Spending capital

Martin Hawes looks at the factors involved when considering how much of your investment to draw-down each year to live the retirement lifestyle you desire – and not run out too soon.

The biggest change that I have seen in my career is that people are now much more willing to spend their capital in retirement. If you go back a generation or two, most people in retirement took their savings to a bank and set up some Term Deposits (TDs). These TDs paid monthly returns, which retirees took for their income, leaving the capital intact.

Today, people no longer spend just the returns that they get from their investments; instead, they look for a managed fund, invest in it, and draw-down a fixed rate each month to live on. Those drawings usually mean they are now living on not just the returns that they are getting from their funds but that they are also taking a little bit of their capital as well.

This change from living solely on investment returns to drawing capital as well as investment returns has been driven by very low interest rates and greater life expectancy (the money has to last longer, but the investment returns are lower).

Taking a regular amount of capital each month means that the amount they have invested is reducing. As the amount invested reduces, there is something of a conflict: you want to take as much money out of your funds as you can so that you have the best retirement, but you do not want to take so much that the money runs out before you do.

You may want the cheque to the undertaker to bounce, but that is no easy thing to time perfectly!

Some rules of thumb may help. For example, the ‘4% rule’ says that you can draw 4 percent from the portfolio annually – i.e. $4,000 p.a. for each $100,000 of capital that you have. Drawing this amount should mean that your money will last 30 years. (Note that although the rules of thumb are usually given as annual expenditure, you are likely to draw-down on a fortnightly or monthly basis).

While this rule (and others like it) can be helpful, they obviously do not take into account any personal factors; like all rules of thumb, they can only ever offer a rough indication. For example, you may know that your life expectancy is more or less than the average, and you would want to spend more or less accordingly.

Moreover, the rules of thumb also do not consider the changing patterns of expenditure through the years in retirement. It is well established that expenditure is usually higher at the beginning of retirement (when you are fitter and more active) and that it gradually reduces as the years go by. Expenditure may then spike a little as you need more care towards the end.

Most of the rules of thumb cannot take account of these expenditure changes, nor some of your own personal factors.

These changing expenditures, along with a deep-seated fear that the money may run out before you do, mean that most people underspend early in retirement and end up with more money than they planned.

Some flexibility and personalisation are therefore very desirable. However, for most people, this requires advice, and for a lot of people this is unavailable. To establish the right draw-down rate requires an annual consideration of some important factors:

• The retiree’s life expectancy. It is a quirk of actuarial science that as you get older, your life expectancy rises (a woman may have a life expectancy of 82 at birth, but if she makes it to 65, her life expectancy is near 90).
• Changing investment returns. While we may know with some accuracy what returns from all of the main asset classes will be in the very long term, in the shorter term, these will fluctuate a lot. Draw-down may need to be adjusted a little according to what these may be in the next few years.
• Likely reduction of expenditure. The expected lower expenditure in the later years may allow for a higher rate of draw-down from a portfolio in the early retirement years – just when it is needed!
• Inflation expectations. This could be most important at the moment as inflation rears up, but even more modest inflation can see expenditure and retirement lifestyles eroded.
• Your own personal situation. This could be anything from your health through to a need for a lump sum to do something special (an overseas trip, work on the house or gifts to children). Your plans for how you want to live in retirement and the things that you most want to do need to be factored in.

These are some of the things that are considered when Lifetime calculates what the member draw-down rate should be. This is reviewed every year with further consideration of what we think a safe withdrawal rate would be, taking into account your personal situation.

Your draw-down from your investments will determine the lifestyle that you can have. There is no wizardry in deciding what this should be, and you cannot take more than the numbers suggest. One of the rules of thumb may be a reasonable start, but you should be able to have a better retirement if you personalise it – and, to finish with my Lifetime Director’s hat on, that is what we are here to do.