Unconventional wisdom: Could you increase your retirement spending by 66%?
A major retirement study suggests many retirees could safely spend far more than they do - but fear and uncertainty keep wallets closed.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Could you increase your retirement spending by 66%?
“A man and his wife had the good fortune to possess a goose which laid a Golden Egg every day. Lucky though they were, they soon began to think they were not getting rich fast enough, and, imagining the bird must be made of gold inside, they decided to kill it in order to secure the whole store of precious metal at once.”
- Aesop
Like many Australians I spent a portion of Anzac Day making eye contact with strangers in the pub, exchanging some cash and waiting for the results of a coin flip to be called out over a microphone. I started off on a roll.
Winning a few rounds of two-up meant I was playing with house money. This psychologically changed my mindset which leads to reduced risk perception and higher confidence. My bets started getting bigger.
An economist would tell you money is fungible. A dollar is a dollar, and it doesn’t matter where it comes from. This is not how most people think about or treat money. People mentally and physically bucket money based on the source and / or the intended use.
There is nothing wrong with this approach - I do this. I have different accounts set-up for different purposes. It helps inspire me to save money and remain disciplined. Bucketing money is known as mental accounting in behavioural finance and it is a type of heuristic or mental shortcut.
Heuristics helps people make decisions in a complicated world but introduce biases into decision making. Perhaps a heuristic is to blame for me losing all the cash I brought to the pub on Anzac Day – yes, things went south.
I will bounce back from this minor financial setback, but a recent study showed how heuristics dramatically change the lives of many retirees.
Retirement goals
An Allianz study titled Reclaiming the Future: Challenging Retirement Income Perceptions found that 61% of people feared running out of money in retirement. Surprisingly that was more people than feared death.
The primary financial goal of retirement is not running out of money. All secondary retirement goals are linked to the primary goal.
A secondary goal could be to support the best life possible…while not running out of money.
Or a secondary goal could be to give financial assistance to someone you care about…while not running out of money.
The common secondary goal of leaving a bequest means you need a buffer…while not running out of money.
The maths behind not running out of money is complicated. Many people struggle to figure out how much they can spend even if they knew all the unknown variables that determine a retirement outcome – the level & sequence of returns, inflation, and the length of retirement.
Since as all these variables are unknown, annual spending levels are - at best - an educated guess backed by historical precedent. Many retirees are ignorant about the interplay of the different drivers that impact how much can be spent.
To add to the confusion emotions can play a powerful role. Optimism about future returns may lead to higher spending. Pessimism lowers spending.
The so-called 4% rule that guides much of the commentary about retirement spending may be backed by historic data but is more of a heuristic than many care to admit.
This is exactly the type of complex decision-making environment that leads to the reliance on mental short-cuts.
How retirees spend income
Retirees Spend Lifetime Income, Not Savings is a study that explores how retirees spend income based on the source. Sources of retirement income were lumped into two categories – lifetime income and capital income.
This is a US based study and while the retirement system is different the sources of Australian retirement income can be classified in the same categories. Lifetime income sources include the age pension and annuities. Capital income comes from the pools of assets that a retiree has accumulated which can be in or out of super and include investments or property.
The study looks at actual spending. This may differ from mandated withdrawals from super. Just because you are required to take money out of super doesn’t mean the money needs to be or is spent.
In the study an assumed spend rate is applied to the total capital income assets to determine potential income. The rate is estimated using a combination of asset levels and age and takes marital status into account. The rate starts between 4% and 5% at 65 and rises to 12% to 15% at 85. This is somewhat consistent with the minimum drawdown rates for super.
Retirees spent approximately 80% of lifetime income and 50% of capital income. Intuitively this makes sense given the difficulty in figuring out how much to spend and the plausable fears of running out of money. These fears don’t exist with a guaranteed income stream like the age pension.
There are also differences based on the level of assets. The only people included in the study have more than $100,000 US in assets but retirees with more than $500,000 spend more than those with less on a percentage basis.
This also makes intuitive sense. If the fear of running out of money drives decision making those with more money have less fear.
However, the key finding from the study is that even people with more assets spend less than the assumed spending levels suggest they could.
The authors didn’t want this to be a theoretical exercise and instead frame the study around real-life choices retirees could make. To do this the assets supporting capital income were converted into lifetime income by exploring the impact of purchasing annuities.
