Allow me to introduce the Hedonic Tilt. That’s a formal title for what most of us want to do in retirement. We want to spend more now, while we can enjoy it. And we’ll cope with spending less later, when our ability to enjoy spending may have gone by.
It’s an entirely reasonable desire. The only problem is that if we get too enthusiastic about spending today, we might have a really big problem in the tomorrow we don’t want to think about.
Fortunately, there is a simple solution: take a constantamount from your retirement funds and adjust, slowly, to the slow loss of your higher purchasing power. You can understand by considering a traditional financial planning example.
John and Jane Restless, both 65 and about to retire, visit their financial planner, Bill Constant. They’ll have Social Security benefits. They own their house free and clear. And their combined retirement savings are a cool million dollars.
The planner tells them that they might be able to spend about 4 percent a year, or $40,000, from their fund. “You’ve got a 95 percent chance of being able to spend that much, adjusted for inflation each year, for 30 years. One of you might, just might, live to 95 but it’s unlikely so this is a pretty safe plan.” (The planner figures are based on a portfolio that is fifty percent invested in the U.S. stock market and 50 percent in intermediate U.S. Treasury obligations.)
There’s only one problem.
John and Jane would really like to spend $60,000 a year from their fund, at least early in retirement, because they want to travel. “Can we spend that much?” they ask.
The planner dutifully puts the $60,000 figure into his Monte Carlo analyzer.
“Sorry, but that’s suicidal. If you take that much there is only a 61 percent chance your money will last 30 years.”
But John and Jane are realistic about their future. They don’t think travel will be as attractive at age 85 or 90 as it is today, at 65. So they’d like to spend more in the first ten years of retirement. If their health holds out, they might like to spend more money in the first twenty years.
“We’re healthy now,” they say, “but we might not be healthy at 75. And it’s a pretty good bet that we’ll have some limitations by the time we’re 85.” Is there a solution?
Yes. And it’s simple. Increase the annual income withdrawal, but don’t adjust for inflation. Make it a constant amount. If they do that, they can withdraw more than $60,000. They can take $68,750 every year for 30 years and still have a 95 percent probability of not running out of money. Indeed, there is a 75 percent chance that they’ll leave at least $2,250,000 behind.
The result? They have an additional $28,750 a year to spend. It will be losing purchasing power, of course, but the extra spending power will all be tilted toward their early retirement years. If, for instance, inflation runs at a 2 percent rate, the purchasing power of their constant annual income won’t be reduced to $40,000 for 27 years— when they are 92 years old. If inflation runs at a 3 percent rate their annual purchasing power won’t be reduced to $40,000 until 18 years have gone by. They will be 83 years old. Either way, they’ll have extra purchasing power in the early years of their retirement.
The price for that extra spending power, of course, is that their $68,750 will have less than $40,000 in purchasing power after 18 to 27 years.
Should that hold terror? I don’t think so. Here’s why.
First, repeated studies have shown that spending declines as we age. Sure, medical spending increases, but other spending declines more. So John and Jane may not even notice.
Second, like most retirees, Social Security will be a good part of their income. That income is inflation adjusted, so the impact of lost purchasing power for their income from savings will be diluted somewhat.
Then there is the angel of death. We don’t all live to age 95. In fact, few do. There is only a 46 percent chance that John will be alive in the 18 years it would take to get to that constant purchasing power $40,000 if inflation runs at 3 percent. And there is a 22 percent chance that both John and Jane will be dead. If inflation runs at 2 percent, that break-even point will occur at age 92. If that happens, there is a 70 percent probability that both will be dead.
The tradeoff should be carefully considered. But here and now is prime time.
Explore Your Retirement Income Options At Your Leisure
Most of the information used here came from the free tool I wrote about recently, www.portfoliovisualizer.com. If you register on this site you can run different models and save them for future reference. Once on the site, go to Monte Carlo simulations, build a portfolio by asset classes, and test different assumptions such as inflation-adjusted income versus unadjusted income.
You can use another online calculator to check the impact of inflation on different starting incomes by using the inflation calculator on www.calculator.net Use the backward rate calculator at the bottom of the page.
You can learn your probability of being alive (or dead) by using any number of online calculators. My personal favorite, however, is an Excel download from financial planner (and prolific researcher) Michael Kitces. It provides the probability of being alive for him, her, either, both or neither. You can find it at this link: https://www.kitces.com/joint-life-expectancy-and-mortality-calculator/.
But remember this, just because something produces what seem like carefully calculated numbers doesn’t make it precisely predictive. People who have more money than most are also more likely to live longer than most. Some analysts are forecasting lower returns in the future than in the past. And combinations of asset classes that worked well in the past may not work so well in the future.
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On the web:
Scott Burns, “The high cost of low returns and yields,” July 24, 2015 http://assetbuilder.com/scott_burns/the_high_cost_of_low_returns_and_yields
Scott burns, “Consumption, it’s so 1950,” August 14, 2005 http://assetbuilder.com/scott_burns/consumption_its_just_so_1950
Portfolio Visualizer website: https://www.portfoliovisualizer.com
Online Inflation Calculator: http://www.calculator.net/inflation-calculator.html?cstartingamount3=70000&cinrate3=2&cinyear3=25&calctype=3&x=54&y=7
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Photo: Scott Burns:
(c) A. M. Universal, 2015