What if you don’t have enough to retire?

As a society we’ve placed the onus on individuals to plan and fund their own retirements. There are many positives to this approach. I am a supporter. Yet despite the positives it is undeniably challenging to entrust this responsibility to individuals who receive no financial education. The impact of a lack of formal financial education is compounded given the cost of professional financial advice.

We’ve all heard the standard retirement advice. Start early. Invest in growth assets when you are younger and add more defensive assets as you approach retirement. Estimate your retirement spending and course correct as you approach retirement. Carefully consider your withdrawal rate to sustain your portfolio. I’ve given that advice in countless articles, webinars and podcasts.

I give that guidance knowing that there is an innate human tendency to procrastinate. Given the day to day demands on our time it isn’t surprising that many of us don’t get serious about retirement until it is right around the corner.

If you plan on retiring soon there are some key steps that you need to take. The first is to estimate how much you need to retire which you can read about in this article. Key to this estimate is an understanding of withdrawal rates which you can learn about here.

Once you understand how much you need to retire estimate if your retirement portfolio will get to where you need it to be. If there is a gap between what you want and what you have this article is for you. Below are some suggestions if you fear you are falling short.

Grow your portfolio as much as possible

How much money you will have in the future is a function of several factors. The one you can’t change is how much you have in your retirement portfolio today. How much that will grow is based on time, the returns you earn and how much you save.

The first thing to do is look at all those factors and see if you can make changes. I will model out a hypothetical scenario where $700,000 is needed to retire in 5 years with $315,000 in retirement savings. Current savings are $10,000 a year which will continue until retirement.

To get there requires a 15% return per year. Anything can happen but to get 15% a year for 5 years is extremely unlikely. If you can achieve those returns my suggestion would be to quit your current job and become a hedge fund manager. Rumour has it that the position pays well.

Future returns are unknowable. However, the goal is to adjust the other factors to get the required return down to a more manageable and realistic level. For the sake of argument, we can assume that level is 7% per year. That also might be challenging depending upon the asset mix and market conditions - but it gives our hypothetical pre-retiree a fighting chance.

The first approach is to delay retirement. If all other factors remain static working 4 more years will lower the required return to 7%. For many people that is too much and that assumes that someone can stay employed at the same salary for four years past retirement age.

The next adjustment is saving more. To get to a 7% rate of return requires saving $45,000 a year for the next 5 years. It is very unlikely somebody will be able to achieve that increase in savings.

The factors that determine the size of a portfolio in the future are not mutually exclusive. Which means that we can adjust both the time to retirement and savings. There are endless combinations but if retirement is delayed by two years and savings are increased to $22,500 a year our hypothetical retiree hits the mark.

Perhaps all of these adjustments are unfeasible or undesirable. It is time to explore other options.

Interrogate the withdrawal rate

A withdrawal rate connects the size of a portfolio with spending needs in retirement. The most widely known withdrawal rate is 4% which comes from the aptly named 4% rule. To plan for retirement, it is crucial to understand what a safe withdrawal rate is and what it means.

An in-depth description of safe withdrawal rates is available in this article. The summary is that a safe withdrawal rate is supposed to protect a retiree from running out of money under a variety of different scenarios. Those scenarios include the retiree living for a very long time, having the misfortune of retiring right as markets plunge or retiring into a high inflationary environment.

In isolation each of those scenarios will impact how long retirement savings will last. The nightmare scenario for a retiree is if all the negative scenarios happen at once. In this case a retiree lives a very long time, market returns are poor, and inflation causes higher withdrawals to meet higher living costs.

The chances of this happening are low but that doesn’t mean it isn’t feasible All it takes is for the retiree to have the misfortune of retiring at the wrong time. The lower the withdrawal rate the more protection a retiree has over this nightmare scenario. A higher withdrawal rate means a better retirement but with the possibility of running out of money if the nightmare scenario comes to fruition.

The following chart is illustrative of the trade-offs between higher withdrawal rates and the probability of success. Success is defined as not running out of money after 30 years of retirement which covers most – but not all – lifespans. The left-hand column represents how much of a portfolio is invested in shares. Shares have higher returns over the long-term, but they come with more volatility meaning a portfolio will fluctuate more in value. That can be an issue during retirement because holding are sold off to meet withdrawals. This can be problematic in falling markets.

The chart can be interpreted in the following way:

In the first row and first column we see the figure of 6.2. That means that if retiree settles on a 6.2% withdrawal rate in a portfolio that is 100% made up of equities there is a 50% chance they will run out of money after 30 years.
In the first row and last column we see a figure of 0.9. That means that if a retiree settles on a 0.9% withdrawal rate in a portfolio that is 100% made up of equities there is no chance they will run out of money after 30 years.

