Critical Stuff: Spend no more than 3% of your savings per year.
In This Chapter: Calculating Doom. It’s not what you saved, it’s what you spend. It’s never too early to simplify.
The ultimate retirement question: Will my savings last through my retirement? There are a host of ways to arrive at some kind of answer. Let me preface this with the simplest answer: Yes. Your savings will last if you always adjust your savings to the current environment–but that’s a nonsense answer. In theory you can just tighten your belt when things get tough. Not many people continue blithely spending until their savings account is depleted. But most people have some minimum amount they need to spend–to pay property taxes, income taxes, medicine and health care expenses, etc.. So yes, you can easily get to the point where you can’t meet your minimum requirements and have to take drastic action.
There are dozens of tools on the internet that can help you make this calculation. The value of the tools generally varies with their sophistication. To do a good job of making this kind of calculation you input all your sources of income, the nature of your portfolio, your age, your spouses age, and the amount of money you spend each month. You probably also set a spend rate expected after the spouse with the shortest expected lifespan dies. Then the tool calculates your likely portfolio and other investment performance, contrasts it against your spend rate, adjusts for inflation, and tells you how much money will remain when you die.
There are four flavors of tool based on the nature of the calculation, Since the way the market behaves is a critical piece of the calculation, and there are other factors that are hard to estimate, the calculators fudge the results on one way or another.
Deterministic: This means the rates of return for stocks and bonds are fixed–usually by the user. This kind of calculation generally just tells you how much money you will have if all the input variables work as intended. In other words, if you are correct in your assumptions about portfolio earnings and inflation rate. It’s basically a model based on compound interest vs. an inflation-adjusted draw rate.
Historic Returns: The calculator uses historical stock and bond returns from some representative period. It’s a slightly more sophisticated approach than just guessing portfolio return. Of course as any prospectus says–past performance is not an indication of future performance. But still, it’s useful.
Historical Stress: The calculator selects a historical blend to build worst case scenarios. Another step up in complexity and sophistication. In some implementations, this model runs with a number of historical versions, yielding a prediction for portfolio performance and inflation based on several historical timespans.
Monte Carlo: The calculator builds a model for how a portfolio might perform and then runs through thousands of possible scenarios, recording the result for each scenario. This is probably the most useful model for giving a range of likely performance for diversified portfolios. It clarifies how decisions on asset allocation can affect risk. The results are generally supplied for several different portfolio designs, with the primary calculation output being a percentage of model runs that yielded the desired result. Monte Carlo tests are a standard statistical method for problems where there are a lot of possible input factors and a wide variation of ranges. In a practical Monte Carlo simulation, the outlier situations are not modeled. In other words, they don’t tell you how your investments will do in the face of any flavor of Armageddon.
So why would you use these calculators? Well, for one thing, most of them will give you a probability for your savings lasting for some spending rate. You can get a good idea of a safe rate to spend. You can also see the difference that various portfolio allocations make. For example, an all-stock portfolio will likely show some higher risk levels for longer time periods, and an all-bond portfolio will not support a high spending rate. Playing around with the allocations, the spending rate, and the amount you have to invest will give you a good idea of what some parts of your plan should be.
There is a well-documented list of retirement calculators on the Bogleheads wiki site at : http://www.bogleheads.org/wiki/Retirement_calculators_and_spending This page seems to be maintained and updated fairly frequently though some of the calculators move around on the website referenced–you might have to search, but it doesn’t make sense to reproduce it here.
Desired Spending vs. Desired Savings
You may not have a clear idea of how much money you’ll have saved at retirement, or perhaps you need a little stimulation to spur your saving efforts. You can stand the model on its head and come at the issue another way by figuring how much you want to spend in retirement.
This calculation requires estimates of your expected longevity, investment returns for various portfolio designs, and inflation. The calculation can use any of the mathematical models shown above, and the output is the amount of money you’ll need to save for retirement. You simply choose a spend rate and then run the models with guesses at the amount of savings required to safely make that work. Your version of “safe” is personal, but I look for a Monte Carlo probability of better than 95 percent. In the process of playing with this, you’ll also find the kind of portfolio most likely to work for the timeframe you’re expecting.
Thumb Rules vs. Calculators
The same kind of numbers can be achieved through thumb rules, and these kinds of rules are often preferred by less sophisticated advisors. Oddly enough, the high expense financial advisors tend to be less sophisticated than low-cost advisors. The reason is simple–the skill set required to succeed in the high-cost model is salesmanship and the ability to instill trust, even when things look a bit bleak. A deep understanding of financial markets and mathematics is not part of the required skills. The financial acumen of high-cost advisors comes from the organization that backs them, such as a large bank or an investment “platform”. That might sound just great to you, but understand that you are being sold a set of products based on the needs and interests of the financial advisor and the platform–your needs come a distant third.
The common thumb rule for spending in retirement is that you can spend 4 percent of your savings per year. It’s not a terrible thumb rule, and it’s even better if you use 3 percent. This rule doesn’t include any direct notion of how long you will live, what inflation will be like, or how the markets will do. It’s a thumb rule, pure and simple, but it’s based on modeling done in a variety of studies, and it’s useful.
Another thumb rule regarding your portfolio is that you should own your age worth of bonds. In other words, if you are 65, your portfolio should be 65% bonds. It’s simple, easy to remember, and it’s based on likely recovery time for a downturn, which certainly makes sense. But in many ways, it’s out of date. If you are 65 and your likely lifespan is 10 years, then it makes perfect sense. If it’s more like 30 years then it makes a lot less sense and you might need to take more risk to meet your future spending requirements.
There are many more thumb rules, and many ways to come at the kind of spending rate, total savings, and portfolio allocation that will reduce the risk of depleting your savings. But before you accept any of them you should understand the concepts that underlie the thumb rule and be certain that it actually applies to you. You are more likely to have actionable guidance that is likely to deliver the results you desire if you run a few models and really see what the results are like.
Budgets, Spending, and the Simple Life
The easiest way to make certain you don’t run out of money is not to spend it. It’s not a total solution since inflation, market meltdowns, or a comet striking the earth can derail your plans. But simplifying your life before and during retirement makes a profound difference. There are numerous tools to create a budget, but any tool you use should differentiate between fixed expense and variable expense. Making the calculation is simple–add up all the fixed expenses and subtract them from your monthly income from all sources. What’s left is your variable expense, which you then choose to allocate. You might consider food to be a fixed expense, but it isn’t. You can spend less or more than you currently do.