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When people think of how much to save for retirement — and, subsequently, how to spend that money wisely in older age — many worry about the risk of running out of money early. They fear the possibility of overspending.
But there’s another less-appreciated danger, too, according to financial experts: The risk of underspending one’s nest egg.
“Overspending is risky. But underspending is risky too,” said Zach Teutsch, a member of CNBC’s Financial Advisor Council and founder of Values Added Financial in Washington.
Data shows that it happens to many retirees.
About a third of retirees still have 100% or more of their initial savings remaining by their mid-80s, according to a recent study by the Employee Benefit Research Institute, a nonpartisan research group.
“When you see so many people into their 80s still at 100%, you see people who are being way too conservative [with their spending],” said Craig Copeland, the director of wealth benefits research at EBRI.
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Of course, the opposite is true, too: “You also see some people with less than 20% [of their assets remaining] who are in the other situation: ‘If I live five more years, I won’t be able to do anything,'” Copeland said.
About a fifth of people who entered retirement with more than $500,000 had less than 20% of their assets remaining by their mid-80s, according to EBRI’s research.
“This will be the foremost challenge in retirement: figuring out how to maximize retirement but still have a buffer at the end,” Copeland said.
The risk of underspending
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The risk of overspending is straightforward: Running out of savings in older age may make it difficult to afford basic necessities, let alone enjoy one’s later years — even more so if guaranteed income sources like Social Security aren’t robust.
The risk of underspending may be less obvious.
But according to financial advisors, it ultimately amounts to something similar: not living as fulfilling a life as one could have.
“It represents a life not lived, the vacations you didn’t take because you were afraid you were going to run out of money,” said Marianela Collado, a certified financial planner and certified public accountant based in Plantation, Florida. She is also a member of CNBC’s Financial Advisor Council.
It’s a difficult psychological leap for many people to go from a savings mindset, in which one’s net worth is consistently growing, to one of drawing down that nest egg and seeing one’s net worth decline, according to financial experts.
“Some people spent all their life saving money, and it’s very hard to switch then to spending their assets down,” Copeland said. “It’s not a comfortable feeling.”
Many people who are retired today have also lived through “an era of very good capital markets,” in which there have been many years of double-digit annual stock returns after the 2008 financial crisis, Copeland said.
That dynamic has made it easier to preserve or even build wealth throughout retirement, he said.
Teutsch said he likes to use an analogy with clients to illustrate the risk of underspending: Imagine you’re sailing a ship through a channel. Rocks on one side of the channel represent running out of money. On the other are rocks that represent the risk of missing out on experiences.
“Eventually, if you sail too far the other way, you end up ditching your boat on the shoals of regret,” Teutsch said.
“I hope people don’t look back and say, ‘I have more than I need, and it means I didn’t need to work nights and weekends, I could have spent more time with my kids and family, or could have given more [money] away,'” he said.
It represents a life not lived, the vacations you didn’t take because you were afraid you were going to run out of money.
Marianela Collado
certified financial planner and certified public accountant based in Plantation, Florida
Retirees shouldn’t be afraid to enjoy the money they worked hard to save for years — within reason, of course, financial advisors said. That’s especially the case earlier in retirement, when retirees are more likely to be mobile and active relative to their later years, they said.
Ultimately, after death, the money will be spent on the retiree’s behalf — perhaps inherited or donated to charity — but they won’t get the chance to enjoy it, the advisors said.
“As long as the financial plan indicates it’s a good idea, I encourage clients to give money to their favorite causes, to kids, to live well when they’re alive and can enjoy it,” Teutsch said. “If you help somebody buy a house [for example], you get a lot of enjoyment out of that.”
Why figuring out retirement spending is difficult
Assessing how to best spend one’s nest egg from year to year is difficult because there are many unknowable factors that have a large bearing on success, advisors said.
For example, one’s life span is impossible to predict, as are future returns on financial assets.
Retirees also must increasingly rely on 401(k)-type plans in which they’re forced to manage their savings rates and investments and determine how to translate that lump sum into future income. Earlier generations were more likely to have a pension, which outsourced much of that complexity to employers.
How much can you spend in retirement?
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There are some guiding principles for do-it-yourselfers, though, according to financial planners.
The 4% rule is “a really good starting point,” for example, Collado said.
This rule of thumb gives an approximation of how much money retirees can withdraw from their savings each year in order to give themselves good odds of not running out of money 30 years later.
Retirees would withdraw 4% of their portfolio in the first year, then give themselves a “raise” in the second year based on the inflation rate. Same in the third year, and so on. These funds would stack on top of other sources of income, such as Social Security.
For example, an investor would withdraw $40,000 from a $1 million portfolio in the first year of retirement, which is 4% of the total. If the cost of living rises 2% that year, the next year’s withdrawal would rise to $40,800 — or, 2% more. Another 2% cost of living increase in the third year would translate to a $41,616 withdrawal. And so on.
One caveat: Retirees should ensure they’re withdrawing at least enough to cover any required minimum distributions from their retirement accounts, advisors said.
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However, the 4% rule isn’t perfect and, since it uses conservative assumptions, may contribute to underspending, advisors said.
Retirees can also consider a “dynamic spending” approach, in which spending isn’t static like the 4% rule would suggest but is flexible according to market conditions, Teutsch said.
In a year of positive stock returns, for example, retirees could take out more money — perhaps a 7% withdrawal — and reduce that sum in down years, maybe to 2.5%, for example, he said.
Retiree spending tends to be more U-shaped than static, whereby retirees generally spend more early in retirement when they’re more active, throttle back when they inevitably slow down a bit and then spend more in older age when they may have a greater need for costly long-term care, for example, he said.
A dynamic approach also helps to reduce something called “sequence of returns risk,” whereby retirees increase the risk of running out of money in retirement by withdrawing from their stocks when the stock market is declining. This risk is heightened earlier in one’s retirement, advisors said.
Retirees might also consider a “dynamic earning” strategy in such years, Teutsch said. For example, people who are able to take on some side work might supplement their portfolio income by working a few hours a week on a consulting project or something similar, he said.
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