The transition to retirement
Even the best retirement plans require revision when confronted by the uncertainties of life
In part one of this series, I took a look at the portfolio I set up for my mother as she approached retirement. Fifteen years have passed. My mother retired and moved twice. Time to check in how things held up.
As a reminder I established a portfolio set-up with two buckets on opposite ends of the risk spectrum:
- A cash bucket had approximately 5 years of living expenses and was meant to guard against sequencing risk, which is finance speak for the bad luck of retiring in a down market.
- A long-term bucket was invested in shares to generate returns and guard against longevity risk, which is the really bad luck of running out of money during her lifetime.
Before we evaluate my mother’s retirement plan, this checklist is a useful tool to evaluate your own retirement plan.
Retirement checklist
- Understand the twin challenges posed by sequencing and longevity risk.
- Don’t look at each asset you hold in isolation and understand how their strengths and weaknesses play out in different scenarios.
- Retirement is a highly personal endeavour. Rules of thumb like the 4% rule can guide your plan but only if the underlying assumptions are understood.
- Spending plans during a long retirement are unpredictable. A solid plan contains requires flexibility and the consideration of multiple scenarios.
- Remember that your finances are a means to an end. Security and enjoying your retirement matter.
To guard against the risk of my mother deciding to move in with me during retirement I relocated 16,000 kilometres away to Sydney.
Did the market treat my mother kindly during the transition to retirement?
No matter how carefully any investor plans the market gets a say in outcomes. And in this regard my mother was very fortunate. The market roared out of the GFC and didn’t look back until the brief bear market of March 2020.
My mother’s retirement in 2014 was not marred by sequencing risk and despite almost a decade in retirement her portfolio is worth more now than when she retired. This is a good outcome. But it isn’t an indication that longevity risk is still not at play.
She recently turned 77 and is in good health so she may need to support herself for decades longer. Years of above average returns was clearly beneficial. But much of this gain was driven by increases in valuation levels. Historically high valuations have corresponded with lower future returns. It certainly is reasonable to expect that her account will begin to fall in value as withdrawals outpace returns. This was the case in 2022 with the drop in markets.
Spending needs can undergo dramatic changes in retirement
Conventional retirement wisdom envisions a smooth increase in spending needs over the course of retirement. That is rarely the case.
The academic approach to retirement spending involves the establishment of a withdrawal rate from a portfolio at retirement. The dollar amount of this withdrawal is subsequently increased on an annual basis by inflation. This concept was famously espoused by William Bergen in the early 1990s with the advent of the 4% rule.
The 4% rule is quite straightforward on the surface. But the devil is in the details and the often-ignored assumptions may not hold up under the reality of life. Spending patterns in retirement are unique to the retiree and heavily influenced by personal circumstances and fate. I’ve learned this lesson with my mother.
For much of her retirement my mother’s spending remained below a historically low inflation rate. In Australia, the Consumer Price Index (CPI) allocates 23.19% of overall spending to housing. There are many people who spend a significantly higher amount of their income on housing in a time of growing rents, sky-high property prices and rising interest rates.
In my mother’s case she owned her home outright and her spending on housing barely budged for years. Inflation is more personal than what is captured in aggregated government statistics. Creating a personal inflation rate with a range of potential scenarios is a more effective way to plan.
As she aged it became apparent that my mother’s seemingly ideal housing situation was unsustainable. She lived in a location that only worked with a car. She needed to drive to get groceries and other essentials and to maintain any semblance of a life. This hit home when she was in a relatively serious car accident four years ago which left her unable to drive for over a month. She was able to get through this period by relying on the kindness of friends of neighbours for support. Expecting this stop gap measure to last over a longer period of not driving did not seem like a wise plan.
We took the opportunity to start looking for housing options where she could maintain independence even if she was unable to drive. In early January she moved into a facility that was easily serviced by Uber, had shuttle bus service to do her essential shopping and maintained an in-house food service option. This was an environment that was sustainable for her over the long-term. It also came with a hefty monthly bill for the amenities.
The apartment she purchased was somewhat less than the selling price of her house. However, her monthly expenses effectively doubled.
In general, spending tends to follow a U-pattern during retirement. At the start of retirement people are active and spending money on activities like travel. In many cases, spending can rise from pre-retirement levels given the extra time available for leisure. Spending often subsequently dips given the natural slowdown that accompanies the aging process. It can jump again for end-of-life care.
The transition between these stages is rarely clear cut. My mother is still active despite going through a housing transition.
The impact of increased spending on the sustainability of a retirement plan
My mother’s increased spending has several implications on her financial situation. The five years of living expenses in cash is now two and a half years. The dividends generated by her portfolio now cover a smaller percentage of her expenses. All of this is occurring against the backdrop of a more challenging investing environment.
The obvious answer is to cut spending. But this is emotionally challenging given the uncertainties of life. Nobody knows how many years of health she has left. It is difficult to miss out on experiences that are richly deserved after a lifetime of hard work. Cutting spending while you are young can be done with an eye on a better future. That is no longer the case. Managing this period has been difficult. The emotional toll of my dual role in looking after her finances and being her son has rarely been more challenging.
None of us know what the future holds but I am certain that we made the right decision. My mother could have continued to thrive in her former home and the fears about losing the ability to drive could have been unfounded. We will never know.
I do know that acting early provided choice. Spots in retirement communities can be difficult to get. She was able to find a place she liked and could wait for a unit to become available that met her needs. This choice would have been lost if her move was more urgent.
All decisions have trade-offs. In this case it is increased longevity risk. The investing play book calls for more growth assets with higher expected returns over the long-term. While intellectually I understand that, I’m not comfortable with the drop in cash levels relative to her increased spending.
The plan is to opportunistically increase cash by selling off some of her assets over the next year. Ironically this re-introduces sequencing risk almost 10 years into retirement. If the market melts down in the next year, it will be challenging to find a good point to sell. The diminished cash bucket provides a bit of a buffer.
The poet Robert Burns wrote that the best laid schemes of mice of men often go awry. An apt description of retirement planning even if it was penned by someone who died at 37.