Have you taken a good look at your spending habits lately? The unknowns and potential changes in today’s retirement landscape require a flexible, yet somewhat studious approach toward spending.
However, if you’re like most people, you probably find it much easier to determine how much you need to save, rather than how much you can spend.
This spending dilemma is important for two reasons. If you spend too much, you may outlive your retirement nest egg and run out of money. On the other hand, if you spend too little, you’ll miss out on making memories and crossing items off your bucket list.
What this new order calls for is a dynamic spending strategy. It works by setting ceilings and floors to your annual spending limits. That means, in a given year, if your investments perform well, you can spend closer to your ceiling limits. But when returns are lower, you should aim to spend closer to your floor calculations. Let’s explain further how you can put this valuable strategy in place.
Start with the basics
The first step in this strategy is to set your spending rate. This is the percentage of your investment account that you plan to withdraw every year during retirement.
Once you’ve nailed down your predicted annual spending rate, the next step is to determine your ceiling and floor spending percentages. Your ceiling percentage is the percentage by which you would like to increase your annual spending if your investments perform well in the previous year. Your floor percentage is the percentage by which you are able to cut back on spending if your investment accounts perform poorly in the previous year.
Time to crunch the numbers
Now it’s time to crunch the numbers. This is where things can get a little tricky if you’re not mathematically inclined, but we’ll provide an example to help explain.
First, using the spending rate that you calculated, multiply that percentage by your portfolio balance from the previous year. This will result in your current year’s spending amount.
Second, calculate your spending range. To do this, multiply your actual spending from last year by your ceiling and floor percentages. This will give you a spending range to guide you for the current year.
These calculations will likely start reveal your spending habits. If your current spending is more than your ceiling amount, you should dial back spending to the ceiling calculation. If you’re spending less than your floor amount, you can gradually increase spending.
A hypothetical example
Let’s assume that your portfolio balance was $500,000 at the end of the previous year and you have a one-year growth rate of 10 percent. We’ll also assume you determined a spending rate of 5 percent, a ceiling rate of 6 percent, and a floor rate of 3 percent. In sum,
Investment account balance before positive returns: $500,000
One-year growth rate: 10%
Spending rate: 5%
Ceiling rate: 6%
Floor rate: 3%
Now we’ll take these percentages to calculate your spending range. To determine your current year’s balance, use the previous year’s balance ($500,000) and growth rate (10% or $50,000).
Current year’s balance: $550,000
This year’s spending rate (5%) = $27,500
Ceiling rate (6%) = $33,000
Floor rate (3%) = $16,500
As you can see from this hypothetical example, it’s possible that there will be quite a significant difference in your spending range. That’s why it’s important to use a dynamic spending strategy to help you get the most out of your time and money.
If you find this type of dynamic spending strategy interesting and would like to make a more-informed decision about how to adopt it, consider scheduling a free consultation with one of our wealth advisors.