Unconventional wisdom: The retirement planning trick that could boost your income
A simple needs vs. wants framework can help you balance security with higher spending.
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: The retirement planning trick that could boost your income
Go confidently in the direction of your dreams. Live the life you have imagined.
- Henry David Thoreau
The Association of Superannuation Funds of Australia (“ASFA”) puts out their quarterly Retirement Standard as a benchmark for comfortable and modest retirement lifestyles.
I applaud this effort as an advocate for improving financial literacy. Anything that gets Australians talking and thinking more about retirement is a good thing.
However, my goals, circumstances and ambitions differ from the guidance.
I suspect many members of the Morningstar community are in the same boat - whether already retired, just starting a career or somewhere in-between.
But remember if you want something different you need to do something different. That means thinking deeply about the best ways to use your financial assets to enable a better life. It is about creating a personalised plan instead of defaulting to a benchmark like the ASFA Retirement Standard.
A better life means different things to different people and your aspirations will influence the best approach to take.
You might want to retire early to spend more time with loved ones or pursuing a passion.
Or financially support friends, family or charities.
You might dream of traveling in retirement, staying in your home or building the world’s largest collection of Beanie Babies.
You only get one shot at life and if you want to summer in Europe or fill your house with formerly popular plush toys go for it.
If you think the ASFA guidance is useful but insufficient to get what you want out of life you need to think about retirement differently and come up with a plan. Here are some suggestions.
Creating your own retirement plan
A personalised retirement plan starts with exploring what types of spending you are trying to support in retirement. This requires some mental accounting.
Mental accounting is treating different money in different ways. The critique that money is money no matter the source or use is valid but I see several benefits from using mental accounting.
Earmarking savings for a certain expense can be motivating. And adjusting the approach you take for specific retirement expenses can be helpful.
There are two primary financial retirement challenges. During your working years you need to know how much to save and when you have enough to retire. Once retired you need to estimate how much you can safely spend without running out of money.
Breaking down retirement expenses into ‘needs’ and ‘wants’ helps with setting a retirement target while informing asset allocation and withdrawal strategies in retirement.
Address spending on your ‘needs’
Your ‘needs’ are the non-negotiables for staying alive – housing, food and medical care. When designing your retirement strategy there are several differences between ‘needs’ and ‘wants’.
Spending on ‘needs’ is likely to persist for longer than other categories of spending. It also may spike towards the end of life as healthcare costs rise. Spending on ‘wants’ often declines as you get older and become less active as retirement progresses.
Inflation and time – longevity risk - are the primary risks to long-term non-negotiable spending. A low withdrawal rate and healthy allocation to growth assets is the best way to mitigate those risks.
The low withdrawal rate also provides protection against sequencing risk which impacts you if you have the misfortune of retiring as a bear market starts. Being forced to sell low to fund withdrawals means running out of money faster.
For my own retirement plan I’ve estimated my annual spending on ‘needs’ and applied a 3.50% withdrawal rate. This allows me to calculate how big my portfolio needs to be to support this portion of my retirement spending. Once you’ve come up with your own estimate divide it by the withdrawal rate.
Is 3.50% conservative? Absolutely. I’m ok with that. As I said I have the capacity, circumstances and desire for more but want to ensure my ‘needs’ are covered in any eventuality. This is my way of buying peace of mind.
The following chart is from the latest Morningstar State of Retirement Income Report. It shows the 90% success rate of not running out of money at various equity weightings using Morningstar’s forward projected returns. At a 3.50% withdrawal rate your portfolio has a high probability of lasting at least 35 years.
I would also consider an inflation protected annuity covering my ‘needs’. An annuity may support higher levels of spending than a 3.50% withdrawal rate.
Breaking spending into ‘needs’ and ‘wants’ buckets has the added benefit of helping me consider how I want to structure my spending.
I try and spend as little of my salary as possible on ‘needs’ which leaves more left over for ‘wants’ and saving. The benefits of avoiding lifestyle creep with my ‘needs’ carries over to retirement.
My focus was taking care of the ‘needs’ component of my retirement first. With that foundation out of the way I could move onto the good stuff – my ‘wants’.
Support spending on your ‘wants’
More nuance is required for ‘wants’ as individual goals vary. Broadly speaking there are three categories of non-mutually exclusive retirement related ‘wants:’
- Retiring early
- A better lifestyle than just getting by
- Helping someone financially
Each category has a unique set of financial considerations.
