Bottoms up retirement planning

Sometimes it pays to go back to basics. With retirement planning it’s no different. The common, top down approach with retirement planning starts with total net worth and then uses a safe withdrawal rate (SWR), most commonly 4%, to figure out how much one can spend per year in retirement adjusted for inflation. See this series of posts if you’re new to this topic. But starting from the bottom, looking at spending first, can add a lot of insight into what investment returns a retiree needs during retirement and allows for the planning of various scenarios. In this post I’ll take you through a simple process that I use to think about various retirement scenarios and what impact those scenarios have on investment returns.

First thing to do is to come up with a simple starting retirement model. For this exercise I’m assuming a 62 year old couple, just retired, with a basic spending requirement of approximately $4K/month, or $48K per year. The couple has $1M in total assets. They also would like to delay taking social security until age 70 to maximize their payouts. At age 70 they would start receiving a total of $2K/month or $24K per year.

To make this basic scenario more flexible and realistic, to the base spending of $48K per year I add a 10% buffer for unforeseen circumstances and factor in a 15% average tax. With these two additions now we’re looking at withdrawing $62.75K per year from the portfolio. If using a 4% SWR from a tops down approach the $62.75K would be way too much. But it may not be necessary to give up on their retirement plans. In 8 years the couple starts receiving $2K/month from social security which needs to be taken into account. In order to do this we need to do a basic spending projection over time. This also allows for other changes in spending later in life. In fact research shows that spending for retirees decreases significantly as they get older.

The data are striking, suggesting that those in the later half of retirement (age 75+ by the BLS data) spend an average of almost 30% less than early retirees (those aged 65-74). In fact, Bernicke shows that this gap has been remarkably persistent over time; the difference is almost the same (on a relative basis) whether you look at the data from 2004, or 1984. The BLS data – along with data from the Health and Retirement Study conducted by the National Institute on Aging that show a smaller but similar decline – have also been widely examined in analysis by the Bogleheads community.

This changing income and spending over time is not part of a tops down model and yet can change the retirement equation entirely. So lets take the basic model and incorporate social security income starting at age 70 and two possible scenarios starting at age 85, no spending reduction and a 20% spending reduction. We’ll take the yearly spending forecasts and come up with an range of investment returns required to make the portfolio last for different longevity periods. I know, it sounds complicated in words but its just a simple excel spreadsheet. To make these models easier to understand I use constant dollars, ignoring inflation for the time being. Below is an example model for a life expectancy of 85.

For a life expectancy of 85, $62.5K per year spending until age 85, $24K in social security income starting at age 70, and a $1M portfolio these retirees need real investment returns of 1.31% per year. We can then run through various scenarios and come up with a range of real investment returns needed to achieve those various goals. In the table below I modeled I show some results.

For those interested I have out the basic spreadsheet model online at Google docs. (see here). I’m pretty sure some of you will add to it and make it better than mine.

The range of annual real returns required varies from 1.31% per year for an life expectancy of 85 to 3.79% per year for a life expectancy of 100 with no spending reduction at age 85. I think this approach gives the retirees a lot more information and confidence than just using a top down 4% SWR and not taking into account potential future spending changes. Armed with this information a retiree can now look at what the investment environment is offering. Once you build this basic model you can run through all kinds of possible life scenarios and think about your plans if those scenarios happen.

On the investment side, lets say this particular couple is very risk averse. A good first place to look for a conservative investment is what 30 year inflation protected bonds are paying. As of this Friday, the 30 year TIP was yielding 1.39%. That is a real yield. In a very risk averse scenario this couple could fund their retirement with 30 year TIPs. On the other end of the spectrum, in the most aggressive retirement scenario this couple could easily fund their retirement plans with a conservative portfolio of dividend stocks yielding 3.79% or higher, achievable even in today’s environment. The point is this range of required real returns allows more flexibility in investment choices, especially considering risk tolerance, than using a tops down SWR model. I’ll come back to the topic of real investment returns in future posts – there is a lot that can be learned from them.

On a personal note, in my plans I have always have a back door, escape scenario. In this scenario, the plan would be for the portfolio to completely run out by age 62, 17 years away for me, when my wife and I would begin living on our social security only. In order to make this work more easily the plan involves moving overseas in order to cut living expenses. Most likely we would move to Southeast Asia, possibly Thailand, where we could live on our social security and still maintain a very nice lifestyle. Maybe even Argentina so my wife, Nina, could finally learn Spanish. We’ve done this type of thing before for several months at a time and its highly do-able. For us having this plan gives us a huge sense of comfort, peace of mind, and freedom.

In summary, some simple bottoms up retirement scenario planning is easy to do and can give you some valuable insight. Most importantly it allows you to plan future changes in your retirement spending and income. It also allows you to figure out what investment returns you need to fund your retirement goals instead of taking for a given what the historical market portfolio has allowed in withdrawals. You may not need as much as you think.

P.S. In a future post I’ll address two real common fear mongering topics – the death of social security and runaway inflation.