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How much can retirees spend and not run out of money?

The Australian superannuation system ensures most people retire with an account-based super pension, either instead of or supplemental to the age pension. A super pension is an attractive investment vehicle because earnings and withdrawals are tax free. People who have saved over their lifetime will hopefully accumulate enough in super to enjoy a reasonable standard of living in retirement.

Assuming a person has achieved a so-called ‘Condition of Release’, which generally means achieving the age of 65 (or 60 and ceasing an employment arrangement), they can move super from the accumulation phase of their working years to the pension phase of their retirement. They are then required to withdraw a minimum amount each year, depending on their age, as shown below (source: ASIC’s MoneySmart website).

How much is needed for a comfortable retirement?

The obvious issue is whether taking this much out of a pension account each year means a retiree might run out of money in the account. Of course, superannuation is not the only source of wealth, and usually, people hold savings outside super as well as owning their own home.

The Association of Superannuation Funds of Australia (ASFA) produces an estimate of how much money is needed for both a modest and comfortable lifestyle in retirement. You can see their assumptions here. Crucially, the numbers assume retirees own their own home and are in good health. Home ownership is a massive issue in retirement, and the following amounts will be insufficient for people required to pay rent in major capital cities.

A simple calculation shows the challenge for retirees in the current low rate environment. If a couple has $1 million in two pension accounts earning say 3% per annum, the income is only $30,000 a year. This is far less than the $61,786 a year required for a comfortable lifestyle if their only source of income is the pension account. They will therefore need to draw down their capital to meet expenses. Moreover, the average combined superannuation balance for a couple aged 65 to 69 is about $418,000 (men $247,000, women $171,000).

Consequently, most retirees fear running out of money. Recent research by AllianzRetire+ reveals only 44% of Australian retirees feel secure in their current financial position, and two-thirds spend only on necessities, worried about unexpected costs and illness.

In a previous article, Graeme Colley of SuperConcepts ran the numbers based on the ASFA comfortable standard for a retiring couple aged 57 and 59. There are many variables in calculating how long the money might last, but assuming income earned on the retirement savings is 5% per annum, and the capital is allowed to deplete to zero in the 25th year after retirement, the total amount required in today’s money is $1.1 million. 

Withdrawing safely with a better lifestyle

There is no simple answer to the safe withdrawal rate dilemma because it depends on many unknown factors, and there is considerable academic research on the subject. If the account delivers a healthy return of, say, 10%, then drawing down 4% each year is fine. But many highly-conservative retirees are restricting investments to cash which earns less than 2%. This barely covers inflation, and so the capital in the account is depleted each year.

This 4% drawdown level is a common guideline used in the financial planning industry as a safe drawdown rate, but it is based on a desire to spend only the fund’s income and not the capital. This often means the retiree lives frugally and then leaves money in their estate, when they could have enjoyed a better lifestyle.

A group of Australian actuaries has developed a new rule to help retirees who have reached age pension eligibility decide how much they can withdraw from their savings. Their report is called, ‘Spend Your Age, and a Little More, for a Happy Retirement’. Actuaries Institute President, Nicolette Rubinsztein, said:

“The reality is that many people can have a better retirement if they have higher confidence that they are able to draw down a little bit more of their savings than the minimum required by the government.” 

“Many retirees draw a bare minimum from their account-based pensions, or their savings, after they stop work. They can’t afford to pay for professional advice from a planner, and they live frugal lives because they fear outliving their savings. But the ‘rule of thumb’ is simple and accurate and takes into consideration a retiree’s asset base and age."

They define ‘optimal’ as a draw down which allows the best possible lifestyle but allows for the fact that spending too much early in retirement means less is available later. The calculations allow for age pension eligibility.

Here is their simple ‘rule of thumb’ for a single retiree:

  • Draw down a baseline rate, as a percentage, that is the first digit of their age.
  • Add 2% if the account balance is between $250,000 and $500,000.

For example, a single retiree with a super balance of $350,000 could draw down $28,000, which is 8% of $350,000. The draw down amount would increase to 9% when the person reaches 70.

What about people with less money? The actuaries acknowledge that someone with only $40,000 might “buy a caravan and go around Australia”, knowing they can rely on the age pension. But those with more money are more likely to use it wisely for a better retirement.

The main problem with these types of calculations is that hardly anybody knows how long they will live, and life expectancy continues to push out. The age pension is also a safety net for the majority of people. For many couples who own their own house and with other assets less than $394,500, the full age pension including supplements is $1,407 per fortnight, or $36,582 a year. This may be acceptable for a modest lifestyle, but people should aspire to better.

It is, of course, possible to assume a market scenario where someone withdraws only 4% a year and runs out of money, but investing should balance the probabilities. As Michael Kitces, a leading consultant to financial advisers, writes in this article on the old 4% rule:

"The bottom line, though, is simply to recognise that even market scenarios like the tech crash in 2000 or the financial crisis of 2008 are not ones that will likely breach the 4% safe withdrawal rate, but merely examples of bad market declines for which the 4% rule was created."

