The New Retirement Reality

So, at least, we are giving the market returns through their target-date funds. But then, when they retire, they have yet to learn what they have been investing in. They have yet to learn how much income they can buy with the money they have saved. They fixate on the total dollar value and must instead consider how to translate that amount into a lifestyle. They want help trying to figure out whether they have enough and what sort of strategy they should use for investing that money to draw an income to fund the lifestyle that replaces their pre-retirement lifestyle.

But doing that is not easy. Many have no idea what percentage of their savings they invest in stocks or bonds. They have no idea what it costs to buy income. So, they need professional help, and this is the opportunity that advisors have to help a client use a straightforward process to develop a retirement income plan.

In the 60- to 69-year-old group, only 19% have any pension income. So, their primary income will be Social Security. A few had a public sector job with access to some form of pension. They have Social Security and retirement savings. This is different from even the older baby boomers because many older baby boomers if they worked for a big company, had access to at least a partial company pension. Today’s workers do not have that. So, we are really among the first generation of retirees who do not have any pension income.

When they retire, many people have a number they’re shooting for; maybe it was half a million dollars, or a million dollars, or maybe $2 million. But they met that number. One of the reasons they met that number was because assets became so expensive. Stocks became expensive. Bonds became expensive. That means that their portfolio had tremendous value. They decided that they were going to retire. But then, to live the lifestyle that they want to be able to lead, in other words, to replace the lifestyle that they had before retirement, they are going to have to spend down that money. However, I consistently find that individuals have yet to realize that they will have to get comfortable with the idea of spending down their savings.

A few years ago, I interviewed retirees, asking them how they were spending money. Many of them were so proud of the fact that they were not spending down their savings. So, they would say things like, “We have more money today than we did ten years ago when we first retired,” “We are doing a great job of going to the two-for-one dinners,” and “We are living frugally.” And they looked at me like I should pat them on the back because they had been so frugal in retirement. So, I would then ask them, “Well, you must really want to give that money to your kids.”

Then, they would say, “Well, no, that is not why we are not spending the money. We helped them pay for college. They have got plenty of money. That is not our primary goal.” But there are only two places that your money can go. It can either go towards funding your lifestyle, or it can go to others. So many retirees, especially mass-affluent, higher-wealth retirees, have yet to devise a plan. What will end up happening is that they will give what is known as an unintended bequest, which means that they die with a lot of money in the bank that they could have spent to provide joy. Instead, what they are doing is trying to preserve their assets.

We have got to move beyond this. In the defined contribution era, this is a psychological problem that we need to be able to help people solve by getting them to feel comfortable spending down their assets, including the home equity in their house. If they have home equity, that could be a source of satisfaction. That could be money that they spend to improve their lifestyle. If their goal is not necessarily to leave a significant bequest, if that is not their primary goal, they need to explore all options for taking the assets they have accumulated and turning that money into a lifestyle.

Step 1: Setting Lifestyle and Legacy Goals

Step 1 of using a goal-based retirement planning process is to have a conversation with a client where you talk about, “All right. How much of your nest egg do you want to leave to others? And how much of it do you want to actually spend?” because there are only two places that your money can go. It can either go towards fun stuff, or it can go towards passing it on to others. That may be fine. That may be what you want. But people should do this deliberately. They should have a conversation. If you are talking to a couple, they must agree about what they want to do with their money.

What I feel is that many couples have never had this conversation. Often, one of the most significant sources of value an advisor can provide is to get people to have this conversation for the first time. Very often, this couple has never even thought about, if it is a couple, that their money can only go to two places. So, what do you want to do with your money? Do you want to live better? Or do you want to pass it on to others? That may be what you want to do. But let us do it purposefully.

Now, I think that one of the reasons that people are not deliberate about spending their money in retirement is that we all feel that we will live forever. There is a piece of art created by Damien Hirst in 1991, and the title of the art is <em>”The Physical Impossibility of Death in the Mind of Someone Living</em>.” I think it is such a great title because it is absolutely true. It is borne out by research that has been done on how we think about death. We cannot acknowledge the fact that we are not going to live forever. So, the artist wanted you to walk around this dead shark in formaldehyde and imagine that it was going to eat you so that you could come face-to-face with the reality that we are mortal.

