Conventional retirement planning begins with the question “how much do you spend each year?” It then projects this number out for 30 or more years with nominal inflation adjustments, and assumes that this is the income that you need to replace.
While this is a fine starting point for understanding if you are in the ballpark of having enough money to retire, it overlooks an important fact:
Retirement spending is not smooth. It’s lumpy.
Your life may have cost $50,000 last year, but when you retire you will buy that motor home you’ve been dreaming about, a year later you will need to replace your roof, and the following year you will need a new car. And what about the bucket list trip to Europe that will blow your budget up to $80,000 three years after retirement?
The large irregular expenses early in retirement may decline as we settle into retired life, but they will be replaced late in retirement by increasing medical bills. This is called the retirement smile, and I wrote about it in Getting the Big Things Right in Retirement Planning.
How do we plan for all of this?
Do we just throw up our hands and go back to the constant spending projection, which is guaranteed to be wrong?
Do we need to just add another 10% of margin to our budget to cover the lumps? 20%?? 30%???
There is a better way to plan that will allow you to retire with confidence.
1 The First 5 Years of Retirement Spending Matter Most
If you will derive 80% or more of your retirement income from a pension, social security, and other annuities, the following discussion will be less critical for you. Your income is less dependent on market returns. But read on because you may still pick up something of value.
It would be impossible to plan for all of life’s large expenses, but it turns out that you don’t have to! For now, it’s only important to have a plan for the big expenses you can reasonably expect over the next 5 years. The reason has to do with the fact that your investment returns over the first 5-10 years are unpredictable, yet play an overwhelming role in how much money you can withdraw over a 30+ year retirement.
To explain why, I will introduce a concept called Sequence of Returns Risk (SRR).
1.1 Sequence of Returns Risk
Life is like a box of chocolates. You never know what you’re going to get. –Forrest Gump
SRR refers to the risk that your portfolio will decline sharply in the first 5-10 years of retirement and larger returns will not come soon enough to allow your portfolio to recover.
SRR was realized for people who retired in 2000 at the peak of the dotcom bubble, when the stock market dropped and did not recover for more than 10 years. The same thing happened in 1972, after accounting for inflation. There are several other examples in history.
To illustrate the importance of sequence of returns, consider two scenarios for a retiree who has a starting portfolio of $1 million and plans to draw $50,000 each year.
In Scenario 1, a bad sequence of returns occurs. The first decade has an average loss of 0.5% per year and the second decade has an average gain of 13.7%. The average annual return over the full 20-year span is 6.6%.
In Scenario 2, a good sequence of returns occurs. The average returns for each decade and for the full 20 years are the same as Scenario 1. However, they occur in the opposite order.
The resulting portfolio values are shown in Table 1. All numbers can be considered to be inflation-adjusted.
($1M starting balance, $50k annual withdrawals)
In Scenario 1, the bad sequence of returns caused the portfolio to drop by more than half in the first 5 years and nearly run out of money after year 20. The retiree would need to make some big changes by year 5 to keep the portfolio solvent.
In Scenario 2, the portfolio has grown to $2M after 20 years! The retiree will probably never run out of money.
Same returns, different sequence, completely different result!
So what does this have to do with irregular spending?
1.2 Sequence of Spending Risk
Now I will define a term called Sequence of Spending Risk (SSR). This is the risk of spending too much too early in retirement—before good returns occur.
SSR is tied to SRR. The sequence of your spending is most significant if you have a bad sequence of returns. It is not as important if your sequence of returns is good.
Let’s look at the remaining portfolio when the retiree from our previous example spends an extra $20k in each of the first 5 years ($100k total) versus each of the last 5 years in the 20-year span. In these cases, the average annual spending is $55k instead of the original $50k.
Table 2 shows us that for Scenario 1, our bad sequence of returns case, spending an extra $100k early in retirement—when the portfolio was down—amplified the drawdown by $437k ($25k+$412k), while spending it late—missing some of the big returns those years—resulted in a $149k lower ending balance. This is a huge difference in when the money is spent!
