Monday, July 6, 2015

Early Retirement: Spending Sooner

In my first post on this topic, The Risk of Retiring (or Being Retired) Early, I provided some thoughts about the risk of retiring early and perhaps extending what might already have been a long and expensive retirement. In my second installment, Retiring Early: Lost Savings, I reviewed the risk of retiring early and consequently saving less. As I mentioned in that second post, limiting savings at the end of retirement has a significant impact, but when we stop saving early, we typically also start spending from savings. The cost of early spending is greater than the cost of forgone savings and the two combined are substantial.

(As always, click on a chart or table to see a larger version. Hover your mouse over any yellow text.)

Here's the chart from that second post showing the cost of forgone savings without the simultaneous cost of early spending, in other words, for a retiree who could stop saving, retire, and avoid spending savings until age 70. (Note a minor change to the chart from my last post: this one graphs balances at the beginning of each year whereas the last post assumed the worker retires at the end of the year.)

Chart 1
As you can see, were this retiree able to retire at age 55 and not touch retirement savings until age 70, her portfolio value at age 70 would be about $265,000 less than it would be if she had kept saving until age 70. She would save $156,000 less over those 15 years and lose $109,000 in interest on those forgone savings.

Typically, however, when a worker retires and stops saving for retirement, he also begins spending from savings. Chart 2 below shows the resulting portfolio balances when a retiree simultaneously stops savings and starts spending at a given retirement age. It also shows the amount of spending supported assuming a constant-dollar annual withdrawal of the portfolio balance at the retirement age.

The amount of the sustainable withdrawal percentage is calculated using Milevsky's formula for sustainable spending (download PDF) using the life expectancy from the "male" columns of the following table. Note that females have slightly lower SWR's because they have longer life expectancies. My first post on this topic noted that the longer you postpone retirement, the greater your expected savings will be and the larger the percentage you can safely spend annually.

Table 1.
For example, if our sample retiree stops saving at age 65 (the inflection point in the purple line on Chart 2), he would have accumulated $1,181,178 by age 65 and Milevsky tells us we can assume he could spend 4% of that amount, or $47,247 annually beginning at age 65. If he saves until age 70, he accumulates $1,712,935 and Milevsky tells us he can spend 4.6% of that amount annually because he has a shorter life expectancy.

These probably seem like hugely different outcomes, and they are, so let me walk through one example of retiring at age 65 (purple curve on Chart 2 above) versus waiting until age 70 (teal curve on Chart 2 above) in Table 2 below.

Table 2.
Retiring at 70 allows the retiree to contribute $56,000 more to savings in this example. Five more years of 7% annual returns with no withdrawals provides over $530,000 more in portfolio savings. Together these amounts create a portfolio at retirement five years later that is $531,756 larger. Because the 70-year old has a 4-year shorter remaining life expectancy, he can spend 4.6% of this portfolio, according to Milevsky, which is 15% more than the 4% he could spend at age 65. The increase in spending from 4% of $1.18M to 4.6% of 1.71M is more than $30,000 a year.

A lot of this difference comes from the huge growth in the portfolio the last few years of retirement resulting from compound earnings. These portfolios grow exponentially and each year that you delay spending affects your savings balance more than it did the year before. (This is why most financial planners urge you to be very cautious with your investments the last decade of your working career.)

A substantial amount of the sustainable spending difference also comes from the increased SWR – the retiree gets to spend a larger percentage of a larger portfolio. In this example, the additional spending increases $21,269 a year from a larger portfolio at retirement and another $10,278 from an increased SWR.

This scenario is an example and there is no guarantee that your portfolio will grow at all in the final five years of your career, let alone that it will grow as much as 7% annually. The intent is only to show how changes in retirement age affect retirement spending. How much it affects spending depends on market returns and life expectancy, things we can't predict.

The earlier you retire, the less money you can spend after you retire. A significant portion of the reduction of retirement spending can be attributed to the fact that you stopped saving earlier, and a larger portion of additional cost is attributable to spending savings earlier. Toss in the lower sustainable spending amount at younger ages because we have to plan for a longer retirement and the body blows add up quickly.

So far, those body blows from retiring early include:
  • a longer (and consequently more expensive) retirement, 
  • fewer years to save, 
  • lost returns on those forgone savings, 
  • lost returns on savings that we spend at an earlier age, and 
  • a lower sustainable withdrawal rate (or life annuity payout) due to the longer expected lifetime in retirement.
Of course, you can turn that frown upside down by looking at the flip side of those bullets as advantages to delaying retirement: a shorter, less expensive retirement, more years to save, etc.
There is still at least one major financial risk to consider when deciding to retire early, or evaluating the impact of forced early retirement, and that is the impact on Social Security benefits. I'll cover that next time.

Note: The assumptions for these calculations are the same as in the initial post, The Risk of Retiring (or Being Retired) Early. I assume the worker will earn the "typical" annual incomes shown in the charts in that post and will save 10% of earnings every year. I assume he or she will earn a consistent 7% annual return on all savings (an optimistic assumption in current capital markets). All calculations are in nominal dollars except for expected market returns used for the Milevsky formula, for which I assume a 5.6% real annual return with 11% standard deviation.