How can an advisor help a client come face-to-face with this reality when it is something that we do not want to talk about? Whenever a financial professional talks with someone about any financial product that only has value if you are mortal, the tendency is simply to deflect, delay, or deny. These are very consistent human responses to talking about your death. I have a financial advisor who is a friend of mine in Dallas, and one of the first things he talks about with clients is, “What do you want your money to do for you 50 years down the road? One hundred years in the future?” Let us talk about building a plan for what you want your money to accomplish, that percentage of your nest egg that you want to use and pass on to others to fund that legacy goal.

Then, you can have a conversation because now your money will allow you to live forever. This is what is known as symbolic immortality. Your legacy can help you live forever. But now, that creates the opportunity to discuss your income because you have already established immortality through your legacy. Let us discuss using the remainder of your assets to fund an income. It is an excellent way to enter into a discussion about income rather than using a technique that requires acknowledging your death. The worst thing that you can do is lead with your mortality. Please find a way to do it in a way that people can accept the fact that they are going to live forever. Then, let us plan on getting the most out of the portion of our assets that we will use to fund an income.

Step 2: What Should Income Look Like? 

So, let us estimate the actual replacement rate from your pre-retirement lifestyle. For most higher-income workers, it is probably more like 60% of your gross salary that is what you want to be able to replace. So, if you are making $200,000, it will look more like $120,000, which you need to replace. Part of that will be replaced with Social Security. Part of that could be replaced with your investments. But what you will find is that many mass-affluent clients are going to need something extra.

They need more investments to fund the lifestyle gap. If you can estimate what that gap is, now you can begin to have a conversation about, “All right, of your investments, how much do you want to devote to plugging that hole in the gap between Social Security and the lifestyle that you want to be able to lead to replace the amount of money that you were spending before retirement? And what other assets can we tap to fund that lifestyle?”

So, let us say $200,000 is what you earn pre-retirement, gross. I am not saying you should cut down your spending after retirement. You should spend about the same amount of money after retirement as you did before you retired. That amount is about 55 to 60% of the amount of money that you were spending pre-retirement. Why? Well, because you were saving money for retirement. If you were taking advantage of catch-up savings, then that is a significant percentage of your overall gross salary that you are already just saving. That is not money that you are spending. You also had to pay payroll taxes during your working years that you do not have to pay after retirement. The amount you spent before you retired is $110,000 annually after tax.

This is precisely what I find when I look at retirees’ spending data. We are creatures of habit. We live in the same house very often. We go to the same grocery stores. We drive the same car. We pay the same insurance. Our spending after retirement, on average, looks exactly like our spending before retirement, at the median. Now, some people spend more. Some people spend less. But, generally speaking, spending, on average, does not change.

One of the things I also want to mention is that I have researched life satisfaction, and what I find is that it is very often the kind of things that may seem frivolous, like going out to eat with friends or going out on vacations, these are the things that consistently predict life satisfaction. So, whatever plan you put together, you want to ensure that no matter what happens in the market or how long people live, they still feel comfortable spending money on frivolous things. So, you can ask people, “During the market crash in 2020, during the decline in 2022, did you cut back on going out to eat with friends? Did you take fewer vacations?”

If that is true, let us think about how to create a plan where you can feel comfortable spending money on those categories, no matter what happens in the market. I want to see the defined contribution retirees live as well as they did when they were working. If that means that your lifestyle is dependent on the ups and downs of the market, that means you are not living well. People tend to cut back on some of these categories when the market does not do well. Let us develop a plan to put a wall around that spending.

Criticisms of the Four Percent Rule

Let me take a minute to discuss the four percent rule and, specifically, some of my criticisms of it. So, where was the four percent rule created? How did it come about? In 1994, a financial advisor named Bill Bengen wanted to make a critical point: even if your portfolio averages an eight percent return, that does not necessarily mean that you can safely withdraw eight percent from that portfolio every year.

So, what assumptions are involved in the four percent rule? Since we do not know what future asset returns will be, Bengen based his research on US historical averages before 1994. The available Ibbotson data provided stock and bond returns between 1926 and about 1990.

He also did not know, as none of us do, how long we would live, so he used a 30-year time horizon. He said, essentially, it is safe if the money lasts for 30 years. You do not know how much money you will spend, so he assumed constant inflation-adjusted spending. So, somebody who follows the four percent rule is basing the safety of the four percent rule on these assumptions.

