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.