If you have reach a certain level of wealth savings, such that you are ready for early retirement, semi-retirement, one question that you might have is, how do you go about:
- Knowing how much you can spend next year, within a fundamentally sound limit
- Repeat this approach of deciding and coming up with this sum year after year
There are much literature about how much you roughly need to reach financial security or independence, the iron clad rules to build your wealth towards financial security or independence but I realize not a lot of it talks about spending down, or in the academic term, withdrawing your money for spending.
These set of planning steps are high level and are scripted in a way to let you execute every year to determine how much you should spend for the following 12 months.
Why do we need to plan for how we spend our money?
There are a few reasons:
- The amount of Wealth Assets that you have saved up is finite. If you don’t tend to it well, you may run out
- If you spend too much, you risk running out of money
- If you spend too little, you do not enjoy enough, leave a large amount to your heirs, and that might not be what you want
- You do not know how long you will live
- Your Wealth Assets would have fluctuating value, since they are in financial assets such as stocks, bonds, property, business. The amount of cash flow you can get from them might vary, depending on how well the wealth assets do from time to time. Thus your cash flow sometimes might be excessive for your needs, but they might not meet your required spending
- You have more than 1 source of wealth assets so which one would you tap first so that it is a sound plan?
You might have or have not considered these points but there may be even more considerations. Like it or not, unless you have excessive amount of wealth savings, you have to work within these parameters.
The different sources of cash flow
As a retiree or a person that goes into semi retirement mode, they may have various sources of income. Some of the common ones are as follows:
- Government Pension
- Annuity Income
- Cash flow from Wealth Machines (property rentals, stocks, unit trusts, insurance endowments)
- Part-time work income or Supplementary employment income
The considerations here is that, taking into account the nature of each of these cash flow sources, which should you spend first and next in a fundamentally sound manner?
When should this action script be carried out
This action script is to be carried out during an annual review of your financial situation. Usually, the recommended period is at the start or the end of the year (which is not much difference)
This is so that you take stock of what has happen in the past 12 months, and whether there are any decisions to be made about your financial situation, which would result in adjustments for the next 12 months.
In this following example, we are planning for a 40 year old male who have accumulated assets and would like to consider semi-retiring.
The above timeline shows that he can start planning either at the end month of December 2013 or January 2014 for the next 12 month.
Step 1: Gathering or Update your Data
First step is to gather a few pieces of data that you would need to make sense of how much you can spend periodically:
- Wealth Assets Accumulated: Amount of wealth savings that you have build up over the years. At a certain point, with a sound rule of thumb, you realize that you have build up enough to be financially secure or independent E.g. $700,000.
- How your Wealth Assets are invested: This would be how your Wealth Assets mentioned in (1) are going to generate cash flow for you and your spouse, and continue to grow in this financial independent or retirement state. What needs to be gathered is how volatile is the growth of the wealth assets, how cash flow is going to be derived from the wealth assets
- Health Status: The couple might need this information to have a good estimation realistically how good or bad the health is and how this would affect how long they will live which will affect the number of years the cash flow is required to be spent
- Amount of Wealth Assets to be left to heir: Some couples would like to leave a part of their net worth to their children. In this case the amount to be left over, whether in terms of percentage or a fixed figure have to be figured out
- 2 levels of Annual Total Expenses: You will need to know 2 levels of expenses that you are likely to spend in your retirement or financial independence stage. These 2 levels are the survival annual expenses, or the expenses that you require for subsistence living and the value added annual expenses, which are the expenses that make living comfortable
- Expected rate of return of the Wealth Assets: As mentioned in 2, this is collecting how conservatively, optimistically and realistically how the different kind of wealth assets will generate
- Expected rate of inflation: The couple should be able to find the official figures of the consumer price index for the country that the couple is spending their retirement in. This is so that when they get down to calculation, they can compute how much they can spend after factoring inflation
- Initial spendable amount: How much of expenses you budget to spend in year 0 of your financial independence or early retirement
- Initial spending rate: Initial spendable amount / Initial Wealth accumulated . This is what is commonly termed as your initial withdrawal rate.
- Preliminary spendable amount: Same as 8 only that this is a rolling budgeted amount spendable for the current year
- Current year spending amount: Actual figure spent this year that just past. This is collected to calculate the next year spending amount
This list may not be exhaustive, but gives a good starting point of what kind of data is required.
If you are doing this after the first year, your job here is to update the list of data. Why do you need to update the data? Over time, what you might realize you do not need, might be needed, such as leaving bequest to the children. Your health shifts, your expenses change, the inflation situation changes, the value of wealth assets changes, the composition of your wealth assets also change.
For our 40 year old future semi-retiree these would be an example of his data:
- Wealth Assets Accumulated: $800,000
- How your Wealth Assets are invested: Of the $800,000, $200,000 is in government pension annuity (CPF) which are only accessible at age 65 years old, 25 years later. His stock portfolio which started at $500,000 at year 0 is valued at $600,000. He believes that himself, being an asset at 40 years old, can still work a lower brain taxing job earning $1000/mth or $12,000/yr
- Health Status: The 40 year old male is generally healthy, but suffers from insulin sensitivity, high blood pressure and back pain on occasion
- Amount of Wealth Assets to be left to heir: At this point he does not have this consideration
- 2 levels of Annual Total Expenses:His survival expenses is $14,000/yr while his value add expenses comes up to $14,000/yr. So total its $28,000/yr
- Expected rate of return of the Wealth Assets: The government pension grows at 2.8%/yr. The portfolio of stocks is volatile but the aim is to earn 5% in dividend returns with 2% capital growth over the long run. The cash is for liquidity so not expected to grow and the human capital pay should be growing at 3%.
