OK, we've looked at why cashflow is so important, so let's move on. To have a comfortable retirement, you can expect to spend money, and your capital WILL erode. We're going to explore both of those, and why neither are necessarily a bad thing.
Erosion of Capital is OK
This requires a mindset-shift. If you’re a follower of the FIRE doctrine, you’ll be quite comfortable with the idea of the value of your amassed wealth declining over time as you spend and enjoy it. But for many of my clients I have to really work hard with them on this. It’s OK – desirable even – to erode the value of your capital over time, with two important caveats:
- You don’t want to be dipping in too heavily when markets, and hence the value of your investments, are down. Ideally, you’d only take money out when the portfolio is in profit, but that might be tricky to get the timing right.
- You don’t want the money to erode too quickly. In short, you really don’t want to outlive your money!
Of course, the difficulty is that we don’t know when we’re going to die. If we did, then we could plan our spending spectacularly well. But we don’t, so we can’t – bummer! I find that many people are uncomfortable with the idea of capital erosion because they don’t have a sense of whether or not their money will last.
This is where the useful 4% rule can be handy, which says that in most circumstances if you withdraw 4% of your capital each year, then it won’t ever run out. Of course, this is an oversimplification, but it does serve a purpose. Personally I’d like to be a bit more scientific than that.
As we don’t know the date of our demise, we need to make an assumption. In my experience most people significantly underestimate their own longevity. I think that this is a function of the way we look at the previous generations to us. We also forget that life expectancy is pretty good these days, and has improved incredibly over the past 100 years, and even the last 50 years.
Promise me at this point that you’ll try to get comfortable with the idea of spending your own money – it’s what you’ve been building for all these years! If you haven’t yet, I highly recommend reading a book called Beyond The 4% Rule, by a previous guest of the show, Abraham Okusanya.
Spending Reduces as Retirement Goes on
There are have several studies into retirement spending, but one of the most influential I think is the one conducted by the International Longevity Centre in 2015 called Understanding retirement journeys; expectation vs reality.
The report is fascinating, but let me summarise it by saying that in the main, spending reduces as we get older. That’s probably in line with what you would expect. That said, in my experience with clients who are retiring, the first five years tend to be the most expensive.
Why? Because we tend to use the time and resources, we suddenly have available (particularly tax-free cash thrown off by pensions) to take holidays, buy camper vans and fix up the house now that we have those resources available.
Only you know what your plans are, but as we think about cashflow in retirement, it can sometimes be helpful to think in five-year blocks of time. Chances are that the most expensive five years will be the first five years, and then in each five-year block, your sending will decline.
The ILC study even found that as spending declines, saving increases. Imagine! Saving in retirement! I bet that’s not in your retirement plans right now, is it?! If we accept that the first five years are likely to be the most expensive, then we need to remember that probably those same five years will be the lightest in terms of secured income.
Maybe our state pension won’t have kicked in yet, or only one of our two DB schemes. Maybe our partner is younger than us and their pensions won’t have quite started but we’ve both finished working. That’s why it really helps to build a timeline about what is coming in when.
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