Retirement Savings? Spend It All.

To save money for retirement and then not spend it is a waste. There are better options than simple spending rules.

Several weeks ago I bought a very large tub of potato salad at a wholesale store. It was on special offer and the expiry date sufficiently distant that I thought it had to be a bargain (you might already surmise that I am not often trusted to go shopping). We discarded it on the weekend only two thirds empty. We started off with gusto but we got tired and our consumption declined.

We were fortunate: we outlived the potato salad. If we had pre-deceased the tub then the children would have been surprised at the inheritance (we had told them to expect nothing) and I would be in the afterlife regretting my poor planning. Forever.

The potato salad is an (imperfect) analogy for the retirement challenge of figuring out how much a retiree can draw out their retirement savings so it lasts just long enough. A common response is to reach for a spending rule and a popular example is the 4% rule. Suppose you have saved $500,000 for retirement then the 4% rule says that you can spend 4% of your savings (in this case, $20,000) indexed to inflation and your portfolio will last 30 years.

The 4% rule was devised by checking whether, going back to 1926, there was a 30 year period when the rule failed on a 50% bond, 50% equity portfolio. While it never failed in many cases there were considerable assets unspent. Saving for retirement and then not making full use of those savings is a waste unless you specifically wanted to leave an inheritance. As an illustration we imagine an investor 30 years ago who invested $1,000,000 in a balanced portfolio (40% Canadian Bonds, 60% Canadian equities) and withdrew according to the 4% rule. At the end of 30 years they had withdrawn $1.20 million (in real dollars) but were left with a surplus of $3.57 million (in real dollars)! The retirees had massively underspent.

Fixed spending rules lock us into a one dimensional construct: run out of money versus underspending. The way out of this is to allow spending to fluctuate as markets and interest rates change. One method, ARVA, is simple to implement and results in the last payout depleting the portfolio to zero (or a previously defined residual if you want to leave an inheritance). When applied to the example above, real spending rose to $2.27 million, a gain of 89%. In this instance on no occasion did the annual income fall below the 4% rule but there is no guarantee this would always occur. The spending profile from ARVA is compared with the 4% rule below.

In the example above our investor conveniently expires at the end of 30 years of retirement. In reality we don’t how long we are going to live in retirement, an uncertainty known as longevity risk. Because the 4% rule often leaves a residual, it might seem this provides some protection for those who live longer than expected. To see why this might be plausible on average but risky for an individual imagine you are starting retirement today. It may be the case that market returns are favourable and after 30 years there are residual assets. It may also be the case that you are still going strong after 30 years but these two events are independent of each other and there is no reason why they should coincide or that any residual assets match your income needs.

An alternative approach to dealing with longevity risk is to use ARVA to compute a level of income assuming you live to, say, 100 (the probability is less than 1% for a male and 2.7% for a female), and to repeat the calculation assuming you have average life expectancy. For example, a 65 year old male can expect to live another 18.8 years until nearly 84 years old. Where you choose to be within these two withdrawal ranges becomes a matter of preference and can be updated every year.

As an illustration, based on current real interest rates, the ARVA estimated withdrawal rates for 2015 are specified in the table below for a single male.

Age	60	65	70
To Average Life Expectancy	4.97%	5.90%	7.18%
To Age 100	3.13%	3.47%	3.94%

Source: PWL calculations

Compared to the task of accumulating assets there has been comparatively little effort made by the financial industry to help investors deplete their portfolios efficiently. We can think of a couple of reasons for this. Most advisors get commission for your savings, not your spending. Secondly there are just too many variables for asset aggregators to deal with: designing effective and efficient depletion strategies has to be done at the individual level in conjunction with an understanding of clients spending needs and other resources. The tools exist.