the portfolio’s percent return (e.g. 8%)
less taxes paid (e.g. 15% of 8% equals 1.2%)
less reinvested inflation (e.g. 1.8%)
less 1% set aside for a rainy day
equals $$ available for spending ( = 4%)

Reference Articles of Interest

“Making Money Last” by Peter Lingane
“Withdrawal Plan Layer Cake” by William Bengen
“Replace Lost Longevity Insurance” by Moshe Milevshy