08/01/08 - Retirement Wishes

By: Jason Whitby, MBA, CFA®, CFP®, AIF®

I recently read a survey of 55 to 65 year olds and their opinions about retirement. Here are three of the survey questions and the results which I found most telling.

True or False: A 10% withdrawal of retirement savings each year will not exhaust my capital.

True or False: At age 65 I will have a 25% chance or less of living beyond age 85.

True or False: My income needs will drop by at least half after I retire.

Hopefully, you found these questions very simple. However, the following survey results from MetLife Mature Market Institute show an amazing and persistent disconnect between retirement reality and the beliefs of many 55 to 65 year olds. At some point, this gap will narrow and even close as they realize that retirement may not be an option or at least not what they hoped for. Perhaps their beliefs will be proven correct, stranger things have happened. But more likely, retirement will be less than gratifying for them. Here are the results.

43% believed they will be able to withdraw 10% or more of retirement savings each year without exhausting their capital*

Actually, the industry agreed standard for a sustainable withdrawal rate is 4%. So to avoid exhausting your capital in retirement, you should plan to withdraw 4% rather than 10% per year. Why do so many people believe 10% or more? I can only assume that they believe a 10% withdrawal rate is possible if their long-term, average investment return was 10%. Otherwise, it makes no sense. So while a 10% average return might be what their returns have been, it completely ignores the volatility they likely experienced along the way. For example, you can not plan to get 10% each year for ten years. Instead, you might get no return for the first five years and then 20% for each of the last five years. This variability of returns is a serious risk to retired investors as they take money out during down or flat years. Most likely, taking a 10% withdrawal each year will send the portfolio on a destructive cycle in down years, especially when significant negative returns follow significant positive returns. For example, a couple retires today with $1 million dollars and starts withdrawing 10% a year. At the end of year 1, the account is valued at $1.2 million due to fantastic performance of +20%. Consequently, the couple withdraws and spends $120,000 leaving an account value of $1,080,000. At the end of year 2, the account is valued at $864,000 after suffering a -20% return. So the couple should withdraw $86,400 to live off of. But this means their standard of living would drop by $33,600 for the coming year. Obviously most people are unable or unwilling to reduce their lifestyle so drastically. So the couple will usually go ahead and maintain their lifestyle that they are now accustomed to and take $120,000 leaving the account valued at $744,000. This unwillingness to decrease their standard of living means that they are now praying for a fantastic return of 16% or better. For without that return, their account will not be able to produce their desired withdrawals of $120,000 without depleting the account even further. And so it goes until finally the couple admits that they have no choice but to change their lifestyle or face the real possibility of running out of money.

This variability of returns is why 4% is academically proven to be sustainable. Of course, this assumes that you want a sustainable withdrawal rate. Instead, some of you might want to “die broke” as the saying goes. In which case, you can withdraw at a greater rate than 4% since you plan to spend all your money during your lifetime. The challenge, however, is estimating when you will die and then, being correct about the date. As we will see, life expectancy numbers can lead to improper planning which brings us to the next survey answer.

60% believed that at age 65 they will have a 25% chance or less of living beyond age 85*

Actually, at 65 years of age, you will have roughly a 50/50 chance of making it to 85. Of course, life expectancy is very specific to each individual and you can get a better idea of yours by using a life expectancy calculator online. Interestingly, most people would say they are above average in many ways such as intelligence, humor, looks, poise, grace and so forth. But people often feel their health and bodies are below average leading to a pessimistic view on their life expectancy. However, 50% of individuals 65 years of age will die before and 50% will die after 85. More concerning is for couples age 65 today, there is roughly a 50% chance that at least one will survive to be 90 years old. Since no one knows for sure when they will go and the data indicates such a high probability of a life expectancy being 85 or 90, setting your financial plan to the average or prior is risky. What will you do when you turn 86 after going broke at 85; especially today when turning 100 doesn’t even get you on Good Morning America anymore? Better to plan on living to 95 or 100.

The reason why life expectancy is such a critical question is simply because it relates directly to the sustainable withdrawal rate. If your retirement lasts only five years, you have fewer years to spend your money and so you can spend more each year. Most people today want to retire at 65 after working for over 40 years. With improvements in medical technology and healthcare, they should now plan on spending almost as much time in retirement as they did working. Think about it this way, before retirement, your living expenses were likely covered by your salary. For the next 30 to 40 years, those costs will need to come from pensions and investments. That is a long time and a lot of money. Of course, many of you will receive Social Security which helps. Or perhaps you plan on spending a lot less in retirement. Matter of fact, the survey shows about half of you do.

49% believed that their income needs will drop by half after they retire*

Assuming your income needs drop by half must mean that you also expect your expenses to drop by half. Why would you spend less in retirement? Well, in retirement certain expenses will indeed decrease. For example, income taxes should dramatically decrease since you will no longer have a salary. Not working means you will no longer spend money on work clothes, dry cleaning, commuting expenses, and so on. Additionally, many hope to have no mortgage expenses at this time. In reality, many new retirees actually see their annual costs go up, especially in the first few years of retirement. After all, you have plans for retirement, don’t you? Traveling, golfing, eating out and just enjoying indulgences cost money. Even if globe trotting isn’t your thing, neither is sitting at home all day. Instead, most retirees spend a great deal trying to enjoy the most out of their retirement right up until they are forced to slow down due to health reasons. So in addition to the fun expenses in retirement, you can almost bet your increasing healthcare costs will offset the decreases you might initially see. Most likely, your expenses will taper down as your mobility decreases in the later years. At this point, you can indeed expect your expenses to be roughly 80% of your pre-retirement needs. Regardless, believing your income needs will drop by half in retirement leads to improper planning and is, inevitably, a recipe for a completely unsatisfying experience.

Hopefully you knew that the sustainable withdrawal rate was 4%, life expectancy to 85 was 50/50 and retirement doesn’t mean a lower cost of living. Better yet, hopefully you have already positioned yourself to really enjoy your golden years. If so, this news should highlight how bad off many of your neighbors and fellow retirees are today. If you find yourself in trouble with this quiz, I hope you still have the time and the fortitude to make the necessary changes, most likely by saving more, spending less, working longer or drastically decreasing your expectations.

*Source: MetLife Mature Market Institute

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