How to Retire: Stay Flexible With Your Retirement Spending

Christine Benz: Hi, I’m Christine Benz from Morningstar, and welcome to the How to Retire podcast. It’s a companion to my book, which is also called How to Retire. Each episode will provide a bite-sized lesson about how to do some aspect of retirement well.

Today’s episode will focus on how to make sure that the amount that you’re spending from your portfolio is reasonable. To tackle this topic, I sat down with Derek Tharp, who is a Senior Research Nerd at Kitces.com and an Assistant Professor of Finance at the University of Southern Maine. I’ve loved Derek’s work on how adjusting your spending in retirement can actually enable you to spend more over your lifetime. I feel like it’s so practical and helpful, especially for people with tight financial plans heading into retirement.

Derek, thank you so much for being here.

Derek Tharp: Thanks for having me.

How Actual Retiree Spending Deviates From Conventional Retirement Research

Benz: You’ve done a lot of terrific research on the topic of withdrawal rates, safe withdrawal rates, which is one of the most vexing questions for people embarking on retirement: How much can they take out? One of the conventions in the retirement spending research is that people spend a fixed amount per year on an inflation-adjusted basis. Of course, that’s not really the way that people spend. So, can you talk about that, how that’s in a lot of ways kind of a straw man when we approach retirement decumulation?

Tharp: Yeah, I think there’s really two key ways that, when we look at retiree spending, it does tend to deviate from what we actually see there. And the first would be that assumption that you’re going to get a constant inflation adjustment over time just doesn’t really hold. We don’t see that people are actually getting that increase in spending. And instead, we do see a bit of a decrease in spending. Now, I think it’s important to note that that decrease that we do see does tend to be at a rate that’s less than inflation. So just to use some round numbers, let’s say inflation is 3%, and somebody’s spending only goes up 2%. So they’re still spending more. It still feels like they’re spending more. But on an inflation-adjusted basis, they actually went backward a little bit. And David Blanchett’s “retirement spending smile,” when you look at the numbers, they are really anywhere from kind of a 1% to 2% real, or inflation-adjusted, decrease in spending is more normal as somebody’s aging and going through retirement. So that’s the first thing that I don’t think really aligns.

The second piece, which my co-author, Justin Fitzpatrick, and myself have referred to as the “retirement spending hatchet” or “retirement distribution hatchet,” really talks about how, for a lot of people, especially if they’re delaying Social Security, hoping to let that benefit grow, pulling on their portfolio in the earlier years, we don’t see this nice level kind of spending. We might actually see distribution rates that are significantly higher on the front end—it’s where we get the blade of our hatchet in that metaphor. And then we see those go down over time. And so somebody spending at a very reasonable level might start out spending 7% in the early years, and maybe that distribution rate drops to 1% or 2% once their Social Security kicks in.

So it’s just a little bit more complex, I think, than really just assuming you’re going to get that constant inflation-adjusted spending amount. That can be nice for research and kind of understanding, asking some questions about what somebody could have spent in the past, but I don’t think it really aligns with how retirees actually spend.

Why Early Retirees Can Spending More Than the 4% Guideline

Benz: Yeah, that’s helpful. So, it sounds like the broad takeaway there is that for people who are just embarking on retirement, if they’re thinking about, say, a 4% type guideline, that they may be short-thrifting themselves and may be actually underspending when you factor in that potentially they are delaying Social Security, and that’ll come online, and that their spending may naturally trend down throughout the lifecycle. Is that one of your messages, that early retirees should maybe feel comfortable spending a little bit more than those standard rules of thumb might tell them are safe?

Tharp: Absolutely. I do think a lot of the kind of standard rules of thumb that are out there do push people to be excessively cautious when it comes to approaching retirement, and especially thinking about, you know, we have the ability to monitor and adjust along the way. So we can make course corrections if it looks like we’re headed down a path where maybe there should be some concern, but especially when we’re using something like the worst historical sequence, is that how to spend today? That means in most historical cases, we were actually being far too conservative and leaving a lot of upside there. And so I think that’s really, it is something that I find concerning and not just for retirees to be able to spend at a little higher level, but also because when we think about the ages and somebody’s talking kind of health span and their ability to use their wealth, we’re talking about missing out on some of the years when they’re going to be most able to be able to go out and enjoy their wealth and use it for things like travel or whatever it might be they want to be doing. And so, to me, that real mismatch is something that I think can really cost people a lot in terms of not just the number side of things but the experiences and what they can do with their wealth as well.

