If there's one question we face in retirement, it's whether our money will outlive us or we will outlive our money. Fortunately for those who are eligible, Social Security will provide some semblance of steady income in retirement, but it's only meant to provide 40% of our pre-retirement income, enough to keep us off the streets. Federal retirement benefits won't fund lavish vacations in Bora Bora, but that doesn't mean you can't have any well-deserved fun in retirement.
If you want to embrace a life of relaxation in retirement while making sure your money lasts as long as you do, it will take some creative planning unless your nest egg has a lot of zeros after it. J.P. Morgan Asset Management published its 2019 Guide to Retirement, which offered some gems of information for people interested in making their retirement money last.
1. Spending decreases in retirement
First, the good news: Spending in retirement decreases substantially, with spending falling across every category in retirement, according to the J.P. Morgan study.
For a couple whose ages are between 45 and 54, average spending per year was near $84,000, but for a couple in their mid-70s, their average annual spending was around $53,000.
Housing costs are a big chunk of this spending in all age groups, but they peak during your 40s and then start declining after. Transportation, entertainment, food, beverage, and travel expenses also decline from age 40 to age 70. Naturally, healthcare costs increase as you age, and charitable donations pick up later in life as well. The biggest takeaway is that on average, you won't spend as much in retirement as you do in your working years.
2. Have a flexible spending plan
The first step to making money last in retirement is having a dynamic spending plan. If we put on blinders and ignore interest rates, the stock market, and inflation, we are setting ourselves up for trouble down the road.
Inflation is the invisible enemy of retirees. If inflation rises by 3% every year, then according to the rule of 72, retirees can expect costs to double in 24 years. With retirees living longer, there's a good chance a 65-year-old will live to see their costs significantly increase.
A traditional withdrawal strategy means a retiree pulls the same amount of money out of their nest egg each year, (4% of your total nest egg is the general rule of thumb), except for minor increases to account for inflation. J.P. Morgan's research finds this approach inferior, warning the 4% withdrawal rule can lead to eroding a principal balance too soon.
Instead, J.P. Morgan suggests using a dynamic withdrawal scenario, in which you employ a more flexible approach to withdrawing and spending money in retirement actively factoring in stock market returns and changes in inflation. A 65-year-old who implemented this strategy versus a traditional spending strategy can spend 14% more over his/her lifetime.
Here's how the dynamic withdrawal strategy works. If the annual rate of return on a portfolio is:
1) Less than 3%: withdrawal remains the same as the prior year.
2) Between 3% and 15%: withdrawal is increased by inflation (about 3%).
3) Greater than 15%: withdrawal is increased by 4%.
3. Goals-based wealth management
A second useful tip to make your money last longer is to align each goal with its own investment strategy and savings account.
We can divide goals into short ones, intermediate ones, and long-term ones. Short-term goals may include a down payment on a house, an emergency fund in cash, or money for car or house repairs. An intermediate goal could be a vacation. Long-term goals might be future healthcare costs and retirement savings.
The key is to align the right type of risk to each goal to ensure your money is working smart and outpacing inflation.
First, figure out how much you need in each bucket and maximize each goal fund's investment return. For example, short-term investments should be in liquid, safe, and high-interest CDs or money markets. Intermediate savings might be in balanced mutual funds. Investments for long-term goals are tilted more toward stocks for growth, and since you'll have time to make up any dips from market volatility.
4. Timing is everything
One of the major risks faced by retirees is having to retire during a bear market, a severe stock market correction or even a recession. Retirees know they need to be invested in the stock market for growth and to outpace inflation over the long term, but a market correction can set them back.
The math looks like this: If you have to pull money out for retirement spending in a portfolio that is losing money, it puts a significant strain on the nest egg because it's a double negative -- a withdrawal plus a loss in the portfolio. In investment speak, we call this a sequence-of-returns risk, which is illustrated by J.P. Morgan's research: A $1 million nest egg in a good market ended up growing to $1.7 million later in life, versus one that started off with the same $1 million but, in a bad market, had $0 left in the 25th year.
There's no way to tell what the stock market will do in the year we retire. Short of telling the future, one approach is to use the aforementioned goals-based wealth management approach that keeps the short-term goals in cash away from the vagaries of the stock market.
The bucket approach to asset allocation ties into this. As you use up the cash for your short-term goals, replenish it with money from the long-term bucket. This will help ensure the short-term coffers are always full and available to meet spending needs. If you encounter a bad sequence of stock market returns, use a dynamic spending approach so less money is withdrawn in a year when the stock market is down.
Retirement planning has come a long way from the days of retiring with a pension and living off of the steady income. With pensions going the way of the dodo bird and Social Security not being nearly enough for most people to live on, retirees have become more responsible for their own success. Having a plan for spending, a plan for withdrawals, and a plan for investing can make the money last a lot longer.
All in all, if we're going to make retirement work, it may take a little more effort, but that effort will be rewarded later on when you're enjoying Bora Bora at age 90 with no worries in sight.