Monday, January 26, 2015

Debating What Income Level is Safe in Retirement

How much we can safely spend each month from our savings during retirement can be an emotional subject. People want more income, but they also want to know that they won’t run out of money. The truth on this subject can be very unwelcome. Financial advisors seem to feel this pressure from their clients because advisors often seek ways to argue that higher withdrawal rates are possible. I give a couple of examples here.

Most people whose lifestyles are not fully covered by CPP and OAS payments have not saved enough to cover the difference over a long retirement. Either their lifestyles must become less expensive or they will drain their savings too fast. These people don’t want to hear that their withdrawal rates are unsustainable.

People seek reasons to believe that they can exceed the well-known 4% rule when the reality is that this rule is overly optimistic because it is based on zero investment fees. In truth, a 3% rule is closer to the mark for a long retirement.

Among reasonable people I discuss finances with, one of the most unwelcome observations I make is that the 4% spending rule in retirement is often too aggressive. In a world where so many people would like to quit working but have less saved than they’d need, there is a strong emotional need to believe it’s possible to generate a high income from savings.

Financial planner Wes Moss uses a 5% rule that he justifies by investing in stocks with high dividend yields and then hoping they produce the same capital gains as other stocks with lower dividends. This shouldn’t be very persuasive, but consider it from the point of view of someone who hasn’t saved enough. Suppose you’re retired at 60 and desperately want to spend $5000 per month, but the 4% rule gives you only $3000 per month. Moss says you can have $3750 and I say that only $2250 is safe. I’m pretty sure most people would listen to Moss and push me out the door.

Even David Toyne, Director of Business Development at the very client-friendly firm Steadyhand isn’t immune to the pressure to allow higher income. In an otherwise useful and informative video interview, Toyne said the following at about the 11-minute mark:
“In retirement you can withdraw 4% of your portfolio and that’s a sustainable withdrawal rate—in other words you won’t run out of money—remember that 4% could be 5% if you trim your fee by 1%.” I’m all for cutting fees, but the 4% rule is based on zero fees. Cutting fees might boost your safe withdrawal rate from 3% to 3.5%, but it won’t get you to 5%.

A justification I hear for higher spending levels is that people tend to spend less as they age. This is almost certainly true, but it is largely because people spend less as they see they’re running out of money. A study examining this question produced data supporting this conclusion. People begin to reduce spending, even in their 60s, if their spending is high relative to their savings. But people whose spending is in line with their savings don’t spend less as they age.

I’m not a lone voice on this point. Jeff Brown makes a case for something closer to a 3% rule, and William Bernstein is quoted as saying “Two percent is bullet-proof, 3% is probably safe, 4% is pushing it and, at 5%, you're eating Alpo in your old age.”

Because their clients want to hear they can safely spend more, even some good advisors want to believe that higher withdrawal rates are safe.

12 comments:

  1. I don't see a lot about annuity written on the financial blogs.

    Would it solve the problem?

    Is it a fair deal?

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    1. @Anonymous: The biggest problem with annuities is that most of those sold have no cost of living adjustments. So, the payout looks great at first and erodes from there. You can buy an annuity whose payments increase by a fixed percentage each year, but there is no guarantee that you will guess the amount of inflation correctly. You'll also find that the starting payout is much lower for annuities whose payments rise every year. Standard Life seems to sell a CPI-indexed annuity, which puts it on a more equal footing with CPP payments, but the monthly payouts seem to be even lower. I've also had difficulty getting quotes without having to engage an insurance agent.

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  2. The only big reason I see that some people spend less as they age is if they have to stop owning and driving a car. Even that, though, is offset by the cost of taxis and often the extra health care costs that required them to stop driving.

    I also find it unsettling to see withdrawal rates quoted as if people will be dead at 85, 90 or even 95. I remember a relative telling me that she couldn't break it to her mother that her annuity had ceased at 95. The daughter was paying for all her Mom's expenses on the sly. And this was several years ago. It's not unlikely that many people entering retirement now may find they need income into their late 90s or even longer. Rushing to drawdown your savings too quickly could be disastrous for those people.

    But as you say, no one wants to hear this. They want to have the golf memberships, the travel, the two cars and the caviar lifestyle but they don't want to have to have saved a huge pile to fund it.

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    1. @Bet Crooks: I agree that it doesn't make sense to leave your very old self very little money. Usually, when I discuss this topic with others, they tend to imagine someone very old, like 90, and assert that very old people just don't spend as much. Even if we accept this reasoning, the truth is that if you start spending too much when you're 60, you'll have to cut back fairly soon (likely still during your 60s). So, overspending causes financial problems while you're still a relatively young retiree.

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  3. I guess it depends on how much you plan to take with you and how you want to live out your last days.

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    1. @CheapMom: Those certainly are factors. But even once they are nailed down, experts disagree on how much you have to save to meet your goals. My observations are that financial advisors succumb to pressure from their clients to say that lower amounts of savings are enough.

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  4. I am taking early retirement so my withdrawal rate will be 4% for the first 12 years, but then once social security kicks in the withdrawal rate will drop to 2%, so I figure this is probably okay. I have set up a bucket of safe funds to cover that first 12 years in case there is a market crash to prevent sequence of returns risk. Crossing my fingers and hoping this works out.

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    1. @Tara: That's safer than a simple 4% rule. You've already identified the major concern -- the sequence of returns risk. Good luck.

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  5. I'm aiming for a 3% rule personally.

    I think inflation is a massive retirement wildcard. In recent years, we've been blessed with uber-low rates. I can't imagine this is going to last forever. I certainly didn't see a rate cut coming this winter.

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    1. @Mark: I guess as your own advisor, it's tricky to overrule your client :-)

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    2. I retire in 30 more shifts(end of March) and am thinking a lot these days about the withdrawal rate. Picking a rate is fine but it depends where your money is. With an RRSP once you RRIF your rate will be 7+ in the first year. You can shelter some in your TFSA but that may not be enough.

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    3. @Jambo411: You're right that RRIF withdrawals are unsustainable. To be safe, you'd need to save a good chunk in a TFSA or non-registered account. I'd prefer that CRA allow smaller RRIF withdrawals to keep the unwary from running out of money too fast.

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