How to Adjust Your Retirement Spending Over Time

Benz: Yeah, that’s super helpful. It seems like research from you and from other entities, including our team at Morningstar that have looked at retirement spending, do point to the value of doing an adjustment-based system if you possibly can. So you’re adjusting to the portfolio’s value potentially as well as what’s going on with your age and your life expectancy.

So the question is, How can you do that simply, or can you? Are there any simple adjustment-based systems that you like? One I sometimes hear about is just do an RMD, required minimum distribution, style spending system where you’re looking at portfolio value divided by life expectancy, but that one seems to kind of buffet people around an awful lot from year to year. Are there any simple ways to adjust spending on an ongoing basis?

Tharp: I love simple. I’m always looking for simple. But sometimes I think we also need to think about doing it right versus simple. And when you look at something like somebody were to go out and get brain surgery, I don’t necessarily want the simplest way to carry that out. I want that done correctly if I’m going through that. And so I think there’s two different ways to look at it. One being that there is some complexities to figuring out how you would set up a good distribution or spending plan in retirement. So there’s that piece of it. But there is ways that I think we can kind of simply get at a number that I think is more important, which is really trying to assess just our total risk or our overall risk that’s in somebody’s retirement plan. And for a lot of people, that’s really what ultimately matters. And so looking for something like—distribution rates are going to change, some of these spending goals might spike, all that might not be so flat and even over time. So, how do we find something that actually would work?

And some of the tools that people are already using, like Monte Carlo simulation, are going to get somebody to—I think people often misinterpret what that number actually means—but it’s going to get them to kind of a, if you think of it more as just a risk level. And we see where that number is, how it’s changing over time. That’s something that is in a nice, simple way, looking at the entirety of somebody’s plan and really trying to smooth things out. And to me, that’s something that really is worth looking at as a simpler type of way. And then using that in my preferred way that I would say is doing it right in my view, where we ideally take that information and put it into a guardrails-type framework, where we say, “OK, here’s when we’re going to increase our spending, here’s when we’re going to decrease our spending.” So that we actually have a plan going into retirement, and we’ve predefined the levels that we would do that.

And one benefit is that can give people a lot of peace of mind if they know, “Hey, I’ve got $1 million in my portfolio today, but risk levels in my plan aren’t going to get too high until my portfolio falls to $600,000. And then once it gets there, I know I need to cut back and here’s the adjustment I need to make.” If somebody knows all that and they know what the adjustment is and that they can tolerate that adjustment, suddenly going through scary downward markets, I think, is a lot less scary with that peace of mind.

So that’s my overall approach. I love simple, I’d love to keep it as simple as possible, but sometimes trying to get that risk picture right is important. And unfortunately, the 4% rule, even the RMD type of approach that you mentioned, that’s going to create too much spending volatility and I think still be a little excessively cautious. So for me, it’s really more that total risk approach that I prefer.

How to Get Comfortable With Variability in Retirement

Benz: One thing that I know that you’ve written about is this idea of helping an investor preidentify how comfortable they are with variability, that this will differ by the household, by the individual, the extent to which we’re comfortable making these course corrections. What should people be thinking about there when trying to decide where they are on that spectrum, say they’re just embarking on retirement? What are the key questions to ask themselves?

Tharp: I think one of the real big questions to ask yourself is how much do you want to try and avoid downward adjustment? If you start spending at a certain level, how averse are you to maybe running into a scenario where you’d have to course correct and cut that back? Because that starting spending level is really one of the biggest levers we have to pull in terms of trying to play with that lifetime overall risk level and a plan. So if we want to reduce the risk that somebody would ever need to make a downward adjustment, the best way to do that is to start spending at a lower level. So that’s really kind of the most powerful way that I think that we have. So that’d be the question I’d ask myself is “How comfortable am I with cutting back?” And of course that comes from understanding your budget and what your needs are, needs versus wants, and all the typical budgeting type of information. So that’s a real big one for me is just understanding that. And then from there understanding maybe also where a floor is, related to that, but you know what sort of income level might somebody really want to stay above. Then you can start to run the numbers and really play around with it to get an answer in terms of does a total risk type of plan fit within the parameters that somebody’s shooting for.

How to Transition From Saving to Spending

Benz: Moving away from the technical aspect of this problem of figuring out how much you can safely spend in retirement, I often encounter retirees who talk about that transition from being a saver, being someone who’s working and continuing to stock money away into someone who’s spending from a portfolio. And I understand that that transition can be psychologically really difficult for some people. I’m wondering if you have thought about that problem, if you encounter the same thing. And if you have any strategies for people who need to help themselves over that hump, so that they’re actually not short-shrifting their quality of life in the interest of preserving that portfolio that they work so hard to build.

