Planning cashflow in retirement is extremely difficult to say the least given nobody knows how long they are going to live for, cannot be sure as to the quality of health they will enjoy and have doubts about the unpredictability of investment returns.
This results in the two main hazards of retirement planning; underspending and consequently not enjoying retirement to its maximum or overspending and running out of money and not being able to fund retirement.
Under provisioning for retirement means you are faced with the stark choices of having to reduce your spending, having to save more in the years up to retirement, working longer, taking on more risk (ie investing in more growth assets) or a combination of these choices.
Overprovisioning for retirement faces its own burdens with the uncertainty on the future weighting heavily on your consumption decisions ie spending too little because of the attendant uncertainty of knowing whether it is too much.
The table produced below was prepared by Jon Kalkman of the Australian Investors Association.
Rather than simply hoping for the best, the table below provides some guidance for that planning. It shows the number of years it takes for a starting amount of savings to reduce to zero if the percentage withdrawn is greater than the percentage income earned.
Spending more than you earn
Assume Sue has $800,000 in savings and she needs an annual income of $64,000 (8%). Assume also these retirement savings are invested and earning 6% based on a rolling return averaged over 10 years. Some years will be higher, some years will be less, but the long term rolling return will be 6%. Therefore, Sue needs to liquidate $16,000 of capital in the first year to pay the shortfall in income and her savings balance progressively declines. According to this table, reading across the rows and down the columns, it will take 23.79 years until those retirement savings are reduced to zero.
If Sue could reduce her spending to 7%, her savings will last for 33.4 years. A $9,000 reduction in expenditure, from $64,000 per annum to $56,000 produces another 10 years of lifestyle! Small changes have profound results.
The table shows that if Sue spends 8% of her savings annually and earns only 1% per year, from a term deposit for example, her savings will be exhausted in only 13.42 years. Why would you use term deposits if you were retired?
This table assumes constant withdrawal and earning rates over the whole time period, and it assumes no fees, taxes or inflation. The table is not a prediction but it can be instructive.
The real world has fees, taxes and inflation
The table can also illustrate the effects of fees. Using the example above, if fees are 1%, actual spending is higher at 9% annually, then the capital is exhausted after only 18.85 years. Fees charges and taxes have a big effect.
With inflation, the effects are even greater. If inflation is a constant 2%, your actual return is 4% meaning your capital will be depleted in 17.67 years.
Age pension as a safety net
In reality, the balance of capital is unlikely to reach zero because in Australia we have the safety net of the age pension. A couple who own their home with $800,000 in financial assets would actually be entitled to an annual part-pension of $6,258. Their combined income (investments plus age pension) is $54,258. If this couple were to decrease their capital by $100,000, under the current assets test, their combined pension would increase by $7,800 to $14,058. The taxpayer has replaced the $6,000 (6%) formerly earned from that $100,000 with an increased pension of $7,800 (7.8%). Their combined income is now $56,058.
When their assets fall to $401,500 this couple gain the full age pension of $37,340 so their combined income is $61,430. The age pension places a safety net under all retirees, thereby reducing the need to liquidate capital. Unfortunately, age pensions are not guaranteed and are subject to the whims of changing governments. So as a long term safety net its questionable.
The challenge of financial independence
For retirees who aspire to financial independence, the task is complex. Without careful planning, retirees are likely to outlive their savings. We know that 50% of males currently aged 65 will survive beyond age 84, but around 5% of that group will survive beyond age 97. Similarly, 50% of females currently aged 65, will survive beyond age 88, but around 5% of that group will survive beyond age 100. Some individuals will survive even longer.
Therefore, if independent retirees wish to plan their retirement with a 95% certainty that they will not outlive their money, they need to plan for a retirement of at least 30 years.
That means, according to the table, they cannot spend much more than their investment earnings – ever!
There is a direct relationship between risk and investment return, but independent retirees also need to balance market risk against the longevity risk that they will outlive their savings. Therefore, those who adopt low-risk, low-return investments may be sacrificing their long-term financial security due to their short-term concern about market volatility. Yet, such conservative investment portfolios are typically considered normal and appropriate and may explain why so many retirees exhaust their own resources prematurely.
This article was originally published by Jon Kalkman, a former director of the Australian Investors Association on 7 April 2021 This article is for general information purposes only and does not consider the circumstances of any investor.