So, a very simplified version of the assumptions of the four percent rule is that you start at 65. You withdraw four percent of your initial balance in real after-inflation terms. What does that mean? So, if you have a million dollars, you spend $40,000 the first year. If inflation is five percent, you spend $42,000 the following year. So, you will spend the same amount of money yearly in after-inflation terms. You are going to spend down your money. If you still have money in the bank at the age of 95, that is considered a successful retirement. If you ran out of money before the age of 95, that was considered to be a failure.

So, if you run a Monte Carlo scenario with a 10% chance of failure, that means that the money ran out 10% of the time before the age of 95. So, if you are a financial advisor who follows the four percent rule to the letter using these assumptions, then I think it is a good idea to set aside $10,000 and put it in an account that you can then use for your client to fund the purchase of a motorcycle at the age of 94. Then, encourage your client to ride it without a helmet because you have only estimated the safety of a withdrawal strategy up to the age of 95. What does that mean if you tell them they have a 90% chance of success?

That means they have a 90% chance of the money not running out before age 95. So, there is no assumption about anybody living beyond 95. According to the four percent rule, age ninety-five is the maximum age humans can live to. Is that realistic? Well, maybe in 1994, that was a relatively conservative assumption. But that is not really conservative now.

Today’s Longevity Assumptions

So, how long are you going to live? Well, none of us know. But it is likely longer than you think. When you look at the longevity statistics, we are gaining about a year every decade in the United States. In the mad men era of the ‘60s, ‘70s, and ‘80s, there was a four-and-a-half-year difference between men and women. That has shrunk to about two and a half years. However, for clients of financial advisors who have enough money to worry about how long the money will last, the difference is less than a year between men and women. The big reason is that higher-income men have made considerable gains in longevity over a recent twenty-year period. Longevity after age 55 has grown by 5.9 years for men in the top tenth percentile of earnings, and it has gone up by 3.1 years for women in the top tenth percentile of earnings.

The increase in longevity for men is spectacular and has essentially occurred because men are smoking less than they used to. Men in the top tenth percentile of income smoke less than men in lower-income percentiles. So, men have done a great job of improving their longevity. Women who make more money also live longer for whatever reason. They are not smoking as much. They are exercising. They are eating better. That is great. But it means that that longevity is getting pushed out farther and farther.

The likelihood that one’s spouse will still be alive at a given age is known as joint longevity, and joint longevity for a healthy 65-year-old couple has gone up to a 43% chance that one will still be alive beyond the age of 95. I talk to actuaries at insurance companies, and what they tell me is that for their healthiest customers, for people who are in the premier class of life insurance, there is actually a 57% chance that one spouse in a healthy couple is going to live beyond the age of 95. So, people who have enough money to worry about how long their money will last will live longer than the average American.

The big mistake I see many people making at retirement is they are assuming that if their dad died when they were 72, they are going to say, “Well, I am not going to live much beyond 75 because it is just in my family.” Well, your dad lived differently. He lived in a different era, probably behaved differently, ate differently, maybe smoked, and exercised less often. Also, medical science has advanced significantly since even the early 1990s. Survival rates for many different types of cancers have gone up dramatically since the 1990s. So, the new reality is that people will live longer, especially higher-income people.

They need to think about possibly putting together a plan where the money will last into their 90s and beyond. Remember, the four percent rule assumes everybody is dying at 95. There is now a 43% chance in a couple that one will still be alive at 95.

Investment Risk is Lifestyle Risk

The new retirement reality is that people are living longer when it comes to longevity. Regarding investments, they generate less income to fund spending than they used to.

Now, we cannot base a retirement plan on this idea of harvesting income from an investment portfolio. First, there are more efficient ways to do it because it very often leads to putting too many of your stock investments in high-dividend stocks, which is not an efficient strategy, or taking too much risk with your bond investments to get a higher yield. Again, there are more efficient strategies. You should have a balanced portfolio. But you should also recognize that you will have to spend that money down if you want to maintain the lifestyle you had before you retired.

What does it mean to take investment risk? Imagine that you go to a bank. You are 55 years old. You put a thousand dollars into one of those vacuum tube thingamajigs and write a note to the teller saying, “Invest in stocks or bonds.”

