I really like this approach to estimating your sustainable lifetime income
Consider this scenario. You’ve just turned 65. You’ve just retired. Now, of course, you have to replace your paycheck with a new source of income. But that’s OK, because you’ve saved $1,000,000 in your “pension pot.” (Congratulations!) The thing is: you don’t know how much you can draw each year from your pension pot. If you knew how long you were going to live, and what investment return you’d earn, then you can do the calculation (or go to an expert who can). But those are two things you don’t know. Together, they make this “the nastiest, hardest problem in finance,” according to Nobel Prize Winner William Sharpe. So you’re not alone in wondering what to do!
Most people essentially give up at this stage. They tend to do one of two things. One: they fly by the seat of their pants, they improvise, they make it up as they go along, and hope for the best. Or, two: the only way to ensure that their pot doesn’t run out is to avoid touching it; so they live only off the income it generates each year. (This effect has been measured in Australia, where a survey shows that retirees leave 90% of their pension pot as a bequest.) And that means that they live much more frugally than their lifetime of saving enables and entitles them to. What a pity!
So it’s clear that most people would benefit enormously, not just financially but also psychologically, from having at least some indication of the annual amount they could sustainably withdraw from their pension pot as a lifetime income. Not just the million dollar people, but everyone. For example, if your pot is $100,000, you could obviously withdraw one-tenth of what the million dollar person can withdraw: exactly the same calculation applies in both cases.
Fortunately there are now calculators that help. You need to make assumptions about your longevity and your future investment return, so there’s no certainty; but as you vary those numbers, you’ll see what kind of range of annual withdrawals is sustainable. And that’s a lot better, and much more comforting, than winging it.
You may have noticed that there’s a calculator on my website. It’s an advanced one numerically, I’m told, but primitive in its use of modern technology. It attracted the attention of the folks at Pensionbar, as I mentioned in an earlier post. Now they’ve refined what they call their Lifetime Income Simulator, and I’m delighted to provide this free link to it.
Let me explain the approach to annual withdrawals that underlies their Simulator. (It shows annual amounts, but of course you can make withdrawals monthly or at whatever frequency you like.)
There are five fundamental elements to it:
- You don’t part with any money to buy products. Instead, you own the pot throughout. It’s meant to last at least as long as you do (or you and your partner, if you prefer); whatever is left at the end forms part of your estate.
- That requires you to select an initial planning horizon, which should obviously be somewhat longer than your average expected survival age. The simulator makes reasonable assumptions for your average survival age, but you can insert whatever number you select. Fortunately I wrote a very early blog post showing you very simply how to do this. (An example might be: Start withdrawing at age 67, and plan to make withdrawals until age 97.)
- You can use the simulator while you’re still saving. But it builds in an approach to the ultimate withdrawals that relies on dividing your pension pot into two parts with different purposes. I explained this approach, which turned out to be very popular with readers of the London Financial Times, and its rationale in a blog post. One pot is intended to provide you with investment safety when markets decline. (The simulator calls this “cash safety.”) The rest goes into growth-seeking assets with a longer-term focus. The intent is to gradually transfer money, as you age, from the growth-seeking to the safety pot. (An example might be: Whatever the annual sustainable withdrawals turn out to be, place five years of those withdrawals in the safety pot, to provide five years for market recovery when growth markets decline. Place the rest in the growth-seeking pot. In this example, using the ages above, when you reach age 92 you’ll be entirely in safety-oriented assets, because your five-year safety pot will then take you to age 97, which is your planning horizon.)
- The simulator adds an additional feature to what I’ve just described. It anticipates that some (many?) people would like to be out of growth-seeking assets even earlier. You can input an age when you’d like this to happen by changing the “Go all cash” age in the simulator. (For example: I don’t want to wait until age 92. Phase me out of growth-seeking assets completely – that is, go all cash – by the time I reach age 85.)
- You need to input a number that represents the average annual rate of return of your growth-seeking assets. (In my case, I use 4% a year. Actually, that’s 4% a year higher than inflation, whatever inflation may turn out to be. The outcome is that the annual sustainable lifetime withdrawal is interpreted as the amount that I can increase to reflect whatever inflation has been. I want my purchasing power to survive inflation. My government pension – which for you might for example be US Social Security or the Canada or Quebec Pension Plan or the UK State Pension: that sort of thing – is inflation-protected, and I’d like my pension pot withdrawals to have the same characteristic too, if I can so arrange it. I explained why in a recent blog post.)
(If you like my safety-and-growth-oriented pots approach, I added much more detail in another blog post.)
Among the outputs is a very nice chart showing how your assets change over time after you start withdrawals. Even nicer is the fact that the chart shows how the assets are intended to be split, year by year, between the safety and growth pots (which are labelled “cash” and “equity” respectively, for simplicity).
And there’s the ability to label one set of projections as the base case, and the others as scenarios that vary the base case inputs. (The “Scenario” page appears when you click on the right-hand arrow on the “Play” page.)
I hope you like this approach and the Lifetime Income Simulator that reflects how it works. I very much like the fact that the Simulator has sliders that allow you to very easily change the inputs and see how the corresponding sustainable lifetime income changes. That achieves two very important things.
First, it’s a reminder that these numbers are simulations, they’re illustrations, not guarantees. The future is uncertain, and that’s life.
Second, the essential thing is that the results give you some sort of orders of magnitude about what’s feasible with your pension pot. It’s like drawing your own personal map for your financial future. I think of it as being in a car. You still have decisions to make – your direction, your speed – but at least, with your map, you have a greater sense of control. And all of that gives you resilience when, as is inevitable, the road turns out to have features that require you to make some sort of change in your plans. A lot better than using the seat of your pants as your guide!
This simulator has useful output and is easy to use – I think it’s much better than the Calculator on the top line of this website.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.