The lessons behind the numbers

The lessons from these insights, notwithstanding the potential for unlimited assumptions and uncertainty, are:

  1. The money required in retirement depends on personal lifestyle aspirations, but the conservative 4% rule should not force retirees into living in a state of permanent frugality and thrift.
  2. Life expectancy and future expenses are uncertain, and anyone who does not want to live on the age pension needs to consider saving more and working longer before they retire.
  3. Owning a home is a significant risk mitigant (which also comes with the financial advantages of tax-free capital gains and exclusion of the home from the pension assets test).
  4. Investing wisely and saving early allows the benefits of compound interest to build retirement balances over time. Education on financial opportunities is an important skill.

Retirement years should be a time to enjoy the rewards of a fulfilling working life, not worrying about when the money will run out.

 

Graham Hand is Managing Editor of Firstlinks, published by Morningstar. This article is general information and does not consider the circumstances of any person.

 

21 Comments
Paul B
December 19, 2019

Interesting article Graham with some thoughtful responses. However I have to ask whether this article is your self penance for the "Ok Boomer" article you published last month. ??

Nick Callil
December 19, 2019

Kevin - it is not strictly correct that the minimum drawdown system results in withdrawing the most at older ages. While it is true that the drawdown percentages increase with age (and the rate of that increase accelerates in the late 80s), these percentages are applied to the retiree's account balance each year which is continually being depleted by drawdowns. The resultant minimum drawdown amounts typically reduce in real terms with increasing age, albeit that varying investment returns can of course cause them to increase, and there are also the 'shark tooth' jumps in income that occur at ages when the percentages change (which will be familiar to anyone who has modelled minimum drawdowns).

That said, it remains a concern that the minimum drawdown rules, who act as an anchor for many retirees in the absence of other guidance, results in too-slow spending in the early years of retirement. Hence the rule of thumb approach mentioned in this article, which result in higher than minimum spending in the early years of retirement while still attempting to manage the risk of running out of money in later years, is a valuable addition to the available thinking on this important topic.

Greg
December 18, 2019

I am a relatively new retiree and, with all of my own “skin in the game”, I have spent some time mulling over this question of “how much”.

I think the article describes working answers for the “average” group of retirees living life and subject to an “average” set of disruptions.

This is fine for economists and actuaries assessing outcomes for large groups of people however – we are all individuals. As individuals, we sit on a statistical distribution curve. Very few of us are likely to live an “average” life. Some of us will be affected by the rolling of life’s dice and be subject to additional disruption and need less, or more financial capacity for those “non average” impacts. Think about:
1. Major health issues
2. lump sum payments to aged care facilities
3. Government changes to pension eligibility and reduced payments
4. Health cost inflation significantly greater than CPI
5. A desire for a “greater than ASFA comfortable” life style
6. A greater than average number of GFC events in the remainder of our life time
7. A longer than average life span
8. Other not imagined but still quite possible life disruptions

None of these events is guaranteed to affect any of us however some of them are likely to affect some of us and they all require additional financial resources.

I think it is helpful to start thinking about outcome “distributions” and “confidence levels” and “likelihood”.

Like many older people, life has taught me that “spending down to zero” only leaves you open for the unforeseen circumstance. I want some dry powder ready to provide “quality of life insurance”.

Accordingly, I am being frugal enough that I build some spare financial capacity for the future and I am still a Growth investor. I hope to underspend against the average however I want to be prepared if circumstances require me to overspend.

Dudley.
December 18, 2019

"underspend against the average however I want to be prepared if circumstances require me to overspend":

But there's an absence of adequately reliable insurance.

Fred Randall
December 17, 2019

I have read quite a few articles that ponder why retirees don't spend more. I think there is great concern among older retirees about having to retain funding to pay for aged care without having to sell the roof over their head.

Dudley.
December 18, 2019

"why retirees don't spend more":

Uncertainty:
* age pension rules,
* investment returns (currently none risk adjusted),
* longevity insurance,
* date of age care,
* date of demise,
Add:
* insufficient capital.
Result:
* reduce expenditure,
* increase savings.

Dudley.
December 16, 2019

The model's core assumptions:
* Risk aversion: the choice of the consumption risk aversion parameter ? normally falls within the range of 1 to 8 with 5 being the most common choice.
* Investment Return: balanced investment option
* Expected Annual Real Return: 3.5%
* Annual Return Vol: 7.0%
* Age Pension rules as at March 2019
* homeowners without bequest motives.
Seemingly well considered for the long term.

What does the 'better frugal than penny-less, never an age pensioner, live to 100' retiree face today:
* Inflation 1.5%
* Living standard change 1%
* Real risk adjusted yield 0%
* Comfortable couple homeowner expenditure $61,000
* Require $3,100,000 capital.

Dudley.
December 15, 2019

Useful application of utility functions.