Retiring early
‘Early’ means different things to different people. But as a rule, early retirement means leaving the workforce or working part-time prior to turning 60 and being able to access super.
Retiring early includes both voluntarily leaving the workforce or protecting against an involuntary retirement. Workforce participation rates drop as people age for several reasons with one study estimating six out of ten Australians retire early due to poor health.
There are two approaches available for retiring early. The first is creating a ‘bridge to super’ where funds are saved outside of super to support expenses prior to 60.
Simplistically if you spend $100,000 a year and want to retire at 58 you need to save enough to support $200,000 of post-tax spending.
The other approach is having financial assets support you before and after you can access super. This could be building a passive income stream and / or applying a withdrawal rate to your portfolio.
A better lifestyle than just getting by
This is similar to the second approach for early retirement. Supplemental funds inside or outside of super support additional spending beyond what you need to live.
How much is needed is based on your lifestyle goals. Estimate your ideal spending on ‘wants’ as an input into your retirement strategy.
Helping someone financially
There are a variety of forms of financial support. There are bequests after death to people or a charity. There are financial gifts and support while you are alive – the much-discussed bank of mum and dad.
One option is giving / segregating funds or an asset like a house. Alternatively, you could simply spend conservatively in retirement increasing the likelihood of leftover money.
Asset allocation and withdrawal rates for ‘wants’
All three scenarios are ‘wants’. This has implications for how you would manage your portfolio. Given the likelihood that spending on ‘wants’ will decrease as you age longevity risk is lower.
Sequencing risk is also lower because you always have the option of cutting back on this portion of your spending. In a bear market that could mean less meals out or less travel or leaving less to heirs.
This flexibility gives you more options like more conservative asset allocation or a higher withdrawal rate.
The same chart for the Morningstar State of Retirement Income shows some of the options.
Allocate half of your portfolio to defensive assets and it is very likely your portfolio will last more than 20 years while withdrawing 5.30%. This is a good deal as you get both higher spending and safety over the active portion of your retirement.
Flexible withdrawal strategies like not increasing spending after a year with portfolio losses or applying a constant percentage increase below inflation can lead to higher initial withdrawal rates.
For instance, according to the Morningstar State of Retirement Income Report a 5.70% initial withdrawal rate with a flexible withdrawal strategy has the same probability of success over 30 years as the standard method. Shorten that time frame for ‘wants’ to 20 years and the percentage you coud safely spend would increase further.
Using flexible withdrawal strategies for your ‘needs’ can be challenging but most retirees can apply these methods to ‘wants’.
You could also take an income approach like I am. The higher I can grow my passive income the more options I have – I could retire early (voluntarily or involuntarily), cut back on work or increase my standard of living in retirement.
Provided passive income grows over time I’m reducing sequencing and longevity risk by not selling the positions in my portfolio. This retains the flexiablity to sell assets to help with a setback or leave a bequest.
Final thoughts
Your reward for being a little more thoughtful about your retirement approach is the potential for higher levels spending.
I’ve modeled the blended approach I’ve outlined where a 3.50% withdrawal rate is applied to ‘needs’ and a 5.70% withdrawal rate is applied to ‘wants.’
In most cases it results in higher initial withdrawal rates than the 4% rule depending on the higher percentages of overall spending dedicated to wants.
One thing the ASFA Retirement Standard does well is show the different lifestyle trade-offs between different levels of retirement spending.
It goes into a lot of detail – what kind of phone you can own, the type of haircuts you can get and utility usage. This is a valuable perspective as it connects your finances to your life.
If you have higher aspirations the trade-offs extend to how you manage and use your portfolio to fund your life.
The more you understand the risks faced in retirement, the better you are able to make the right decisions to get what you want out of life. That is the recipe for success.
Want to model out your own retirement? Email me and I will send you a spreadsheet I built which can allow you to model out different scenarios.
I can be reached at [email protected]
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Sydney is in the midst of a burger renaissance. Seemingly every week there is some dubious new list ranking the world’s best burgers. Sydney is always well represented. I’m skeptical of many of these rankings and I dislike paying a small fortune for a burger…but then again, I do like a burger.
One of these lists is why I found myself at The Grill at the International in Martin Place. The description of the burger on the menu informed me the beef came from the O’Conner Ranch and was grass fed. I’ve never heard of the grass covered O’Conner Ranch but I ignored the $34 price tag for the burger (fries included!) and ordered it anyway. It was quite good but did little to diminish my burger loyalty to the Gidley.
