Spend Defensively If You Invest Aggressively
Harold Smith, age 66, and Maude Smith, age 64, have been planning their retirement for a while. They did very well with their investments and both made a very good living. They saw the train-wreck coming in the housing market, and while they didn’t sell at the peak, they did ok when they sold their home in Nashville and moved into a rental in Havana, Florida (just outside Tallahasse).
Then came the financial meltdown. Harold and Maude have watched their retirement assets drop by 40 percent. While they still have $1.5M in retirement assets they are unsure how fast to draw them down in retirement. Right now they are invested 60-40 in stocks and bonds, with their stocks allocated 60 percent in large caps, 15 percent in small caps, 20 percent in international developed countries, and 5 percent in emerging markets.
Harold and Maud aren’t sleeping well at night; they’re worried they are investing too aggressively and that they may be spending too much given the portfolio they are holding. ESPlannerPlus can help them see if this is true. It can show them how different investment strategies and spending behaviors will affect the likelihood of their experiencing low living standards in the future.
Harold and Maud can tell the program not only how they are going to invest their assets, but also whether they wish to spend aggressively, conservatively, or cautiously.
Aggressive spending means Harold and Maud want to spend based on the assumption that they’ll earn average returns each year in the future on their investments. Conservative consumption means Harold and Maud want to spend based on the assumption that they’ll earn zero real returns on their investments. (Zero real returns means investment returns just keep pace with inflation.) Cautious consumption means the couple wants to split the difference between spending aggressively and conservatively.
If they were to invest in long-term U.S. government inflation-indexed bonds (called TIPS, for Treasury Inflation Protected Securities) right now and earn 2 percent real after inflation (this is a roughly the current long-term TIPS rate), they can afford to spend $99,781 each year in today's dollars (in real terms) until Harold hits age 100 and dies for sure at which point Maude gets to spend $62,363 for her remaining 2 years. (This lower spending level still gives Maude the same living standard since the program assumes two can live as cheaply as 1.6 and if you multiply $62,363 by 1.6 you arrive at $99,781.) This $99,781 is after paying for their Medicare premiums and taxes.
If Harold and Maude maintain their current portfolio, they can expect a 7.66 percent real return. Were they able to earn this return for sure, they'd be able to spend $141,528 each year above and beyond taxes and Medicare premiums.
Of course earning the mean return on risky assets is hardly a sure thing. Were Harold and Maude to spend each year in an aggressive manner (assuming they'd always receive the mean return in the future), they'd start out spending $141,528, but each year they'd adjust their spending based on where their assets stood, i.e., their spending would adjust through time to reflect the performance of their portfolio.
Spending aggressively comes with risk. By Harold's age 85, they have a 25 percent risk of spending less than $111,052; and they have a 5 percent risk of spending less than $93,628. On the upside, 25 percent of the time, Harold and Maude will be spending at age 85 $152,238 or more, and 5 percent of the time, they'll be spending $196,622 or more.
Were Harold and Maude to maintain their portfolio, but spend cautiously -- assuming they’ll earn a 3.83 percent real return (half of the 7.66 expected real return) -- they'd start out spending $113,933, which is a lot less than $141,528. But this cautious spending behavior limits their downside. At age 85 the 25th percentile downside value is now $117,789 (rather than $111,052), and the 5th percentile downside value is $98,541 (rather than $93,628). On the upside, 25 percent of the time, they'd get to spend, at age 85, $163,275 or more (rather than $152,238 or more) and 5 percent of the time, they'd be spending $213,118 or more (rather than $196,622 or more).
Finally, were Harold and Maude to maintain their portfolio, but spend conservatively -- assuming they’ll earn a zero real return -- they'd start out spending $86,877, which is less than even the TIPS safe spending level of $99,781. But this conservative spending behavior limits their downside risk even more. At age 85 the 25th percentile downside value is now $121,501 (rather than $111,052 with aggressive spending), and the 5th percentile downside value is $100,906 (rather than $93,628 with aggressive spending). On the upside, 25 percent of the time, they'd get to spend, at age 85, $170,212 or more (rather than $152,238 or more with aggressive spending) and 5 percent of the time, they'd be spending $224,138 or more (rather than $196,622 or more with aggressive spending).
So by adjusting their spending behavior based on economics’ dictum; namely, "Spend cautiously if you invest aggressively," Harold and Maude can somewhat control their living standard risk in the out years.
But the real question is whether Harold and Maude want to play the market at all at this stage of the game. As discussed in Spend ‘Til the End (by Laurence Kotlikoff and Scott Burns) and Worry Free Investing (by Zvi Bodie), take the money and run (i.e., invest in TIPS) may be the best move for the couple. As we’ve seen, asset markets can and will go completely nuts from time to time.