Spending in retirement: How much is enough?

One of the key decisions that needs to be made from a personal finance perspective relates to the drawing of income from your portfolio when you are relying on it to provide for your income upon retirement.

It is a crucial decision for two reasons. The first is that it will dictate how much income you will have after you finish work. The second is that for those people planning toward retirement, this figure will dictate the level of assets you need to accumulate for any given level of income.

I am going to look at two approaches to this problem: one is a simple model of spending the income received from your portfolio, and the other a more research-based solution that links asset allocation to ‘longevity’ and withdrawal rates. I will finish by considering a couple of idiosyncrasies of the Australian retirement landscape that might encourage people to be a little bolder in how quickly they manage and withdraw income from their portfolio.

To use a case study to illustrate what we are discussing, let’s use the example of a couple who retires with $1.3 million in investment assets. They are trying to work out what this means for them in retirement – should they be planning to spend $40,000 a year, $60,000 a year or $100,000 a year?

Spending investment income

A simple – but very legitimate approach – to this problem is to suggest that a retiree with a range of investments might choose simply to spend the income that their investments earn. With a well-balanced portfolio, this is reasonably sound thinking.

Let’s assume that our couple with $1.3 million of investment assets decides that they are going to leave one-third in cash, one- third in Australian shares and one-third in residential property. At the moment they should be able to get at least 4% income on their cash investments, find a residential property with an after-cost yield of 4% and receive income (including franking credits) of 5.5% on a portfolio of Australian shares.

*Includes the value of franking credits, which will be received as a tax refund by most retirees

Their total income: $58,455.

What is wrong with just spending this amount each year? The answer would be not much – it is a reasonable way to look at your retirement situation. Over time you would expect the income from the Australian shares and property investment to increase, providing an important buffer against inflation and effectively increasing the income that you have to spend. Having $433,000 in cash-style investments provides a great deal of liquidity for any cash needs. Spending the income of the portfolio preserves the underlying investments (although inflation will eat away at the $433,000 invested in cash), meaning the portfolio will be well placed to fund a retirement over many years.

The biggest risk in this situation would be an economic shock that saw very low interest rates and decreased share dividends and rental income. If you were prepared to cut your spending to cope with such an outcome, then this approach to funding your retirement is certainly sound.

For those people thinking about how much they need in retirement, this portfolio would be providing an income-to-spend of 4.5%. That is, for every $100,000 you have invested in this way, you might expect to receive about $4,500 of income a year.

The research-based approach

The second approach looks at putting together the key variables for a retirement portfolio, namely:

• The asset allocation (especially what proportion is allocated to growth assets like shares, and what proportion is allocated to cash and fixed interest (bond) investments).
• The length of time that the portfolio needs to provide income (often a figure of 30 years is used, effectively simulating a retirement from age 60 to 90).
• How quickly a person draws from their portfolio (4% a year, increasing with inflation, 6% a year increasing with inflation and so on).

In 1994 William Bengen wrote an article in the Journal of Finance that suggested that a person aged 60 would be unlikely to run out of funds if they allocated 50–75% of their portfolio to shares and drew from that portfolio at a rate of 4% a year. This was based on simulations using historical data and applied even if that person outlived their life expectancy by 5-10 years.

This became known as the 4% rule, and has been widely researched and tested since. Bergen has written further on this topic, suggesting that the inclusion of assets such as small companies in a portfolio could see the withdrawal rate become 4.5% to 5% a year. Interestingly, these figures fit around my first example of simply withdrawing the income produced by a portfolio.

There are also critics who say that this drawing rate of 4%-5% is too high. Their primary argument is that much of these simulations are based on US sharemarket returns during the period 1900 to the early 2000s, a time when the sharemarket performed exceptionally well. This inflates the returns that the simulations are based on, and leads to a higher withdrawal rate.

This 4% to 5% a year withdrawal rate is consistent with the findings from Guidelines for Withdrawal Rates and Portfolio Safety During Retirement, by John J Spitzer, Jeffrey C Strieter and Sandeep Singh of the State University of New York (US Journal of Financial Planning, October 2007). It looked at how likely you were to run out of funds during a 30-year retirement.

They found that with a portfolio that had a 60% exposure to growth assets (shares and property), a person had about a 12% (one in eight) chance of running out of money while drawing at a rate of 4.5% a year, and increasing their drawing each year in line with inflation.

For the person thinking about the amount of money that they need for retirement, a drawing rate of 4% suggests a withdrawal rate of $4,000 for every $100,000 invested, up to a withdrawal rate of $5,000 for every $100,000 invested if you use a 5% figure.

A more aggressive withdrawal rate – Australian situation

In Australia, we have factors that might support a higher portfolio withdrawal rate, including franking credits that provide a tax return for most Australian share investments and an age pension system that provides a safety net for people, even with levels of assets above $1 million. These factors might lead to someone being comfortable drawing at a higher rate for different reasons – franking credits because of the extra source of returns, and the age pension because of the safety net it provides if portfolio funds are depleted too quickly. (See A pension strategy where everyone can win).

There are other non-financial factors that might cause a person to decide to withdraw at a higher rate early in their retirement – including the assumption that they will spend decreasing amounts of money on things like entertainment and travel as they get older.

Conclusion

The rate at which you draw from your portfolio is a crucial personal finance decision. Looking at the problem a number of ways, an average withdrawal rate of 4.5% a year seems reasonable – with some suggestions that, in the Australian environment, being bold and drawing a little more is worth consideration.

Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.