Also note that spending it early caused the money to run out in year 15 vs. year 19 if the money was spent late.
Looking at Scenario 2, our good sequence of returns case, an early sequence of spending reduced the final portfolio value by $195k ($2.060M-$1.865M) and a late sequence of spending reduced it by $81k. In absolute terms the retiree still has plenty of money left over in both spending sequences and is not at risk of running out.
The early spending cost $242k less for Scenario 2 than Scenario 1 at the end of 20 years. The late spending cost $68k less for Scenario 2.
It is only in a bad sequence of returns situation where we should be concerned about the sequence of retirement spending.
1.3 Recap
I hope I have convinced you at this point that the first 5-10 years of irregular expenses are what matter most.
The high travel and recreation expenses that you are planning at the beginning of retirement are more risky than the high medical costs you can expect at the end. This is because the solvency of your portfolio relies on having enough money to mitigate Sequence of Returns Risk. Reducing its value at the beginning of retirement does not allow those dollars to absorb a bad sequence of returns and compound for decades more.
On the other hand, there will be time to adjust to a bad sequence of returns or celebrate a good sequence before the end of retirement. If a good sequence occurs, there will be plenty of money to take care of your later expenses.
2 How to Plan Out Your Retirement Spending
2.1 Start with your baseline expenses
First, make sure you understand the regular expenses in your life.
What does a typical year of spending look like for you? You can go back over last year’s credit card and bank statements and take out any large, one-time costs to estimate this number. Or you can use an app like Mint or Personal Capital, which categorizes expenses for you.
Before retirement, you may have saved up for car and home maintenance and new cars through a sinking fund. This is a concept that can be carried into your baseline budget as an average expense each year. Though the timing of the actual costs may be irregular, they are a predictable part of life and continue beyond the first 5-10 years. Add them to your baseline.
Make sure this is a close enough representation of your retired life. If you will be moving, check the cost of living in that area and adjust as needed. If you will be taking up an expensive hobby, make sure that is accounted for also.
This will serve as the baseline spending that your portfolio needs to cover every year.
My family’s baseline expenses for an abundant life are about $90,000 after accounting for taxes, giving, and medical insurance. However, medical insurance is currently subsidized by my wife’s part-time job!
Yes, this means we are not fully retired and on the descent of our financial journey yet. But we are at the summit of financial independence, making big life changes, and living our best life now. So our plan still serves as a good example.
2.2 Plan the first 5 years of irregular expenses in retirement
To the best of your ability, forecast when your irregular expenses will come and how much they will be. Financial planning is not an exact science, so don’t worry about having perfect knowledge. You can be conservative on some of the numbers if you’d like.
My 5 year plan looks like this:
I am only trying to get in the ballpark here to make sure I have approximately enough set aside for the next 5 years. And I know that these years are going to be much more spendy than the 10 after that because we are gearing up for activities in our new our home state of Colorado, getting our new home in order, and planning a once-in-a-lifetime trip around the world before our daughter gets too old to think her parents are cool anymore 🙂 .
I am predicting that we will need to replace some old windows in 4 years at a larger expense than our annual maintenance budget would cover. Similarly, we might decide to buy a 2nd vehicle in the next 5 years if life isn’t working out in our small town with just one.
This is where I am being conservative. Even though there could be a little double-counting, if an expense is big enough, more unusual, and will come early enough in retirement, plan for it here.
2.3 Separate into discretionary and mandatory expenses
Irregular expenses will come in two flavors: discretionary and mandatory.
You may be able to patch up the leaky roof, drive the car without air conditioning, or live with knee pain for a little while, but it will need to be fully repaired or replaced soon enough. These are your mandatory expenses.
Discretionary expenses are the things that you could completely do without or modify so that they cost much less.
I hear some of you shouting at the screen that a car is discretionary if you live in a city. You could also replace your discretionary BMW with a Toyota! Sure, there is some gray area. But I think you get the idea.
