Spending Effectively In Retirement

The question of how and how much money to spend in retirement is a critical one to answer. Spending too much each year post retirement may mean that our corpus runs out before we die. Spending too little may see us live a lower quality lifestyle than we deserve to post retirement. Defining and managing how much we spend each year post retirement is therefore a critical aspect of retirement planning. So today I am going to talk about a few guidelines which would give us a framework to spend better post retirement.

Spending Limits Instead Of Withdrawal Rates

Answering the question as to how much to spend each year post retirement is critical to spending effectively post retirement. To answer this question, we usually tend to look at thumb rules like the 4% rule. This would give us a withdrawal rate that would govern annual spending post retirement.

There is a fundamental issue that reduces the utility of such withdrawal rates. Our spending needs may change from year to year. So withdrawing a fixed inflation adjusted amount each year post retirement would not work. In fact, our spending in retirement may follow a phased pattern. During the first phase of our retirement (say until age 65), spending on discretionary expenses such as travel may be higher.

During the middle phase of retirement (say between age 65 and 75) we may slow down physically. Therefore we may tend to spend relatively less from our corpus during this phase. During the late phase of retirement (say age 75 onwards), long term cognitive and lifestyle issues are likely to kick in. This would lead to an increase in spending owing to healthcare expenses. We are therefore likely to withdraw more from our corpus during this phase. This means that our spending patterns throughout retirement are likely to resemble a smile shaped curve. This is borne out by the concept of the Retirement Spending Smile as shown in the graphic that follows.

All of this points towards the fact that the concept of a safe withdrawal rate is arbitrary. A possible way around the use of withdrawal rates may be to define an upper limit to portfolio withdrawals for each year in retirement. This can be done as shown in the illustrative example below.

Available retirement corpus = Rs 8,00,00,000

Current age = 55

Life expectancy = 90

Years in retirement = 90 – 55 = 35

Spending limit for the current year = 8,00,00,000/35 = Rs 22,86,000

This shows that spending for the year should be capped within Rs 22,86,000. This does not mean that the individual cannot exceed the spending limit. It only means that if the limit is exceeded, the individual may have to curtail spending for some years in the future. That would compensate for the excess in the current year. This calculation can be repeated year after year. It would define each year’s upper spending limit.

In years where portfolio returns are higher than expected, the spending limit may proportionately increase. When returns are low, the spending limit may proportionately decrease. Spending limits are hence a much more realistic alternative to withdrawal rates. They consider market conditions, the corpus available and residual life expectancy. This provides for greater flexibility in spending post retirement.

Ensure Adequate Inflation Protected Income Is Available

Inflation is a constant threat that retirees must factor into their plans post retirement. This is more true where the degree of dependence on the portfolio post retirement is high. It is hence vitally important to have adequate inflation protected income in place during retirement. This would give retirees greater peace of mind. This in turn would allow them to spend more confidently post retirement.

Pension schemes can create a minimum level of guaranteed income post retirement. This guaranteed minimum level of income is technically called an income floor. Post tax pension income should ideally be equal to annual expenses in the first year of retirement. Withdrawals can be made from the portfolio to cover for inflation in expenses over time Pension schemes can therefore form a considerable part of the debt component of a retirement corpus.

The option of creating an annuity ladder can also be considered. This involves buying an annuity at various points in retirement. The annuity rates would increase with the age at which the annuity is purchased. The income floor would therefore become higher as the individual progresses through retirement. An abnormally large initial retirement corpus would be required to create an annuity ladder.

Ensure Adequate Health Insurance Is Available

Significant healthcare expenses are another major risk post retirement spending. They may force us to dip into our retirement corpus. This would interrupt the effects of compounding on our retirement corpus. It would also take a significant chunk out of our annual spending limit. We must therefore have adequate health insurance coverage in place all through retirement.

Our medical insurance would then cover any healthcare expenses we incur. Purchasing health insurance in our later years may make us ineligible for coverage. The premium on any coverage we do receive may be exorbitant. It is hence vital to purchase health insurance coverage when we are young. Our chances of enjoying coverage for a reasonable premium would be higher. From there, we can renew the coverage for as long as we live.

Ensure Portfolio Withdrawals Are Made From The Appropriate Sources

Sourcing and structuring portfolio withdrawals appropriately are critical to peaceful spending post retirement. It must first be understood that withdrawals post retirement must not be made from investments which generate volatile returns. This is because we cannot risk a significant drop in the value of our investments right when we need to make a withdrawal. This rules out the option of tapping into equity and other market linked assets for withdrawals.

Withdrawals must only be made from non volatile and highly liquid products in the corpus. Savings deposits, liquid funds and money market funds therefore become ideal avenues from which to make most of our withdrawals post retirement. Any money meant to be withdrawn from the portfolio must first be moved to these avenues. This should be done a few years before the withdrawals fall due. It would mitigate the risk of a drop in the value of our money when the withdrawal is due.

Spend Without Guilt Or Hesitancy

A number of retirees find it hard to spend from their retirement corpus in a carefree manner post retirement. This is mainly down to a concern that spending from the portfolio could deplete the corpus and cause it to run out. These concerns are understandable. But our retirement corpus designed to last us for our entire life expectancy post retirement. This means our corpus is meant to run out over the course of our lives.

So provided we have an adequately sized corpus, it is okay to let it run out over our lifetimes. Of course, this needs to be done in a properly planned fashion. But beyond that there is no need to be guilty or hesitant about withdrawing from our corpus post retirement.

A separate reserve can be created for major discretionary spends like travel post retirement. Money meant to be passed on the next generation can be treated as a separate goal with a bespoke portfolio. The retirement corpus can then be used exclusively for core expenses. This would further put retirees at peace when spending from their corpus.

Effective spending post retirement is ultimately about having a sound plan behind it. Our retirement spending plan should essentially answer the following questions :

A. How much to spend each year in retirement?

B. What are the risks that can affect my spending?

C. How well am I protected against those risks?

D. From which sources am I going to spend post retirement?

Having clear answers to each of these questions would mean that our spending post retirement is purposeful and effective.