Frugally is more enjoyable when it is optional.

john
December 15, 2019

Is this sentence meant to be 65 ? See "" the average combined superannuation balance for people aged over 15 is only about $289,000"" ??

Graham H
December 15, 2019

Hi John, the number is correct but agree it would make more sense to quote a number for a retiree, so I have replaced the 'over 15' with data for people aged from 65 to 69. Balances fall after that.

RobG
December 15, 2019

So much written on this subject is academic nonsense including the calculation as to what is a "comfortable retirement". What is "comfortable" is personal and is directly related to your "pre retirement personal cost of living" - that may be $61,786 pa as above, or it may be $100,000 or $150,000 or.....

The amount of capital you need in retirement, then becomes a multiple of your cost of living, given expectations of investment returns, inflation and Govt mandated minimum draw downs as you age. 20 times your cost of living, in Super at retirement, may not be a bad place to start!

Maudie
December 19, 2019

Downsizing to an apartment can add strata fees of more than $10,000 per year. Currently paying $12,000 per year strata fees and $2,500 in rates.

Ray
December 14, 2019

Good article Graham,
One thing that no one seems to write about are the problems associated with trying to obtain a 4% return in a SMSF whose assets are weighted towards property investments. Returns on recently purchased residential property in Sydney tend to be more in the range of 2 - 3%, and hence drawing down even a 4% pension can be problematic if one doesn’t have large cash reserves in their member accounts. Unlike shares, bonds or cash, property is a lumpy, illiquid asset, and you can’t just sell off the bathroom to get that extra $40k if you are short of funds. This is probably why the ATO is targeting the SMSF that have high levels of property investments, especially when geared up.

Frank
December 15, 2019

Simple!
Join a Not For Profit super group and start the comfy feeling of 7,8,9,10 % PA over Ten> + years!
And Relax!!!!!!!

Graham
December 15, 2019

Frank, we can't invest in the past, only the future. With bond rates now at 1%, the capital gains that have delivered the strong bond results in those diversified funds will not be repeated. And usually, equities don't deliver similar results when measured from a high valuation point, like now. You may be right, but replicating the returns of the last decade in any fund (retail or industry or ETF or LIC) will be a struggle.

Warren Bird
December 16, 2019

Ah Graham, over ten years bond returns are not driven by capital gains. Falling yields over that time period have dragged returns down, not lifted them up, as the capital gain from lower yields is a fleeting thing. I've written about that for you many times!

Still, your retort to Frank is valid*. "Past performance is no guarantee of future performance" is not just a compliance box to tick in marketing, but a statement of reality. Every super fund expresses the investment objectives for their range of products in terms of cash or inflation plus a margin over the long term. With cash and inflation low, even if they achieve their margin, the absolute returns are going to a few % lower than the 7-10% that he mentions.

* That is, unless Frank is being ironic and having a go at Industry Fund advertising!

George
December 14, 2019

Thanks, we read too much about how much we need and not running out of money rather than having a good time after a life of work.

Kevin
December 14, 2019

One of the things that’s always struck me as odd, is the current system of minimum withdrawals is weighted towards withdrawing the most as you get older. Perhaps this is to help ensure that little capital remains upon death, or perhaps the capital is expected to reduce as we age, so the higher withdrawal percentage compensates to maintain the pension income.

However it seems to me most people would prefer to spend more during the initial years of retirement (local holidays in Oz, overseas trips etc) whilst still in reasonable health. Then as health issues slow people down, or indeed prevent them from traveling, the need for income reduces substantially. The dilemma is the ideal situation of withdrawing much more than the minimum 4% during the initial years of retirement comes at the expense of capital and a reduced effect of compounding. Whereas if only the minimum is withdrawn as a pension and travel is deferred, by the time compounding has worked its magic it maybe too late due health issues...

AndyB
December 15, 2019

The requirement to increase withdrawal with age does indeed seem to contradict the lowering of needs as age increases. However, the compulsion to withdraw does not bring with it a compulsion to spend. Amounts surplus to immediate needs can be saved for a rainy day or invested outside super.

Erica Hall
December 16, 2019

There has been some work done on retirement consumption patterns by Morningstar's Head of Retirement Research in the US, David Blanchett. His research found US retirees are spending less than models predicted. Traditional consumption models assume straight line expenditure in retirement, potentially too simplistic. Whilst every individual journey is different, Blanchett's research found that in retirement spending declines over time, but not forever, as we continue to age our health fails and our medical expenses increase. To your point, high consumption points occur during early retirement and then increase again towards the end of retirement.

Aaron
December 19, 2019

Erica,
Your reference to Blanchett's work is good but your last comment is a frequently repeated error. If you read his paper and look at the 'retirement smile' chart you will see that at no stage towards the end of retirement does aggregate spending growth turn positive. The "real change in total expenditures" improves from around -2%p.a. to -1%p.a. at age 85.
This trend might mean that spending eventually stops falling (ie the growth increases to 0%p.a.) but nothing in the evidence suggests any increase in aggregate spending at older ages.


 

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