Spending for retirees between 60 and 80 years old could increase by more than 66% if an annuity is purchased. That is a meaningful difference in outcomes. The conclusion is the same as comparing implied spending and actual spending - retirees are underspending based on their asset levels.
Source: Retirees Spend Lifetime Income, Not Savings
Lessons for retirees from the study
The obvious lesson is to convert accumulated assets into an annuity to improve living standards in retirement. But people don’t like annuities for various reasons including the desire to leave a bequest. I know fully annuitizing assets are a non-starter for many people. I’ve focused on some practical lessons.
Actively shift your mindset
One factor the study doesn’t consider is the mindset shift required in retirement. A nest egg that allows a retiree to spend above a bare minimum doesn’t happen by accident.
It means consciously choosing to do what most people can’t or won’t - years of discipline and sacrifice for the future. A decent salary helps but doesn’t guarantee a particular outcome.
After developing a wealth building routine a scarcity mindset can take hold. The shift to spending down a portfolio is an underappreciated challenge in transitioning to retirement and takes effort to overcome. Don’t forget to work on intentionally adjusting your mindset.
Consider a partial annuity
A partial annuity may be more appealing than a full annuity. I have a long way to go before retirement but over the years I’ve started to think more seriously about this option. I think an inflation-protected annuity covering the ‘needs’ portion of my budget might suit my situation.
I would retain the upside of keeping most of my assets invested while protecting myself from any eventualities. Another potential advantage in our current political environment is to offload assets that may face higher future taxes. This is obviously an evolving situation and tax policy is subject to individual circumstances.
Investing for income
I began this article with the beginning of Aesop’s The Goose with the Golden Eggs fable. The ending should come as no surprise:
“When they cut it open they found it was just like any other goose. Thus, they neither got rich all at once, as they had hoped, nor enjoyed any longer the daily addition to their wealth.”
The investing equivalent to the golden goose is the adage to not spend your principal. Is this a rational approach or a heuristic? Academics and financial professionals believe it is the latter and sneer at what they see as the naivety of focusing on dividends. I’m not convinced.
Are shares just ticker symbols and prices flickering on a screen? Or are they stakes in businesses which earn and distribute profits to their owners? There is truth in both but treating a share as an ownership stake promotes better behaviour.
Income generated from a portfolio is not exactly the same as lifetime income as it isn’t guaranteed. But it is a way to generate cash to spend without touching the mechanism for generating future cash by retaining the income producing assets.
Combing an income strategy with a cash buffer and opportunistic asset sales might be a formula to satisfy the mental challenges of retirement. It may align better with a pre-retirement wealth-building mentality and dampen the fears of running out of money. It is also a way to retain wealth to achieve the other common retirement goal of leaving a bequest.
Final thoughts
I am very much not retired but I’ve been grappling with some of the emotions about spending that retirees face. Starting to spend a portion of my dividend income is an ongoing mental challenge.
My relentless focus on saving and investing when I was younger was partially driven by an aspirational vision for my future. But fear was also a strong motivator. I was anxious about future share market returns and my ability to stay employed and grow my salary. That scarcity mindset hasn’t - and likely won’t - go away.
Spending dividend income means I have less of a buffer for the future. I’m very aware of the consequences of my decision and I still have occasional doubts. I am likely going to be more than fine from a financial standpoint. But I can’t help envisioning scenarios where things don’t work out.
Personal finance decisions are not just about numbers on a spreadsheet. It is a decision-making environment fraught with emotions – some rational and some decidedly not. Economic models and studies put those emotions aside to seek the ‘answer’ to a personal finance problem. In the real world we don’t have that luxury and all just do the best we can.
Email me at mark.lamonica1@morningstar.com and let me know how you approach retirement spending decisions.
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What I’ve been eating
Pilu is one of my favourite restaurants in Sydney. When the same team opened a new restaurant called Flaminia in Circular Quay it was immediately on my list. While Pilu focuses on Sardinian cuisine, Flaminia takes a broader Italian lens. The menu is organised by cuisine from major port cities in Italy – Cagliari, Naples, Venice, Bari and Palermo.
Pictured is the mozzarella in carrozza which is a mozzarella cheese sandwich coated in egg and flour and fried. Hard to go wrong with that. The anchovy was a nice touch and cut the richness of the fried cheese. The dish is from Campania and listed in the regional capital Naples’ section. Flaminia isn’t Pilu but still well worth a visit.
