Retirement is when you finally get to start spending the money you’ve spent decades building, but how do you know how much is safe to spend? Getting your retirement strategy right means balancing withdrawals, investment risk and cash reserves so you can enjoy your money without eating through your capital too quickly.
How much can you safely spend in retirement?
One of the biggest questions in retirement is no longer how much you should save, but how much you can safely spend.
For people who have spent 40 years earning more than they spend and consistently putting money aside, that transition can be surprisingly difficult. There can be a psychological barrier to watching an investment portfolio fall after spending decades trying to grow it.
But being too afraid to spend creates another problem. You could reach retirement with enough money to enjoy yourself, only to avoid holidays and experiences because you’re worried about running out.
This is where understanding your withdrawal rate becomes important.
Take a $2.5 million investment portfolio as an example. A 3% annual withdrawal would provide $75,000, while 4% would provide $100,000 and 5% would provide $125,000.
There isn’t one withdrawal rate that works for everyone. Your approach will depend on your wider financial position, including whether you plan to downsize your home, own investment properties or have other sources of wealth.
Your retirement spending may change over time
Your retirement spending doesn’t necessarily need to remain the same every year.
The first decade could be when you want to spend more. If you retire at 65, the period between 65 and 75 may be when you’re most likely to travel, take longer trips and spend money on experiences.
As you get older, that spending could naturally decline.
Research data shows that retirement spending can fall by around 2% to 3% a year after accounting for inflation.
That means your withdrawal strategy can evolve rather than assuming you need exactly the same income every year for the rest of your life.
The uncertainty, of course, is that nobody knows exactly how long their retirement will last. That makes finding the right balance between enjoying your money now and protecting your future capital particularly important.
What happens when markets fall?
Market volatility becomes more complicated once you stop earning an income.
While you’re working and regularly contributing to investments, a market downturn can give you an opportunity to continue investing at lower prices.
Retirement flips that situation around.
If your portfolio falls while you’re simultaneously withdrawing money to fund your lifestyle, you may be forced to sell investments at a loss. That means those losses become crystallised rather than having time to recover.
For example, imagine you begin with a $2.5 million portfolio and withdraw $125,000 a year – a 5% withdrawal rate.
If the portfolio falls 20%, its value drops to $2 million. Continuing to withdraw $125,000 means you are now taking out 6.25% of the remaining portfolio.
One difficult year may be manageable. Several difficult years early in retirement can have a much greater impact.
Why investment losses are harder to recover from
A common misconception is that if an investment falls by a certain percentage, it simply needs to rise by the same percentage to recover.
The maths doesn’t work that way.
If $1 million falls by 50%, you’re left with $500,000. If that $500,000 then rises by 50%, you only get back to $750,000 – still 25% below where you started.
The larger the loss, the greater the subsequent return required to recover:
- A 20% loss requires a 25% gain.
- A 30% loss requires around a 42% gain.
- A 40% loss requires around a 66% gain.
- A 50% loss requires a 100% gain.
Now add regular withdrawals to the equation and recovering becomes even harder.
A $2.5 million retirement portfolio that falls 30% drops to $1.75 million. Even if it subsequently rises by 30%, it only recovers to $2.275 million and that’s before accounting for any money withdrawn to fund your lifestyle.
Understanding sequencing risk
It’s not only the returns your investments generate that matter. The order in which those returns happen can have a major impact on how long your money lasts.
This is known as sequencing risk.
The episode uses an example of two portfolios that both start with $500,000, withdraw $25,000 annually and alternate between returns of positive 10% and negative 5%.
The only difference is the order.
One portfolio starts with a positive year, while the other starts with a negative year. After 24 years, the portfolio that experienced the positive return first has $94,000 remaining. The portfolio that started with the negative return has just $36,000.
Experiencing a large loss early in retirement can be particularly damaging because you have less capital left to recover, while still needing that money to fund the years ahead.
Unfortunately, you can’t control what markets will do in the year you retire.
What you can control is how you prepare for that possibility.
Getting your investment risk right
One way to manage that risk is to ensure your investment portfolio is appropriate for your stage of life.
Chasing the highest possible returns may make sense when you have decades ahead of you and are regularly contributing. Retirement is different.
James discusses his preference for retirees to avoid taking more risk than a balanced portfolio, describing an allocation of around 60% in shares and property and 40% in cash and bonds.
The goal isn’t necessarily to maximise every possible return. It is also about creating a smoother investment journey and reducing the chance that a major downturn forces you to sell investments at the wrong time.
Going too far in the opposite direction creates another risk.
Holding everything in conservative assets can leave your capital vulnerable to being eroded by inflation. The challenge is finding the balance between generating returns and protecting the money you need to fund your retirement.
Why cash can be valuable in retirement
Cash can play a very different role once you retire.
Rather than having every dollar invested, James discusses keeping around 12 to 24 months of income available in cash.
If markets fall, that cash reserve can provide another source of income. Instead of selling investments after they have fallen in value, you can potentially reduce or pause withdrawals from your portfolio and use your cash reserves while waiting for markets to recover.
When markets are stronger, those cash reserves can then be balanced back out.
The amount of cash you hold may also need to change as you approach retirement. The emergency fund that worked when you were 40 may no longer be appropriate when your salary is about to disappear and your investment portfolio becomes responsible for funding your lifestyle.
Planning for that transition before you retire can give you more options when markets inevitably become volatile.
Key takeaways
- There is no single withdrawal rate that works for everyone in retirement.
- Retirement spending may be higher in your earlier years and naturally decline as you get older.
- Market downturns become more challenging when you’re withdrawing money rather than regularly contributing.
- Selling investments after markets fall can crystallise losses and leave less capital available to recover.
- Investment losses require disproportionately larger gains to get back to where you started.
- Sequencing risk means poor returns early in retirement can have a much greater impact than the same poor returns later.
- Taking too much investment risk can expose your retirement portfolio to unnecessary volatility.
- Being too conservative can also create problems if inflation gradually erodes your capital.
- Holding 12 to 24 months of income in cash can provide flexibility when markets fall.
- Your investments, withdrawal strategy and cash reserves should be considered before you enter retirement, rather than once you have already stopped working.
Next Steps
Want to know if your investments are set up for retirement? Talk to the Lighthouse Wealth team about reviewing your investment strategy, risk profile and cash reserves before you start drawing down your portfolio.
If you’d like to watch more, check out this episode below.
For a no obligation discussion to see how we can help you on the path to wealth, please contact us.
Disclaimer:
The information in this article is general information only, is provided free of charge and does not constitute professional advice. We try to keep the information up to date. However, to the fullest extent permitted by law, we disclaim all warranties, express or implied, in relation to this article – including (without limitation) warranties as to accuracy, completeness and fitness for any particular purpose. Please seek independent advice before acting on any information in this article.
