The problem with current retirement planning
Nobody retires with the expectation of running out of money. Retirement is supposed to be a time to pick up new hobbies, have lunch with your friends during the day, and enjoy the money you’ve saved and invested throughout your life. Unfortunately, most people have serious issues with their retirement plan and are in danger of running out of money when they are least prepared for it.
Problem 1 – outliving your money
Current retirement planning works by determining how much money you can withdraw each year to last a certain amount of time. How is that time period determined? Some people use a set time period (like the 30 years used in the Trinity Study). The issue with using a set time period is that there’s no way to know if that time period is appropriate for you. Maybe 30 years is reasonable if you retire at 65 years old. But what if you retire early?
According to the Social Security life expectancy tables, at 40 years old I have a life expectancy of 38.53 years (meaning I would expect to live until I’m 78.53 years old). My wife is a few years younger than me; at 35 years old she has a life expectancy of 47.19 years. She’s expected to live about 9 years longer than me, which is great for me. I’ve told her many times I hope I die before she does!
But back to the problem with the life expectancy tables – those tables are an average. Roughly half the people will live longer than indicated in the tables and half will die sooner. What happens if you are one of the 50% of the population who will live longer than average? What if there are huge advances in medical care that massively lengthen the average life span? Look at the increase in lifespans over the last 60 years – in the developed world the average lifespan has gone from roughly 65 to 78. What if lifespans increase by another 13 years in the next 50 years?
The issue with planning to have your money last a set amount of time is that you’re basically gambling/hoping that you die before the money runs out. What happens if you have the good fortune (or is it bad fortune?) to outlive your money?
Problem 2 – locking in a standard of living
Most withdrawal plans start with a set withdrawal rate (say 4% of your initial nest egg) and then annually increase the amount withdrawn to keep up with inflation. This sounds great – you’re protecting your purchasing power and ensuring you can enjoy the same standard of living next year as you’re enjoying this year.
But there’s a bit issue with this that nobody seems to talk about – you’re locking in today’s standard of living forever. If you retire at 45 years old you could easily have 40 years of retirement. Think about that. 40 years is a long, long time. Do you really think you’ll have the same interests and hobbies over the next 40 years? Do you think you’ll want to live the same lifestyle for that entire time? Wouldn’t you expect a lot to change in 40 years?
Maybe today you’re happy with living in a trailer, or never eating in a restaurant, or biking everywhere to save money on gas. But will you want to live in a trailer when you’re 70? Will you be able to bike everywhere when you’re 80? The lifestyle that you’re happy to live today might be a lot less appealing later in life. Some expenses will be higher and some will be lower, but you’re ensure that the total can never be higher than it is today (adjusted for inflation, of course).
A retirement that relies on a fixed withdrawal rate, even if adjusted for inflation, cuts off a lot of options in the future. If you can’t afford to travel in retirement today then you’ll NEVER be able to afford to travel. If you can’t afford to play golf in retirement today then you’ll NEVER be able to afford to play golf.
It seems a bit sad to permanently cut off options for the rest of your life.
How do those in the early retirement community propose to address these problems?
Standard response 1 – I can always go back to work if I need to
You say you’ll go back to work if needed?
If you’re forced to go back to work it will be when the market is down, not up. After all, if your nest egg is increasing every year it’s pretty unlikely you’d think your plan is failing, and it’s only when your plan is failing that you’d decide you need to go back to work, right? Unfortunately, bear markets are almost always caused by recessions. You’ll be looking for work at the worst possible time – during a time of high unemployment. You’ll have lots of competition for any job you’re interested in working.
And when you DO start looking for a job you’ll realize that any work skills you had will have long since atrophied. Your technical knowledge will no longer be relevant. You contacts in the working world will be gone. Nobody is going to hire a 65-year-old who hasn’t had a job in 20 years.
You’ll be the least desirable worker in the work force.
In addition, you’re assuming you’ll be ABLE to go back to work. The vast majority of people who retire before they want to do so because of health reasons. So even if you want to work it’s entirely possible you won’t be able to work for health reasons.
Standard response 2 – I’ll cut spending
The other standard argument is that you can start cutting costs before you run out of money. That sounds great, but the reality is that as you get older it’s harder to cut expenses. You can’t exactly fire your gardener at 80 years old and start mowing your lawn yourself. Are you going to stop taking your medications or paying property taxes? Yes, your travel expenses will probably drop quite a bit, but that might be more than made up for by higher medical costs, in-home care, and other expenses.
It’s a lot easier to cut expenses when you’re young and flexible and it’s harder to cut expenses when you’re older and more reliant on others.
The other issue is that many people hit early retirement the second they can fund a bare minimum existence. They’ve calculated that if they sell their car, rent out a room on AirBnB, cut all meat from their diet, and only wear used clothing they can survive on $29,000/year, so as soon as their passive income stream hits $29,000 they retire. Great! Then, two years into retirement there’s a recession. Their passive income drops due to empty rental units and/or dividend cuts. Where are the early retirees going to cut their spending to match their lower income? They have already cut everything out of their budget so they can achieve early retirement in the first place!
Never touch the principal!
How can I be sure I’ll never run out of money? Well, there’s only one surefire way to ensure you never, ever, ever run out of money, no matter how long you live or what you returns are, and that’s to never touch the principal. Drawing down your principal will eventually lead to a zero balance. Since it’s impossible to know how long you’ll live, it just doesn’t make any sense to retire with any withdrawal rate that can’t be expected to last forever.
Instead, you live off the income from your investments. You’ll want your income to grow faster than the rate of inflation, which can be done either by selecting investments with solid growth potential or by reinvesting some of your income. Since your income is growing faster than inflation your margin of safety will grow every year as well. You’ll be able to sustain a different/higher standard of living if so desired at some point in the future.
If you never touch the principal you’ll never run out of money. Pretty simple, right?
My goal is to save up enough so that I never have to touch my principal. Ideally, I’d like to save up $5 million so that I could have a retirement income of $100,000 plus whatever social security will provide (if social security can provide anything in the future). I will caveat that I am nowhere close to that number but think I am on track to hit it someday.
$5 million is a pretty big goal! You say you’re nowhere close to hitting that goal but you hope to one day. Do you have a projection of when that would be?
Also, if you’re only looking for a $100,000/year income, you don’t need anything even close to $5 million. A 3% withdrawal rate is VERY safe, and at 3% you only need $3.3M in assets to retire. That’s still a lot of money, but it’s a lot less than $5M.
My general thinking is to invest and save as much as one can, but don’t let 3 to 4% withdraw rule without ever touching the principle become that important of a concern. It’s not possible for people in their 30s and 40s to know how they’ll feel in their 60s or even late 50s.
I have a feeling when someone reaches their 60s, unless their financial situation is dire, most of them won’t be thinking much about 4% withdraw rule after they begin to notice their friends and acquaintances start to die one by one. At that age, health problems can hit completely unexpectedly, so I would think health concerns and even the possibility of needing 24hr permanent long term care worries starts to take over.
I agree with you to a point, but you’re just as likely to live too long. The issue is that if you overspend when you’re younger, you’ll find yourself at 80 years old with no savings. You’ll be too old to go back to work (nobody would hire you even if you were able to work).
Your point about needing to think more about healthcare in retirement is a legitimate one. Not only is regular healthcare a concern, but long-term disability/long-term care insurance becomes more important too. The hope, of course, is that you have built such an incredibly strong balance sheet that you’d be able to pay for those expenses out of your yearly income from your investments.