Balancing act for funding your retirement is a tricky test

One of the most difficult – and important – calculations in finance is how much investment capital you will need for retirement.

To be able to calculate the savings needed, people need to make some assumptions about the amount of income they can safely draw from their retirement capital. This means finding the retirement income Goldilocks spot, drawing neither too much nor too little.

On the one hand, in retirement you want to have the best possible life, while on the other, you do not want the money to run out before you do.

Like Goldilocks’s porridge, chair and bed, the amount that you take and spend from your capital needs to be just right.

There is a rule of thumb in finance which says that in retirement, you can draw 4 per cent of your savings to live on each year. The 4 per cent rule tells you that for every $100,000 you have saved, you can take $4000 in income each year for 30 years.

Given its importance to retired people’s finances, this 4 per cent rule has been much studied. Although it has been criticised by some, it is largely still considered by most to be a fairly useful tool for modelling what a retired investor can expect to be able to live on.

It may be a bit rough and ready, but having a rule of thumb like that is very useful when planning your finances.

There are several things that could make the 4 per cent rule either too optimistic or too pessimistic.

Firstly, the 4 per cent drawdown rule is based on someone having a balanced portfolio (50 per cent of the portfolio in shares and property, with the other 50 per cent in bonds and cash). If you arrange the portfolio so that it is more conservative than this, your returns are likely to be lower, and so your drawings should be correspondingly lower. Such a conservative portfolio will have less volatility, but the money is more likely to run out before you do.

Conversely, if you invest more aggressively, your money might last longer but the volatility risk will be higher.

Secondly, the sequence of your returns may not be good. Returns from any portfolio will be volatile, but the timing of the volatility may be unfortunate. For example, if there is a major market fall shortly before or after retirement, it will be difficult to maintain the planned income drawdown.

It is close to retirement when the portfolio is at its highest value, so a major market fall then will see the greatest loss of money.

This is why it is often wise to start to lower your investment risk as you approach retirement.

Thirdly, some people are uncomfortable watching their capital decline.

Drawing 4 per cent will usually mean that not just investment returns are being spent, but the capital itself is being used to the extent that nothing is left after 30 years. If you want to maintain investment capital for inheritances, your drawdown rate will need to be less than 4 per cent.

Planning this decumulation phase is as tricky as it is important – and, unlike Goldilocks, there is not much room for experimentation.

 

Article from Sunday Star Times by Martin Hawes