Those two scenarios are illustrative of the trade-off a retiree needs to make. And we can see the impact on the hypothetical retiree discussed previously. The goal is a $700,000 portfolio at retirement. That portfolio value doesn’t mean much in isolation. It is just a way to generate a certain living standard based on the withdrawal rate. The goal might have been determined using a 4% withdrawal rate. That would give the retiree $28,000 a year in spending. The real goal is $28,000 a year in spending and not a $700,000 portfolio.

We can see the difference in the two scenarios from the chart. If the withdrawal rate is 6.2% the retiree would only need $451,000 to support that spending. In this case there is a 50% chance of running out of money. If the withdrawal rate is 0.9% the retiree would need $3,100,000. Vastly different amounts of money.

To achieve a 7% required rate of return for the next 5 years our hypothetical pre-retiree would have to raise the withdrawal rate from 4% to 5.6% to meet $28,000 in spending.

Depending upon the asset allocation of the portfolio that would lower the success rate from 80 to 85% to 60% or less. Maybe that is a trade-off our hypothetical pre-retiree would take and maybe it would be deemed too risky. Once again this isn’t a decision that needs to be made in isolation. An increased withdrawal rate could be used in conjunction with the other options previously suggested such as delaying retirement and trying to save more money.

Explore a flexible withdrawal rate

Another option would be to take a flexible withdrawal rate. The details of flexible withdrawal rates can be found in this article. but the summary is not following the prescribed yearly increase in the dollar figure withdrawn by inflation. Instead, a retiree would change how much is taken out of a portfolio each year based on market conditions. All of the flexible withdrawal rates allow a portfolio to last longer which allows higher withdrawal rates.

Morningstar researchers looked at four different flexible withdrawal strategies and all of them indicated that at a 90% success rate of retirement savings lasting for 30 years a higher withdraw could be taken at the start of retirement. This is a another way that our hypothetical pre-retiree could make up for the retirement savings gap.

Consider an annuity

Finance professors love annuities. Almost everyone else hates them. There are lots of dynamics at play here. Individuals are predisposed against annuities. Anyone who earns an asset-based fee off an investor portfolio is naturally inclined to not support annuities. That includes super funds / asset managers and some financial advisers. On the other side any advocacy from an annuity provider is also self-interested. The key is to figure out if they are right for your own situation.

Annuities come in all sorts of flavours and before purchasing one do your homework on the specifics. In general, an annuity is an exchange of a lump sum of money for a guaranteed series of cash payments. Many annuities will guarantee these payments for the remainder of your life. In some cases, they are partially or fully adjusted for inflation.

An annuity can solve a lot of the challenges associated with retirement. If you happen to live for a long time the lifetime guaranteed cash flow provides protection against longevity risk. Yet many people reflexively avoid annuities. The thought of turning over all or part of your hard-earned nest egg is challenging.

For the purposes of this article, I will focus on one specific aspect of an annuity that can help retirees who don’t believe they have enough money to retire. Below is an example of current annuity rates in late February 2024 from Challenger which is one of the largest annuity providers in Australia. Men receive higher payouts because of shorter lifespans.

This chart shows the annual payout for a $100,000 annuity. An investor would exchange $100,000 to receive the above payments for life. It should become readily apparent that the equivalent payout rate for an annuity is higher than most withdrawal rates that an investor would be advised to take from a retirement account.

The reason that the payout rate is higher is because a withdrawal rate is designed to protect an investor from the chance of living far longer than average. An annuity provider gathers a large pool of investors so it is not a problem that some people will live long lives. Some others will die early. The annuity provider is more concerned with the average lifespan.

If you are short of funds for retirement using an annuity may be a solution to get more spending out of your nest egg. Our hypothetical pre-retiree’s portfolio would grow from $315,000 to $415,000 at a 7% return for 5 years. A man could exchange that lump sum for $22,989 a year for life with full protection from the impacts of inflation. A woman could get a payment of $21,675. That is still short of the $28,000 desired but is higher than a 4% withdrawal rate.

Final thoughts

The lead up to retirement can be a stressful time for an investor. Account balances are as large as they’ve ever been which magnifies the impact of market moves. There is limited time to course correct with additional savings. The uncertainties of retirement become real – how long will it last, what market conditions will be faced and what unknown financial and life challenges are ahead.

Worrying about not having enough money can add to this stress. The good news is that there are a lot of different levers that can be pulled to try and reach a good outcome. The key is understanding the intricacies of retirement planning to make an informed decision.