Tharp: It’s a great question. It’s something that I do see a lot of people, especially people who are really good at planning for retirement, really good at saving, setting aside, when it comes time to actually make that shift into spending mode, that can be really tough, especially if they’re maybe even spending, when they’ve heard about the 4% rule and maybe they’re seeing, “Oh, I actually need to take 6% in these first years of retirement,” and that can be a real scary type of feeling. I do think there are ways that, at least theoretically, tools like annuities could help with some of that in terms of, I think, people look at spending like a pensionlike income or an annuity-like income stream differently than they do from pulling from their portfolio. The challenge there as well, though, I think, in my view, some people will also look at that initial annuity contribution as a spend in itself. And so that might be scary to try and overcome that. And I think that’s where we get the whole annuity puzzle and why aren’t people actually wanting to take lump sums and put them into these annuity products at the rates that a lot of research would indicate could be beneficial for retirees.

So I think part of it is that same sort of, it’s hard to spend. I think getting a good plan in place, however, if somebody wants to approach that, is often one of the most comforting things we can try to do, and playing out some of those scenarios, and especially in a risk-based framework like I’ve been talking about where you can see, “OK, here’s some different paths. Here’s where I would have adjusted. Here’s where I would have cut spending or I would have received a spending increase” and especially running that through, like some of the worst times in history, kind of stress-testing, “OK, if I went through the dot-com bubble or I went through the Great Recession or the Great Depression” and just see what that would have actually looked like and see, “OK, could I tolerate that?” That’s really one of the best ways I’ve found to try and build some of that peace of mind and confidence that somebody could feel like, “OK, yeah, I can do this. I can spend at this level.” But it’s certainly a very real challenge for many retirees who’ve been good savers.

How to Account for Long-Term Care in Your Retirement Spending Plan

Benz: Yeah, and of course, a big wild card in this, and I think one reason why retirees often do underspend is if they don’t have insured long-term-care expenses, if they’re planning to use their portfolio in case they have a long-term-care need, I think that is where some of the reticence can come in. Like how much will that be? What if I end up being one of those people who needs long-term care for a very long period of time? Do you have any thoughts on how to address that consideration in the context of our retirement spending plan?

Tharp: Yep, absolutely. I think that’s, it is one of those fears that’s there. And even if somebody has insurance, if there’s a cap or a maximum that’s going to be paid out on their insurance, it can still be a concern. “OK, well, what if I’m in a very prolonged type of situation where my body is healthy, but my mind is struggling, and that’s really what’s causing the need for that care?” So it’s a real challenge. I do think some planning around, maybe even kind of earmarking, let’s say somebody, they weren’t—long-term-care insurance just was never an option, not something they pursued—they still might want to look at a portion of their portfolio maybe as earmarked for those expenses down the road. And if they can carve that out, you could even create this total risk type of framework I’ve been talking about where you could say, “OK, I have this $300,000 that I’m setting aside as really something that’s here as an asset that I want to be able to preserve that possibility down the road. And I just want to spend a prudent risk level based on the other assets that are in the plan.” So maybe carving something out like that could be helpful for somebody that doesn’t have some coverage in place. Of course, getting coverage in place could also be very beneficial. And I know it’s not super common, but even some of the products out there that might provide really truly kind of a lifetime type of protection instead of more of a capped benefit could be something to look at as well if somebody’s really trying to find that maximum level of comfort with that risk.

Benz: OK, Derek, I love your work on retiree spending. Thank you so much for being here with us to discuss it.

Tharp: Thanks so much for having me.

Key Takeaways

Benz: Here are the key takeaways for me from this conversation.

One is that retirees should feel comfortable spending a bit more from their portfolios in the early years of retirement for a few key reasons. First, people’s spending changes throughout their retirement years, and often it trends down. In addition, the early years of retirement are often the high spending ones simply because many people delay Social Security, and when they start receiving Social Security, their spending declines.

In addition, research from Derek and others points to the value of potentially changing up spending based on how your portfolio has performed. But it’s helpful to take a close look at your budget to figure out where you would cut your spending if you needed to. That can help you figure out whether a dynamic spending system is appropriate for you.

Finally, one of the wild cards in a lot of retirees’ spending plans is whether they’ll confront long-term-care costs later in life. If you don’t have long-term-care insurance, I love the idea of setting aside assets for it and segregating them from your spending portfolio.

The book How to Retire goes even deeper on retirement spending with experts Wade Pfau, David Blanchett, Jonathan Guyton, and Ramit Sethi.

Thanks so much for being here. I’m Christine Benz for Morningstar.

Watch more from How to Retire with Christine Benz.