The challenges of financing retirement change dramatically on the day you retire.
You may imagine that retiring with adequate savings one day will feel like winning. But you’re really just taking a lead into the locker room at halftime. In reality, the game will have changed and the challenges will be even greater in many ways when you return to the court for the second half. The goal shifts from accumulating a pile of money to making a pile of money last.
It’s a different game.
We refer to the period before retirement as the accumulation phase because our goal is to accumulate enough wealth to maintain our pre-retirement standard of living after we retire and the paychecks end. We call the period after retiring the decumulation, or spending phase because our objective then becomes stretching out our wealth to pay our bills for the rest of our lives.
The accumulation environment is very different than the spending environment. Here are some of the important characteristics of accumulation:
· We have jobs and paychecks that cover our living expenses. The paychecks arrive, for the most part, during both bull and bear markets. A temporary loss in the stock market may not affect our spending at all.
· We hopefully have some money left over to save in a retirement account and to increase its value.
· We can take some risk with our investments, because we don’t need that money to live on (yet) and that generally means we can earn a higher return.
· Our investment returns apply to a growing base of capital as our wealth grows. When we are 30, we might earn 8% a year on a $20,000 portfolio, or $1,600. When we are 60, we might earn that same 8% on a portfolio of $500,000, yielding $40,000.
· Dollar Cost Averaging (investing the same amount of money every year) allows us to buy stocks at lower prices over time.
· We could lose our entire retirement savings portfolio and possibly have time to rebuild it before we retire.
· We may have health insurance paid for by our employer.
Here are some important characteristics of the spending phase:
· No more paychecks. Expenses are paid from our savings.
· No more savings contributions. Our portfolio increases only when our investments do well.
· We need to reduce investment risk, because we no longer have paychecks to bail us out during bear markets. That generally means a lower return on our investments. We might expect a 6% portfolio return instead of 8%, for example.
· Our investment returns apply to a shrinking base of capital as our portfolio is being depleted. Even if we earned 8% every year, it would return 8% of a (probably) smaller number every year.
· Dollar Cost Averaging works in reverse. We spend roughly the same amount every year so we sell more stocks at lower prices and fewer stocks at higher prices.
· We pay for health insurance out of our own pockets. It is very expensive.
· Since we are no longer working, when the retirement savings is gone, it’s gone.
· On the positive side, we no longer pay FICA taxes and no longer need to save for retirement.
If accumulation is like sailing a boat with fair winds and a following sea, as they say, with plenty of fuel for the engine if the winds die down, then investing in the spending phase is like pounding into the current with strong headwinds in a boat that’s growing heavier as it takes on water and has spent its fuel reserves.
During the accumulation phase, you’re contributing to savings and not spending from savings. In the spending phase, you’re doing the reverse. And probably earning a lower return to boot.
A retiree spending 4% of her savings each year adjusted for inflation has to earn 4% plus the rate of inflation plus the cost of taxes and commissions on her investments just for her portfolio to break even that year.
Let’s say John has a portfolio worth $100,000. His investments return 8% one year and inflation runs 3% for an inflation-adjusted rate of return of 4.85%. (This example is in constant dollars.)
This younger John contributes $4,000 at the first of the year to his 401(k) account. Before retirement, his portfolio increases to $104,854 plus $4,000 of new savings for a new value of $108,854.
Because John’s portfolio is growing, a 4.85% inflation-adjusted return next year will provide an additional $5,284 of real value (4.85% of $108,854).
If this scenario occurs after retirement, the older John still earns $4,850 in the market, but his portfolio shrinks a bit from spending $4,000. He is no longer contributing to his 401(k), so his portfolio value ends the year at $100,854.
Because older John’s portfolio is shrinking in the spending phase, an 8% return next year with 3% annual inflation will provide only $4,896 of real value, 7.4% less than younger John’s portfolio would earn.
And so it goes, on and on.
There is a larger message here than “investing is really tough after you retire” that I will address in my next post. It’s about the amount of risk you can actually handle after you retire, because it will be much harder to recover from large portfolio losses.
I used a sailboat analogy to describe the difference between accumulation and spending phase economics, but having just finished my eighth year of retirement and surviving the 2008 market crash, the real estate crash, seventeen grand a year for family health insurance, two kids still in college and a third in med school, I can think of a more visceral analogy for how investment feels after you retire.
Remember when you were a kid sledding on a hilly street of packed snow and near the bottom, at top speed, your runners ran into a patch of dry pavement?
Yeah, sort of like that.