Three steps to planning your spending in retirement


A self-funded retiree and former corporate heavyweight, Don Ezra from Firstlinks outlines his strategy for sustainable retirement income.

Key Points


  • Self-funded retirees should assess their combined longevity and uncertainty, decide their tolerance for investment risk and estimate a pace for sustainable spending.  
  • You can afford to take more investment risk with your portfolio than conventional thinking suggests by taking a disciplined approach.

On retiring from his job as Co-Chairman of Global Consulting for Russell Investments Worldwide, Don Ezra, sat down with his wife to plan how best to make their retirement savings last. It is a matter that a lot of retirees – especially those who are self-funded – must consider.

How much can you sustainably withdraw from your pension pot? What’s a sensible way to allocate assets in it? How long will you live? You don’t know. What return will you earn on the money? You don’t know that either. 

In this extract from the Firstlinks newsletter, Don Ezra outlines how he plotted his retirement future – in terms of investing, saving, and spending.  

Break down the problem


The principles are straightforward. 

Make a reasonable assumption about average future lifespan. That, along with the benefit formula, leads to an estimate of the annual cash flow promised. Make some reasonable assumptions about the investment return of the fund. That tells you whether the amount in the fund, plus the future returns, will be sufficient. If it’s insufficient, you need to add more money. 

There were three steps. 

First, we assessed our combined longevity and its uncertainty. 

Second, we needed to balance cash flow safety and investment growth, in other words, decide on our tolerance for taking investment risk. 

Third, we needed to estimate the pace at which we can sustainably withdraw money to spend. 

It’s like driving on a long journey. We know where we are on the map, and we’ve made our own decisions on direction and speed. There’ll be corrections as the map unfolds, but we feel we’re in the driver’s seat, and that’s as much control as anyone can have. 

1. How long will you live?


Average life expectancy works fine as an estimate. For us, outliving the average was a big financial risk, with a 50/50 chance of this happening by definition. I thought we should reduce the risk and see what the numbers looked like when we used a longer time horizon, one that, not 50 per cent, but only 25 per cent of couples like us would outlive.

2. How will you allocate between assets?


The second step involved balancing cash flow safety and investment growth. 

We wanted growth, so we focussed on investing our pot in a global equity index fund. Yes, there are alternatives, but this was simple, inexpensive and didn’t require expertise. But wait. Putting 100 per cent in growth assets from which we need to make periodic withdrawals exposes us to something called ‘sequence of returns risk’ (or sequencing risk). 

Because we’re always withdrawing money, our assets decline over time. So, if we have poor returns early, there won’t be enough of a base to make up the losses even if the later returns become above average. So, we need to be able to make withdrawals without affecting the shortfall too much. 

What do pension funds do when faced with this problem? They don’t invest 100 per cent of their assets to seek growth. They invest some assets in ways that automatically match a few years of cash flow, so they get that early cash flow without touching the growth assets. 

3. How much will you take?


Every year we take a year’s indicated withdrawal from the safe assets and replenish them by cashing in from the growth assets. The withdrawal (to be increased by inflation each year) must be calculated so as to last 31 years. 

Answer: For each $100,000 of our pension pot, the indicated annual sustainable withdrawal was $5,080. 

So, the safety amount is five years of that, or $25,000 in round numbers. To my mind, this isn’t an investment, it’s our personal self-insurance bucket against a market decline. The remaining $75,000 goes into growth assets. 

This framework leads to our decision


Now, with these numbers available, we could make our decision. We scaled the annual withdrawal numbers to reflect our total retirement savings pot (which includes all our financial assets, not just our tax-deferred assets). We went for the higher withdrawal level at a risk tolerance of 25 per cent. We didn’t consider anything in between 25 per cent and 10 per cent. 

Theory and practice


What happened when we put all this to work? 

The global stock market index dropped about 8 per cent in December 2018. We took no action and decided to see where we were in five years. When the global index fell 8 per cent in February 2020 and a further 13 per cent in March, our attitude was the same. 

Of course, we were lucky that the market recovered quickly. It was much worse from September 2008 to February 2009, when the cumulative fall was 40 per cent. But again, we were lucky, because before the end of 2009 the markets had recovered that loss. 

What if [5 years after a market crash] it hasn’t recovered, and we’ll have exhausted our self-insurance bucket, and we’ll be forced to cash out from the growth assets at some low level, with no further protection from market volatility. 

If this happens, we could at least avoid a massive cut to our withdrawal amount by spreading that reduction over the remaining period to the end of the planning horizon. A bad outcome means five successive years of gradual reductions, followed by complete exposure to market volatility. 

More risk than traditional planning


One takeaway from this exercise, is that you can afford to take more investment risk with your portfolio than conventional thinking suggests. But the hardest is the ongoing discipline. 

Disclaimer: This is an extract of a longer article in Firstlinks. This article expresses the views of author Don Ezra and not necessarily those of National Seniors Australia. This article is general information and does not consider the circumstances of any investor. We encourage all seniors to obtain credible and authoritative financial advice. 

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