- Expected rate of inflation: Based on the past 10 to 15 years, the inflation rate averages 2%
- Initial spendable amount: Although in 5, the total amount is $28,000/yr, this guy would budget with $25,000
- Initial spending rate: Based on his first year stock portfolio of $500,000, his spending rate would be $25,000/$500,000 = 5%.
- Preliminary spendable amount: For the current year , he budgeted to spend $26,000/yr from his stock portfolio and $12,000/yr from is supplementary job income
- Current year spending amount: Current year he spent, $27,500/yr
1 to 7 and 10 to 11 requires annual updates.
Step 2: Perform calculation to determine preliminary spendable amount
The goal of this step is
- to compute how much of a budget that you can spend in the next year
- the sequence of steps to take to spend the wealth assets
Note here is the definition of the Spendable Amount. Spendable Amount is the amount that is available for the person to spend.
It is not the amount that the retiree will spend, but the amount that is available to spend for the year.
In this case following the previous example, the 40 year old has 3 cash flow stream:
- Government Pension Annuity
- Stocks Portfolio
- Supplementary job
1 is not available to him at this point. Since 2 is more volatile and could have higher potential to accumulate for the future, he will spend 3 first then 2.
For 2, his current year preliminary spendable amount is $26,000/yr
For 3 , his supplementary job brings in $12,000/yr
So the total preliminary spendable amount for next year is $26,000 + $12,000 = $37,000/yr
The sequence will be to spend the supplementary job income first, since it is more bond like and then the stock portfolio.
Step 3: Apply Smoothing to your preliminary spending amount
This step is important because we will need to adjust the preliminary spendable amount for next year so that the spending is fundamentally sound.
By that we mean that
- We adjust to health conditions
- We adjust to stock portfolio negative or positive performance
- We try to ensure in the long run we don’t run out of money
There are a few systems to ensure that we meet our objectives here:
- I wrote about the variable withdrawal methods
- David Zolt explains here the Target Percentage Adjustment
- Wallstreet Journal here has a few methods that are popular
This step can be rather advance, and require the person to read up a bit on roughly how these methods are carried out, what are their pros and what are their cons.
The end result is to derive the final spendable amount, or the budget that is available to the retiree to spend in the next year.
Suppose we use a variable withdrawal method. The variable withdrawal method follows a rule that if the year the stock market didn’t do so well, we do not increase the preliminary spendable amount by the inflation amount, or the consumer price index. If the stock market do well, then we increase the preliminary spendable amount by the inflation amount.
If the amount derive on top far below the current spending rate, because the portfolio is doing extremely well, we increase the spendable amount by 10%, if the amount derive is far above the current spending rate, meaning the portfolio is doing very badly, we reduce the spendable amount by 10%.
In the case of our example, our stock portfolio’s preliminary spendable amount is $26,000 and the stock portfolio value is $600,000.
Inflation for the current year is 2.5%. So we adjust the preliminary spendable amount by the inflation to $26000 x 1.025 = $26,650.
Since for the year, the stock portfolio performance grew by 15%, we use the amount spendable to be $26,650 instead of $26,000.
The current spending rate, computed by $26,650 / $600,000 = 4.4% is above 4%. So we won’t boost this spendable amount by 10%. Had the portfolio grew to $700,000, the current spending rate would be 3.8%. This would mean our portfolio is doing better than expected, and we could give $26,650 a boost to $26,650 x 1.10 = $29,315/yr.
In total the final spendable amount will be $26,650 + $12,000 from his supplementary job = $38,650/yr.
It looks like this amount is far above his list year spending of $27,000/yr
Step 4: Store the results for the next year
We will need the figures again so we will need to store some of the data calculated for use in next year.
Here are some examples:
- Wealth Assets Accumulated: $800,000
- How your Wealth Assets are invested: No change
- Health Status: Update any changes
- Amount of Wealth Assets to be left to heir: Update any changes
- 2 levels of Annual Total Expenses:Update any changes
- Expected rate of return of the Wealth Assets: Update if long term stock market expectation changes
- Expected rate of inflation: Update data for year 2013 to 2.5%
- Initial spendable amount: No change. This is persistent
- Initial spending rate:No change. This is persistent
- Preliminary spendable amount: Change from $26,000/yr to $26,650/yr and keep the supplementary income the same
- Current year spending amount: Update near the end of 2014. You won’t have the data now.
That’s it. For next year you can circulate back to Step 1.
Is this too complex for you?
At this point, I might have lost many of you with these 4 step actions to systematically spend down your money.
You might want to focus more of your time enjoying your retirement or financial independence. I respect that.
However, not running out of money is important. Having enough for your expenses is important as well.
The action script above is more for the DIY Planners like myself.
However, if would require something similar, it is better to engage a certified financial planner. You pay them a fee, and they review the data with you, and advice you accordingly.
One group of people that help their clients plan how to draw down and spend their wealth in retirement is Providend. Using their proprietary Retirewell method, Providend ensure you can safely spend down your wealth for your entire life.
If you enjoy this, do check out some of my other retirement and financial independence articles @ my retirement series here.