I have a question about spending down a nest egg in later life vs. leaving an inheritance. If possible, my wife and I would like to keep our principal intact (or relatively intact) for our adult children, but we also want to enjoy our retirement. Can you quantify this? What kind of return would we need on our savings if we wish to leave a financial legacy for our family? And what kind of return would suffice if we decide, as the saying goes, to “spend our kids’ inheritance”?
These questions are more important than many retirees realize. Decisions about your principal—whether to tap it or preserve it for your heirs—can make a big difference in how retirees invest their money, and, as such, how much risk they need to take in later life.
I asked Charlie Farrell, a managing director in Denver with Beacon Pointe Advisors, if he could run some numbers and discuss what makes for a durable portfolio in later life. Here are excerpts from our conversation:
WSJ: Are retirees today looking for, or embracing, a particular kind of portfolio?
MR. FARRELL: I think retirement is primarily about a more-comfortable lifestyle in its various forms. As risks of things like healthcare challenges increase, and as we face the realities of reaching the end of our lives, most people would prefer more comfort or stability around their finances, if possible. In general, that means portfolios with lower volatility.
WSJ: How do you build a “comfortable” portfolio? And how does that relate to tapping, or not tapping, one’s principal in retirement?
MR. FARRELL: The level of comfort you can get in a portfolio is roughly dependent on two things: whether you’re OK spending down principal, and whether you have control over what I’ll call your personal inflation rate. If you’re OK spending down principal—in other words, you don’t have a specific goal of leaving a legacy to children or charity, and you simply leave whatever is left—and if you have control over your personal inflation rate, you have far more flexibility to design a less-volatile portfolio.
WSJ: How do you determine your “personal inflation rate”? And how do you control it?
MR. FARRELL: You could add up everything you spent over one year and then add up everything you spent the next year and compare the numbers. But a more-practical approach is to manage your money to a personal inflation rate that you choose. In other words, you spend within a specific budget and cap your personal rate at some percentage.
Let’s say inflation is running at 8% and you want to cap your inflation rate at 5%. In that case, you wouldn’t spend more than 5% above what you have been spending on a monthly basis going forward. That way you will be forced to manage your money to that number, and to make the cost and quality trade-offs necessary to hit that number.
WSJ: What are some of the trade-offs?
MR. FARRELL: Let’s say you spend $120,000 a year, but only $50,000 of that is on essentials like utilities, healthcare, taxes, insurance, maintenance for your house. The rest is discretionary: entertainment, travel, hobbies, etc. You can’t do much about, say, your car insurance. But you can make different choices around the discretionary spending.
The point is to experiment with what you’re doing and see if you can hold inflation in check in retirement and still enjoy life. For instance, you might want to buy an expensive car, but you decide to get a more modest model. If you can do that—if you can keep your personal inflation rate in check and maybe even lower it—that reduces the pressure to increase annual withdrawals from your nest egg. And that means you need less return to make your savings last as long as you do.
Historically, the most difficult cycles for retirees have been ones with high inflation and plunging or stagnating markets—basically, what we have today. If it only lasts a year or so, it’s no big deal. But if it drags on, it’s going to be a bigger challenge.
WSJ: Let’s talk about returns. What kind of return would a couple need if they’re willing to tap their principal vs. a couple who would like to preserve it?
MR. FARRELL: Let’s say you start with $1 million and withdraw 4%, or $40,000, a year and have no inflation and no portfolio growth. The money will last 25 years. So to get to 30 years, you only need about a 1.5% return on your portfolio, if inflation is 0%. If you move inflation to 2%, you’ll see that to make it 30 years, you need a total return of about 3.5% (a 1.5% return plus the 2% inflation rate). Move inflation to 3% and you can make 30 years if your return is 4.5%, and so on.
So roughly a 1.5% return above inflation will get the money to last 30 years. That’s on paper, of course, but it gives you a basic sense of how much extra return you need. It’s not too much, actually, if you’re OK spending down principal over time.
WSJ: And what about the couple who wants to preserve principal?
MR. FARRELL: Here, you’d need about 3% to 3.5% above inflation, with inflation in the 2% to 4% range. Let’s say your personal inflation rate is 2%. In that case, you would need a return of about 5% to 5.5%. While it doesn’t seem like much more, you’d likely have to allocate meaningfully more to stocks to try to achieve this return.
If you assume a 3% bond return and 6% stock return, you would need a little over 80% of your money in stocks to hit a 5.5% portfolio return. But to hit a 3.5% return, you’d need only about 30% in stocks. Thus, the desire to maintain principal makes a big difference in how much risk you might take.
WSJ: Seems straightforward.
MR. FARRELL: Well, these are spreadsheet assumptions, and, of course, the real world is a lot messier. Who knows what returns will be going forward. But if you need more returns, you’ll need to hold more in equities, which increases volatility and uncertainty—and, thus, generally increases discomfort.
So if you don’t mind the possibility of consuming principal over time, and if you can get control over your personal inflation rate, you can be more conservative and, thus, have more comfort. It’s really about what things are most important to you.
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