Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 420

Digging deeper into planning for retirement spending

Three steps to planning your spending in retirement” was published by Firstlinks on 7 July 2021, having appeared earlier as the leading article in the (London) FT Money edition in April. Judging by the 14,000 reads on Firstlinks, it was helpful to many readers but they also had comments and follow-up questions.

Here I’ll respond to three of them:

  • flexible withdrawals
  • using equity dividends for safety
  • tax implications.

First, as background, let me summarise the approach I described that I use for my wife and myself.

I identified two independent financial risks: that we might live longer than most people of our age, and that our equity investments might drop in value early and stay low for a while, making us withdraw spending money from a depleted pot.

To reduce the chance of each to no more than 25%, we selected a planning horizon of 31 years (based on our ages), and invested five years of withdrawals in short-term securities (our insurance bucket), because historical statistics suggested that a falling equity market recovered in real terms within 5 years 75% of the time.

We calculated the sustainable annual after-inflation and before-tax withdrawals that went with this combination and invested everything that was not in the insurance bucket in a global equity index fund (our growth bucket).

There were lots more points, but that’s the essence of it.

Flexible withdrawals

I appreciate the Australian comments that I’ve over-thought the issue, and that my analysis and introspection must make retirement impossibly difficult for me. “Lighten up,” I was told. Invest in well-run companies and the rest will take care of itself.

Thanks for your concern. I’m actually thoroughly enjoying retirement – particularly because of my analysis. The worry is over. I re-examine our position every year, and adjust our withdrawals a little bit, as I’ll explain in a moment. The other 364 days, I’m happy.

With no insurance bucket, and 100% in well-run companies (tough to identify them in advance, isn’t it, and it’s too late after the badly-run ones reveal themselves), that wouldn’t have worked if, for example, we had retired at the start of 1973 (the worst-case historical test, and worse than I’m planning for, obviously, but still very instructive).

I used US stats and found that the first two years of equity real returns were -8.3% and -34.2%. After 5 years the cumulative equity real return was still worse than -30%. Subtracting 5 years of withdrawals, the remaining assets were down to 33% of their original value.

What would the insurance bucket have achieved? The bucket itself would have been exhausted (slightly earlier than expected, because cash cumulative returns were -7% over the period), and the remaining assets would be down to 43% of their original value. That may not sound like much of an achievement, but future withdrawals from that point forward would have been at 70% of the original withdrawal rate, compared with 53% with the growth-only approach. Sad, but noticeably better.

A number of readers said that they use flexible withdrawals in response to changes in the market value of their growth pot. An excellent idea! I do too. But I don’t vary the withdrawal in proportion to the market swing (like reducing it by 30% if the future indicated supportable withdrawal rate is 70% of the initial rate). Instead, I spread the amount of the swing (30%, in this example) over our remaining planning horizon, to smooth it out. 

Spreading relies on a belief in (or at any rate a hope for) ‘mean reversion’, the notion that, over the long term, returns will come back to the average. But if future market declines are steeper and longer than before, the gradual declines in withdrawals won’t be enough. It’s a risk to be conscious of. 

I wonder how the reader with a 100% equity portfolio would have reacted by the time 1975 arrived. Regardless, it’s easier to cope in hindsight!

I’m reminded of the saying that “no battle plan survives its first contact with the enemy.” That’s right: no plan will ever work out perfectly. But the work that’s gone into the plan will help you adapt, as circumstances change – that’s why we plan. And that gives you resilience.


Register here to receive the Firstlinks weekly newsletter for free

Using equity dividends for safety

An excellent comment said, in essence, that the safety bucket should take into account the cash flow from equity dividends, and that this would increase the size of the growth-seeking bucket. Quite right. 

As an example, with a 30-year planning horizon and a 5-year safety bucket, and using my 4% real annual return assumption for equities, a 1% dividend yield used towards the withdrawal would reduce the initial size of the safety bucket by about 1/3, a 2% dividend yield would reduce it by about 2/3, and a 3% dividend yield would reduce it to virtually zero.

That ought also to increase the implied sustainable real withdrawal. And it does. But by very little, unfortunately. Even the 3% dividend yield only increases the annual withdrawal by about 2%.

Tax implications

In most countries (although not for most retirees withdrawing their superannuation in Australia), each year’s withdrawal is subject to tax, so you don’t get to spend it all. For many, tax will itself be a significant expenditure. So if there’s a way to minimise it, that becomes important.

I have no general principles for you. It’s as if you’re asked to approach the taxing authorities with all your money stuffed in various pockets in the clothes you’re wearing, and they say, “From Pocket A we’ll take 40%, from Pocket B 20%, you can keep whatever is in Pocket C, from Pocket D …” And so on.

Naturally, before you approach them the following year, it makes sense to rearrange your money across the pockets. But finding out how to do this is difficult, and whole tribes of people make their living by getting to know the complexities and advising non-technical citizens about how to minimize the total.

 

Don Ezra, now happily retired, is the former Co-Chairman of global consulting for Russell Investments worldwide, and the author of “Life Two: how to get to and enjoy what used to be called retirement”. This article is general information and does not consider the circumstances of any investor.

 

3 Comments
Trevor
August 12, 2021

"I have no general principles for you. It’s as if you’re asked to approach the taxing authorities with all your money" [exposed and "up-for-grabs" ? Yes ! "We" know that "special" feeling Don ! ] "Naturally, before you approach them the following year, it makes sense to rearrange your money" "But finding out how to do this is difficult, and whole tribes of people make their living by getting to know the complexities and advising non-technical citizens about how to minimize the total."[ while helping themselves "personally avoid poverty" and making quite sure that they "minimize the total" for you !]. "The worry is over. I re-examine our position every year, and adjust our withdrawals a little bit, as I’ll explain in a moment. The other 364 days, I’m happy." It seems to me that you just can't help yourself when it comes to analysis ! But I will take your word for it that it is only 1 day a year normally , and two days on leap-years of course , and that the other 364 you are happy ! I hope so Don, because if you can't "get it right" then the rest of us are stumped! 

James
August 12, 2021

Just out of interest which " global equity index fund " did you go with? I use a Vanguard one.

Don Ezra
August 15, 2021

I've always used Vanguard. I had to change a bit when I moved from New York to Toronto, when I realized I was suddenly exposed to currency risk too. So I did what pension trustees do: I hedged 50% of the exposure, so that I'd never be wholly wrong or wholly right, just minimizing regret! Vanguard's funds hedged to CA$ are small, so for the non-Vanguard 50% I use a combination of two funds in Canada that together are reasonably close to global exposure.

 

Leave a Comment:

     

RELATED ARTICLES

Three steps to planning your spending in retirement

How decumulation in retirement differs from accumulation

Risk in retirement: five strategies for finding the right balance

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.