Smart ways to make your retirement money last
Over and above any pensions they might receive, Canadians face two key questions when it comes to retirement planning: 1) How much can I afford to withdraw from the money I’ve saved? 2) How should I adjust my spending in response to changes in the value of that money?
A popular rule of thumb suggests that retirees should settle on a four per cent withdrawal rate at retirement — adjusted for inflation every year thereafter — regardless of their changing circumstances.
But that doesn’t make a lot of sense. Assuming the past 20 years of your life have had their financial ups and downs, why would you expect retirement to be any different?
Since no one knows what the future will bring, it pays to be flexible when it comes to retirement spending. In other words, like any rule of thumb, four per cent is really only a general guideline.
The good news is that there’s no law that says you've got to stick to the identical withdrawal rate for the rest of your life. In fact, a growing body of research suggests that updating your withdrawal strategy on a regular basis improves outcomes significantly.
To stay on top of things, you need to take into account how your portfolio performs, the rising cost of living, the expected mortality of both you and your partner, and the kind of financial legacy you may want to leave.
However, you may be hesitant to implement a more active withdrawal strategy, given the sometimes complex software or processes involved.
The solution is to narrow the focus, maintains David Blanchett, head of retirement research for Chicago-based Morningstar Inc.
Rather than trying to trying to keep too many balls in the air, he suggests concentrating on two formulas to simplify the withdrawal amount calculation.
The first equation, which Blanchett labels a ‘dynamic’ formula, works for periods of 15 years or longer and can be used to determine the optimal withdrawal rate for each year of retirement using just four variables.
Those inputs include asset mix, the remaining retirement time horizon, the targeted probability of success and a ‘what-if’ factor that reflects portfolio over/underperformance relative to any built-in future return expectations.
For example, if you believe the future returns for a 60 per cent equities portfolio will be two per cent lower than the assumed returns in a retirement calculator, then that ‘let’s be cautious’ factor would be minus two per cent.
To assist with such customized calculations, Blanchett has created a detailed Excel spreadsheet that enables you to develop your own scenarios.
In testing this dynamic withdrawal model, Blanchett found that the optimal retirement horizon is the retiree's median remaining life expectancy plus two years — and the optimal target probability of success is 80 per cent.
Some planners would consider a probability of success that was below 80 per cent to be a failed plan since that would mean that, in one out of five cases, you’d run out of money during retirement. But that’s not necessarily the case, Blanchett argues.
The reality is that for most retirees spending doesn't simply continue unabated until the cupboard is bare. Instead, at some point, it becomes clear that the income to expenses pattern is unsustainable, and that some adjustments need to be made.
The second formula he favours is based on the U.S. Internal Revenue Service's required minimum distribution rules (similar to those governing registered retirement income funds in Canada), which force an investor to begin taking a minimum amount of money out of his or her tax-deferred savings plan at age 70.5.
This approach works better for periods of less than 15 years, Blanchett maintains. This method's principal attraction is that it requires only your retirement period as the single input because the IRS stipulates withdrawal percentages based on life expectancy tables.
The result is that actual spending responds to fluctuations in the value of your assets because the dollar amount of the withdrawal is based on the portfolio's current market value. In other words, whether you like it or not, you effectively cut back a bit when returns are poor.
Both approaches should appeal to retirees who are flexible when it comes to sustainable spending and interested in what's realistic at each point in time, he notes.
In addition to Blanchett’s spreadsheet, you might also want to have a look at FireCalc, a more visual tool that replicates the type of analysis done in his research.
There are several templates available, but sticking with the ‘Start Here’ box on the right-hand side of the page is probably the quickest way to model a sustainable spending level for you and your family.
Got a question about investing, saving or retirement? Send Gordon an email and we might answer your question in a future column.
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