Here is my plan again with discretionary and mandatory expenses broken out separately:
About 75% of my irregular expenses are discretionary, and I can control them until they’re spent 1-3 years from now. If my investments decline sharply and I am no longer comfortable with this plan, then I can change it!
The renovation could be delayed or cut back. The trailer could turn into tent camping. The trip around the world could take us to less expensive destinations.
But I have some control over my portfolio’s performance as well. I have made adjustments to reduce volatility and limit the downside risk, as you know if you have subscribed to Pathway to FI and seen the Model Portfolios and how I am allocated now.
You can subscribe for free here or at the bottom of this page.
2.4 Decide if you have enough money to handle large irregular expenses
Now that you know how much you expect to spend during the most critical years, you need to make sure you have enough money to support it.
2.4.1 Calculate how much you need to cover your baseline expenses
To handle your baseline spending, you first need to determine the expected Safe Withdrawal Rate (SWR) of your portfolio. There are several approaches that can be taken here. I will write about them in more detail in the future, but here is a quick summary:
- 4% Rule of Thumb – This is the most popular approach due to its simplicity. But it is also only valid for 50/50 stock/bond portfolios and a 30-year retirement horizon.
- SWR Specific to Your Portfolio – It is now quick and easy to calculate your portfolio’s SWR using a tool such as Portfolio Charts. Going back to 1970, the Model Portfolios for Summit and Descent have both achieved greater than 6% SWR!
- Perpetual Withdrawal Rate (PWR) – If you have a retirement horizon longer than 40 years, you are better off using the more conservative PWR. You can get this number from Portfolio Charts as well. The Summit and Descent portfolios had greater than 5% PWR. A 1% improvement in withdrawal rate amounts to a 25% increase in income over the 4% rule!
- Additional Strategies – Another great resource if you really want to get into the weeds is the Early Retirement Now SWR series. Many different strategies are analyzed there, including variable withdrawal rates based on various rules and metrics. As far as fixed withdrawals go, a 3.25% PWR based on an 80/20 stock/bond portfolio seems to come out on top.
In my case, with a portfolio similar to the Summit model portfolio, I can use a 5% PWR. Dividing my baseline expenses of $90,000 by 5% (or equivalently, multiplying by 20) gives a portfolio need of $1.8M.
Before I devised the Pathway to FI portfolios, I conservatively planned to withdraw at a rate of 3.25%, which requires a portfolio of closer to $2.5M, so I may have over-saved! The extra savings is a Margin of Safety (MoS). This will come up again below.
2.4.2 Treat near-term irregular expenses separately
The best way I have found to handle large expenses that are coming up in the next few years is to consider them separately from baseline expenses.
If the money is kept in your portfolio, it will be subject to short-term market volatility and Sequence of Returns Risk, and it will be painful to withdraw if the markets are down.
If it is instead held in a high yield savings account, money market, CDs, or I-Bonds (I recommended I-Bonds for any savings you won’t need for at least 1 year) it will be there when you need it.
You can make a different decision for each of these buckets by treating baseline and irregular expenses separately.
I would recommend keeping your baseline expenses invested until they are needed since this bucket is used continually throughout retirement. Keeping a full year or more constantly in cash is a drag on returns over decades. You will have periods where this doesn’t work out, but statistically, you will come out on top. The SWR Series mentioned above does the math on this.
You can go ahead and keep your irregular expenses in a safe savings vehicle such as I-Bonds. This bucket will start large, but will generally shrink each year, reduce SRR, and help you sleep at night. Since it won’t carry on beyond the first 5-10 years, it will not affect lifetime returns as much.
Back to my personal plan, I would start with $129k in savings vehicles to cover upcoming irregular expenses plus $1.8M in my regular portfolio for baseline expenses. So I should have at about $1.93M in total in order to be comfortable with my plan.
2.5 Revisit your retirement spending plan annually
As with any other aspect of retirement planning, it is wise to do an annual health check on your irregular spending bucket and your baseline portfolio.
2.5.1 Check on your irregular spending bucket and look beyond year 5
After the first year, ask yourself what has changed.
