The Third Reason to Use a Conservative Spending Rate in Retirement

Most research on retirement spending strategies accounts for longevity risk and market risk. They account for longevity risk by simply assuming that you live to an advanced age. And, after making that assumption, various modeling is done with regard to investment returns, with the conclusion generally being that it’s prudent to spend from your portfolio at a pretty low rate early in retirement, because you might get bad market returns (especially in the critical early years of retirement).

That’s all well and good. It’s an important takeaway — because of market risk and longevity risk, a low initial spending rate is a good idea. (What “low” means depends on circumstances, especially your age, current interest rates, and stock market valuations.)

But most such research still leaves out a major source of risk that exists in real life. Specifically, most such research assumes that your amount of annual spending is something over which you have complete control. But anybody who spends even a few moments thinking about it realizes that that’s just not the reality.

Maybe your car needs to be replaced unexpectedly. Maybe you have a major home repair that isn’t covered by insurance. Or maybe you end up needing 10+ years of expensive chemo treatment. Or you need several years of nursing home care or in-home care. Or maybe there’s a pandemic which ends up causing a large amount of unexpected inflation soon after you retire.

Spending shocks happen in real life. And, critically, they can occur in years in which your spending plan actually calls for reducing your spending.

For example: imagine you’re using a spending plan that calls for you to spend a given percentage of the portfolio each year based on your age. At your current age, you’re supposed to spend 4.5%, and your portfolio has declined over the last year, which means the dollar amount of spending is supposed to be reduced. But you also just learned that you’re going to need a particular medical treatment which you sure as heck aren’t going to skip. And that means that you’re going to be spending 7% of the portfolio balance this year — and likely next year as well — regardless of what the spending plan says.

That’s a big point in favor of a low initial spending rate — to build in “wiggle room” for such spending shocks. In a recent piece of research, Wenliang Hou for the Center for Retirement Research at Boston College found that, for retirees, the risk from health costs was actually greater than the risk from market uncertainty. And that’s just looking at one source of spending shocks (albeit probably the largest source, with inflation being the other largest potential source).

It’s also a point in favor of doing regular updates to your financial plan throughout retirement to see if you’re still on track and to see what adjustments should be made (to the extent that they can be made). As the late Dirk Cotten once remarked, “retirement finance has no cruise control.”