Wednesday, July 1, 2015

How Much Can I Spend in Retirement?

This is a common question asked by people approaching retirement - How much can I spend?  The real question is how can you spend and not run out of money before you and your spouse die?

Unfortunately, there is no definite answer since we are dealing with the future, with unknowns such as inflation, interest rates, financial crises, and stock market returns.  On top of that, a big unknown is how long you and your spouse will live.  So how do we deal with the question of whether a cash flow filled with unknowns will last an unknown period of time?

Start with your life expectancy, which you can estimate via some calculators on the web, see the links below.
You will find out that you will likely live until age 82 or so.  But this is the average life expectancy, you have a 50% probability of living longer and you should really use a higher age in your estimates or you will run out of money.  Let's assume you will live until 92 and so will your spouse, and we will call you Mr. and Mrs. Smith

If we have estimates of life expectancy, how do we estimate how much you can spend each year?

First, we start with your guaranteed pension money, which will be from the government (SS or CPP) and maybe from your former employer(s).  This is money you can count on, and is often indexed to inflation.  Let's assume Mr and Mrs. Smith will get $16000 per year from government pensions and Mr. Smith will get a small pension of $9000 a year from his previous employer, Vandalay Industries.

Second, we look at retirement savings, and estimate how much you can spend per year.  Let's assume our 65 year old couple, Mr and Mrs Smith have saved $1,000,000.  There are different theories on how to estimate this:
  1. The 4% rule: spend 4% of your nest egg a year = $40,000 in our example.
  2. Use the Vanguard Monte Carlo simulation tool covered earlier in this blog: $38,000 a year for 27 years with 97% chance of not running out of money.
  3. Use an annuity calculator.  This assumes you will put your money into an annuity to generate life long income for you and your spouse.
    1. If you want an annuity with a fixed income, that gives 50% to the surviving spouse when one dies, you get $60,600 per year
    2. If you want the payments to rise with inflation (3%) and 50% going to surviving spouse, you get $39,180.
So most of the estimates of how much to spend of savings are quite close, $38,000 to $40,000, or 4%.

Third, we total up the pension and investment spending to get an estimate of how much to spend:

  $16,000 Govt Pensions
+ $9,000 Vandalay Industries Pension
+ $38,000 Retirement Savings spending (conservative estimate)
$63,000 Can be spent per year in retirement

This will increase each year by increases in the pension amounts and the rate of inflation for the Retirement savings component.

As always, do not believe everything you read on the Internet, including this blog. This blog provides information but should not be used as a definitive source of financial guidance.  Get advice from a competent financial advisor before making important financial decisions.  

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