Did you spend more than expected in year 1?
Did you decide to take up woodworking, and now you need a shop and tools?
Did the trial trip in a rented RV make you change your mind about motor homes?
Is it now apparent that your pool will need major repairs this year?
Will you have a wedding to pay for sooner than expected?
There is nothing magical about 5 years versus 6 or 7. So if you see a big ($10k or more) looming expense in year 6, now is the time to consider it. By year 2 of your annual health checks, you can look out to year 7 and so on.
There is no need to go past year 10. Sequence of Returns Risk is either realized or over by then, and you do not need a separate bucket anymore. You can simply handle irregular expenses out of your baseline portfolio as they come up.
Based on the above assessment, does the irregular spending bucket still have enough money to cover the remaining years? If not, you will need to draw additional money from your baseline portfolio to cover the shortfall.
Looking at my example, let’s say that after year 1 my sports gear ended up costing $1k more than the projected $4k. On top of that, the home renovation was bid at $9k more than my $40k estimate due to increased material and labor costs. I now need to cover another $10k that was originally unplanned.
2.5.2 Check on your baseline portfolio
How has your portfolio performed? Can it handle an additional draw, or do you need to reconsider some of your discretionary expenses (for now) due to a potentially bad sequence of returns?
Rule of thumb: Consider reducing or delaying large discretionary expenses if your portfolio is more than 10% below its starting value early in retirement.
In my example, let’s say my portfolio lost 10% in the first year and I withdrew an additional 5%. My portfolio value is now down 15% from $1.8M to $1.53M. Instead of completing the entire home renovation as planned in year 2, I decide to reduce the project to one room instead of two. This brings the cost back down by $19k. Rather than drawing $10k, I now have a surplus of $9k and can let my portfolio recover before I decide to complete the second room.
2.5.2.1 Margin of Safety
If you don’t like the idea of letting the markets determine whether or not you complete your dream home or travel as planned, build a Margin of Safety into your starting portfolio value.
Remember how I over-saved?
My Summit-based portfolio lost less in year 1 than my old portfolio would have. Based on historical performance, I can expect it to recover more quickly also! This allowed me to target just $1.8M as my financial independence number.
I started with closer to $2.5M, however. This is a $700k MoS ($2.5M – $1.8M). The $90k baseline expenses withdrawal was only 3.6% instead of 5%. With the 10% investment loss, my portfolio value is down by 13.6% to $2.16M. Because of the MoS, it’s still $360k above target instead of being $270k short!
Margin of Safety is a psychological tool that allows me to ignore market fluctuations and keep living an abundant life—even in the midst of a bad sequence of returns.
3 Summary
Irregular expenses are an important part of planning for an abundant retirement. Planning to spend the same amount every year of retirement is not realistic, and can lead to a bad plan.
A better plan is to:
- Understand your baseline expenses
- Estimate the first 5 years of irregular expenses
- Separate them into discretionary and mandatory
- Calculate the portfolio value needed to cover baseline expenses
- Keep this money invested until it is needed
- Treat near-term irregular expenses separately
- Use a savings vehicle such as I-Bonds or a high-yield savings account for this bucket
- Revisit your plan annually and add to the irregular expense bucket if needed
- Look out as many as 5 more years (10 total) if expenses larger than $10k are expected
- Before you retire, consider a Margin of Safety to mitigate Sequence of Returns Risk and ensure that you can live your dream retirement without worrying about the markets
- The Pathway to FI Model Portfolios can greatly improve your portfolio’s Safe Withdrawal Rate to build a Margin of Safety without requiring additional savings
Read What Should My Asset Allocation Be to see the Model Portfolios and a white paper describing their historical performance relative to other common portfolios
Are you prepared for irregular retirement expenses?
Have you already retired in the last 5 years? It isn’t too late to make adjustments.
Do you have questions about how to complete the plan described above? I would love to discuss with you. Contact me from the financial coaching page.
And don’t forget to sign up for FREE at the bottom of the page to get much more value from PathwayToFI.
Join me on the path to FI!
