My How to Safely Spend More in Retirement

Dana here.

Imagine going to the Grand Canyon, walking right to the edge, and looking down. Sound scary? Some people can do this with no problem. Others can do this if there is a solid railing. And some, like my Dad, need to stand back several feet even if there is a secure railing in place. We each have a different tolerance level for how close we can get to the edge and still feel comfortable enough to enjoy the view.

This same effect is in place in retirement. How much can we spend each year? Well, that depends on how long we’ll live, what rate of return we’ll earn on our savings and investments, and how much we need to hold back for potential unknown expenses later in life. Not knowing how to plan for all these variables, many retirees, if not most, stand far back from the edge. They spend so cautiously that they forego items that could have made a difference in their quality of life.  

Is there a middle ground? A way to know what you can spend and feel confident that you won’t go over the edge? It turns out there is.

In a new research paper, Guaranteed Income: A License to Spend, authors David Blanchett and Michael Finke find that retirees who hold a larger portion of their wealth in guaranteed income spend more than retirees who have the same amount of wealth in savings and investments.

What exactly does that mean?

Well, an income stream has value. If you receive a pension or annuity income of $1,000 a month, you can calculate how much savings and investments you would need to have to replicate that guaranteed income. The present value of $1,000 a month for life for a 65-year-old is approximately $237,189 (using a 3% per year discount rate and 30-year life expectancy), which means that $1,000 a month for thirty years is roughly equivalent to $237,189 in the bank today.

Yet, retirees who get the $1,000 a month for life (wealth in the form of guaranteed income) spend more than the retiree with the equivalent $237,189 in savings and investments.

Or, put another way, if you have $1,185,945, that is equivalent to $5,000 a month of income, but you’re likely to want to keep away from the edge and only spend $4,000 a month. But if you put that $1.1M in an annuity paying you $5,000 a month, you’d be likely to spend it all.

I wouldn’t use this research as a reason to put all your money into an annuity issued by an insurance company to pay you income for life. Still, it is a case to recognize the value of guaranteed income in a retirement income plan. We measure this value by calculating a coverage ratio.

We look at the amount of annual guaranteed income you’ll have when you reach age 72 and compare that to your projected outgoing expenses. We want to see a coverage ratio of about 50%, meaning your guaranteed income sources will cover at least half of your annual living expenses.
 
This 50% is not a hard and fast number. It is adjusted based on your household wealth and on the amount you consume relative to your wealth. A household with financial assets of $2.5 million or more who typically only spends $50,000 a year from their savings can feel secure with a coverage ratio of less than 50%. In contrast, a household with financial assets of less than $1 million of savings spending $40,000 a year from those savings would want a coverage ratio of 50% or greater.

Despite these ratios, we had one client with financial assets of about $5M who insisted on putting $2M of his savings into an annuity to provide guaranteed income. He knew he would spend more if it were paid to him in a monthly format. If he left the funds in his portfolio, he felt he would not be comfortable drawing as much out.

While this might not seem to make common sense, we humans are, first and foremost, emotional beings. While we aspire to make logical, rational decisions, our emotions impact us, and no one wants to live in retirement feeling like if they take that extra trip, that may put them too close to the edge.

We use several approaches to make sure people can see what they can comfortably spend without going near the edge.

First, we do the math so that each person can make the most of any guaranteed income they already have access to, such as Social Security, pensions, existing annuity contracts, or deferred compensation plans. Each of these cash flow sources comes with choices as to when you begin taking it, and in some cases, what survivor options you choose. By making the most of these options, you can maximize the guaranteed income already available to you.

Next, we run a series of retirement readiness assessments which include a Monte Carlo simulation (probability), a fundedness test (like what a pension plan runs each year), and a historical audit (which illustrates how sustainable the portfolio would have been in the past.) We can then demonstrate how the purchase of additional guaranteed income would impact the results of these assessments.

And most importantly, we discuss options. There are pros and cons to all choices. For one person, shifting $2 million of their wealth from investments to guaranteed income may be optimal. Yet, for many people, that would be too much. 

Overall, we find that as retirement experts, much of what we do for retirees is provide them a license to spend. They call us to see if they can afford to increase their withdrawal to keep up with rising costs, fly the family in for a holiday, buy the beach condo, or get the RV and travel for a few years. We have a process and a set of metrics we use to give them an answer quickly. Most of the time, the answer is yes, you can do that, and you aren’t going to be too close to the edge.

Having a modeling process and guaranteed income in place provides two sure-fire ways to safely spend more in retirement. Those who want help creating their own license to spend in retirement can learn more about what we do on our Services page of the website.

Our next free, live webinar, How to Plan for Taxes in Retirement, will be on Thursday, September 23, 2021.

In retirement, you need to set up your tax withholding or make quarterly tax payments. How can you estimate how much you'll need to withhold and how will it change throughout your retirement years? In this free webinar, we'll show you how the tax code works for retirees and how to make sure you pay the least amount possible over your retirement years. 

We'll be looking at practical examples of how to apply the tax code to these three phases of planning for retirement:

• While you are still contributing to savings
• When you are taking withdrawals
• How you allocate your investments

Come learn how to reduce your tax bill!
 
When: Thursday, September 23, 2021 at 5pm AZ/ 7pm CST/ 8pm EST

You can register at How to Plan for Taxes in Retirement

Podcasts & Video

Phased-Income Approach to Retirement Withdrawals
Sensible Money's Chuck Robinson and Retirement Daily editor Robert Powell discuss how a phased-income approach to retirement withdrawals is way better than any rule of thumb.

Phased-Income Approach to Retirement Withdrawals

How to Make an Investment Plan
If you missed our last webinar you can watch it, or any of our other webinars, on our YouTube Channel.

How to Make an Investment Plan

Sensible Money in the News

The startribune.com quoted Dana in this article: "Overthinking your money decision? Here's how to change that"

Dana contributed to Forbes in: "A Second Look: Four Retirement Rules Of Thumb"

Dana also contributed to this article from US News & World Reports : "What to Know About Platinum Investments"

Financial Sense is an almost-monthly publication of Sensible Money. It's about financial planning and smart money decisions, not sensation and hype. You know.... sensible.