You shoot it back up to the teller, who invests the money for the next 20 years. You come back 20 years later. Now, you are 75 years old. You need the money to fund spending that month. You ask for it back. You open up the vacuum tube, and the amount of money you have available is the amount you can spend that month. So, the growth in your bond or stock investments over those 20 years will determine how much cash you can spend that month. That is how I want to get people thinking about investing because investment risk is lifestyle risk.

When stocks do not perform as well as you had hoped, that means it will impact the amount of money you can spend that month. When you invest in safer investments, that means that, on average, you will have less income. But it also means there will be less variation in the amount of money you have available to spend. So, we can give too much credence to historical returns on stocks, which have been significantly higher than bonds or cash.

So, when we use the historical averages to project how much money a retiree will have 20 years down the road, we conclude that taking more investment risk is the only appropriate strategy for funding long-term spending goals. But if you actually put a dollar into a vacuum tube, shot it up for 20 years, and invested it in the S&amp;P 500, bonds, or cash, this is the amount of money that you would have 20 years later.

Bill Bengen used data from the middle of the 20^th century in the United States, years when stocks just trounced bonds. They were the obvious choice for any long-term investment. Also, the internet bubble between the late 1970s and the late 1990s was another period where stocks just thoroughly trounced bonds.

There have been several periods when stocks returned less than long-term bonds and even a couple of periods when they returned less than intermediate-term bonds. When we run a Monte Carlo simulation, we use these historical returns.

Well, if you think about between 1934 and 1953, a dollar never grew to an amount less than seven dollars over the next 20 years. Since the late 1980s, a dollar has never grown to seven over the next 20 years. So, in the current environment, you cannot expect stocks to do what they did for investors in historical periods. That means that if you run a Monte Carlo using these data, it can give you a false impression of the amount of income you can generate by taking greater investment risk. This is a big problem in retirement income planning and projections of safe spending amounts, and that is that you are using stock returns from this historical era that may not happen again in the future.

So, taking investment risk is not necessarily the solution to all of life’s problems. On average, it will allow you to spend more money and pass more money on to others. But it is not necessarily the foundation on which you can rest a safe retirement income strategy.

Step 3: Figure Out How Much the Client Needs to Spend

So, how should we think about taking investment risk? Imagine that someone puts 40 cards in front of you, and on the back of each one of those cards is written a return on your retirement portfolio. Most of the cards are between zero and 10%. One of them is positive 40%. Two are negative 20%. One is negative 30%. You spread all the cards out in front of you.

Then, you have to pick them up one at a time and live with the consequences of whatever you see on the back of that card. Now, most of the time, it is going to be between zero and 10%. But you could pick up the negative 20% card in the first year of retirement. You could pick up the negative 30% card in the first year of retirement. In 2022, many retirees picked up the negative 20% return card. Some retirees who put 10% of their portfolio in crypto and decided to put more of their bond portfolio in high-yield bonds may have picked up the negative 30% card in 2022.

What are the consequences of picking up the low-return card in the first year at the beginning of retirement? Well, let us say you were very conservative and followed the three percent rule, which I think is close to safer in today’s environment. It gives you a 94% chance of success. But if you pick up the negative 20% return card, you go from a 94% chance of success down to a 69% chance of success. If you pick up the negative 30% card, you go from a 94% chance of success down to a 48% chance of success. So, what do you tell someone who goes from a 94% chance that they can take $30,000 out of a million-dollar portfolio to saying, “Now, it is less than 50/50.”

Well, your only response is to ignore reality, which is not a very good response, especially if you started out thinking you had a 94% chance of success because you were so conservative. The only other response is that you will have to cut spending back. You could cut it back to $25,000. Maybe even less if you want to maintain the same 90% probability of success. But this shows you that you have to be willing to be flexible in the face of picking up a lousy card at the beginning of retirement. If you get unlucky, then there is always a possibility that you will have to cut back to avoid the possibility of running out of money too early.

This is one of the reasons why everybody should have a conversation with retirees or near-retirees about how much of their spending they are willing to cut back on if the markets do not do well. In my research, about 65% of spending in retirement is inflexible. So, you must be able to cover medical expenses, food, property taxes, and insurance. All of these things are essential expenses. No matter what happens to the market, you have to be able to cover them. Some expenses may seem flexible, but it should be up to the client to decide how flexible they are willing to be.

Are you willing to cut back on gym or country club membership if the market does not do well? If not, we must develop a strategy to lock in that part of your retirement budget. You may have some expenses that are more flexible. So, you may be willing to cut back on some of your entertainment, legacy goals, gifts, or things like that. That is fine. We will take greater investment risk when it comes to those spending goals. However, the client should always know that no matter what happens in the market, they will always be able to fund those basic expenses they want to put a wall around.

So, really, the conversation is about putting a wall around your basic expenses to make sure that no matter what happens in the market, you are always going to be able to cover those. One great question you can ask a client is, “How much do you need to live on?” Most people have never thought about that, but it initiates a conversation about their lifestyle, and it is a conversation that many people have never even thought about.

But it allows them to start getting into a mindset that opens them up to different types of possibilities, strategies, and financial products that can cover those inflexible expenses. You should never cover inflexible expenses using volatile assets because volatile assets require that you be flexible if the market does not do well. So, about 35% of a retiree’s budget is flexible expenses, and for these categories, you can talk about how much you are willing to cut back. Do you want to put a wall around any of these expenses to insulate them from market risk? If you do, let us talk about some other solutions.

As part of the illustration of what is wrong with the four percent rule, imagine you have two retirees. They both are friends. They both have exactly a million dollars. One decides to retire on January 1, 2022. The advisor tells them they can pull out $40,000 plus inflation annually with a 90% probability of success. The other client waits a few months. They wait until May 20, 2022, to retire, and they now have $840,000 in their investment portfolio. They go to the advisor and say, “How much can we withdraw? We waited a few months,” the advisor tells them, “Well, according to the four percent rule, you can only spend $33,600.”

They say, “Well, that is not fair because we had the same amount of money as our friends. You told them they could spend $40,000, and we have more money in our investment portfolio now than our friends do. You are telling our friends they can spend $40,000 and telling me I can only spend $33,600.” The problem with a fixed spending rule is that it needs to acknowledge the new reality of where the market is and your new failure rate. To acknowledge that, we have to take new information into account, and when we take new information into account, we have to be willing to be flexible.

Step 4: Create a Plan for Funding Inflexible Spending

This is where I think it opens up a conversation to potential solutions. Those potential solutions can include Social Security, annuities, bonds, and money tapped from home equity. Home equity money could be a preferable solution or the only solution that some clients have to fund those inflexible spending goals.

What I find is that at the top percentiles, the people who get lucky and the market does really well at the beginning of retirement can actually spend more money. The ones who get unlucky have to continually adjust their spending downward, and what that means for some retirees is that they may have to cut back to the point where they are spending less than their inflexible spending goal.

For many retirees, this is what keeps them up at night. This is what they are worried about, and it is a possibility. When we run a Monte Carlo, we see that in some of the simulated retirements, people get unlucky, and they are going to have to cut back, and they may even have to cut back beyond that threshold where they do not have enough money that they need to be able to live on. So, part of the job of a financial advisor is to get the client to feel like they can continue to spend money no matter what happens in the market.

If you take an investment risk, there is an upside. But there is also a downside. The downside is that you might have to cut back if the market does not give you the returns you had hoped for. Can you create a lifestyle where you build a wall around the essential spending to satisfy the client and create a happy retirement? And if people have that income walled off, they will feel more comfortable spending money on frivolous things, like going out to eat with friends or going on vacations. If they do not have that spending walled off, they will not live as well as they could.

For many Americans, they may never get a chance to live the lifestyle that they want to lead in the defined contribution era. What does that lifestyle look like? What percentage of your expenses do you want to build a wall around? And then, what sort of solutions can I present to you to build that wall, to create a moat, so that no matter what happens in the market, you still feel comfortable spending the money you have saved?

In the defined contribution era, you need to have a plan for spending down your savings, and it isn’t very easy. Especially when it comes to using riskier types of investments, there is always the possibility that you must be flexible. I like using a goal-based approach that distinguishes inflexible spending from flexible spending. Then, what you want to do is create a plan for funding both those flexible expenses and those inflexible expenses. Offer all the solutions to meet the inflexible spending goal.