I spend a lot of time talking with people who have retired early or are otherwise financially independent. From a purely anecdotal point of view, I'd say most of these folks are well-adjusted. They work to maintain balance in life, and especially with their personal finances.
That said, I've noticed that a lot of retirees — early retired or otherwise — struggle to know how much they should spend. I believe this dilemma exists for a couple of reasons:
- First is the life expectancy problem. You don't know how long you're going to live. If you did know the precise date of your death (or even the year of your death), retirement planning would be much easier. You'd be able to say, “Okay, I have ten years left and $300,000 in the bank. Based on that, I should be able to spend $30,000 per year.” But you don't know when you're going to die, so a lot of retirement planning becomes guesswork.
- Second is the question of what your money is for? Do you want to leave a legacy for your children (or somebody else)? Do you want to maintain a chunk of change for possible end-of-life medical issues? Or do you want to use your wealth to live life to the fullest while you can? In my case, my ideal would be to die broke. If I could spend my very last penny on the last day of my life, that'd be perfect.
The general response to these two problems is to follow what has been dubbed the four-percent rule. Generally speaking, it’s safe to withdraw 4% from your portfolio every year without risk of running out of money. (There are a lot of caveats to this guideline. To learn more, follow that link to my Money Boss article — or wait for that story to migrate to Get Rich Slowly in a few days!)
The AAII Journal — the monthly magazine from the American Association of Individual Investors — has published two articles in recent months about the problem of spending in retirement. Let's look at what they have to say.
I'm going to link to and quote from both AAII Journal articles below, but be forewarned that the AAII Journal lives behind a paywall.
People Who Spend Too Little in Retirement
In the first article (from the April 2018 issue), Meir Statman asks, “Are you spending too little in retirement?” To paraphrase the author, your financial life can be divided into two basic stages.
- During the accumulation phase of your life, you're building wealth. During this period, you work hard and invest wisely. If you're careful (and fortunate), you'll build a wealth snowball by maintaining a large gap between what you earn and what you spend. The folks who create the widest gap are likely to accumulate more wealth more quickly than those with smaller gaps.
- During the consumption (or preservation) phase of your life, you shift from earning money to spending money. After you retire (and remember, the definition of retirement is no one fixed thing), your income is sharply reduced. You might not even have an income. Instead, you live off the money you accumulated during the accumulation phase of your life.
During the accumulation phase, Statman says, self-control is an important trait. Financial discipline and conscious spending allow smart savers to build large nest eggs. But here's the thing: The very same qualities that help people during the accumulation phase of life actually hinder them during the consumption phase.
Excessive self-control is evident in the tendency to spend less today than our ideal level of spending, driving us to extremes beyond frugality. The prospect of spending money inflicts emotional pain on tightwads even when it might otherwise be in their interest to spend.
It's ironic, he notes, that saving is difficult for the young, but spending is difficult for the old. What good is building a stockpile of wealth if you don't actually use that money? “We need not feel guilty about spending our hard-earned savings on ourselves,” Statman writes.
But he's careful to point out that, “Some people derive no pleasure from spending on themselves.” He urge these people to consider spending on others. Give money to family members. Actively contribute to causes that are important to you. Find ways to use your money while you're still alive instead of leaving a fortune when your dead.
Grasshoppers and Ants in Retirement
The second article (from the June 2018 issue of the AAII Journal) is about grasshoppers and ants in retirement. This piece is more academic than the first, but it's also more interesting.
“Many academic studies show that retirees, particularly wealthier retirees, spend down their nest egg much slower than economic theory would predict,” the authors write.
This excessive thrift is a mystery to many economists who don’t understand why individuals would make sacrifices during their working years in order to live better in retirement if they don’t have the intention to spend down their savings in retirement. Why not go on more vacations, buy a larger house, or drive a nicer car early in life instead of setting money aside that is never spent? This tendency is especially puzzling since the average retiree doesn’t exhibit a very strong desire to leave a bequest.
On the other hand, there are indeed people who act as “grasshoppers” in retirement, spending lavishly so that their savings run the risk of depletion. Here's one way the authors describe the difference between ants and grasshoppers:
When ants receive a windfall in retirement (such as an inheritance), they spend about $5 more each year for each $1,000 they receive. When grasshoppers receive an inheritance, they spend an extra $260 per year. This means that when a grasshopper receives an inheritance, it will be completely spent within four years.
Now, based on what we all know from the fable of the grasshopper and the ants, we'd expect that ants would be the heroes in this situation, right? They're the ones who'll come out ahead in the long run. Not so fast. While the ants should feel some relief that they're not going to run out of money in retirement, the authors say they could take some lessons from grasshoppers:
Grasshoppers are behaving much more like economically rational life cycle consumers than the ants. Why did the ants save up all that money if they’re not going to spend more in retirement? This is especially puzzling if ants don’t have a strong desire to pass this wealth on to their children or to charity.
How Much Should You Spend in Retirement?
These articles are interesting from a psychological perspective, but they don't offer any practical takeaways. The real question is: How much should you spend in retirement?
Here's my advice:
- Determine your current annual spending. If, like me, your spending fluctuates from year to year, calculate a three- or five-year average spend. Call this number your current annual spending.
- Determine your safe spending level. You can use whatever method you'd like for this, but for simplicity's sake, I'd say use the afore-mentioned four-percent rule. Take your entire net worth and multiply this by four percent. If your net worth is $1,000,000, for instance, you'd get a result of $40,000. (If you're risk averse, either leave home equity out of the equation or multiply your net worth by three percent.) This number is your safe annual spending.
- Compare the numbers. Find the difference between your current annual spending and your safe annual spending. If your current spending is greater than your safe spending, you should probably cut back. But if it your current spending is less than your safe spending, give yourself permission to spend more — if you want.
Usually when I write at Get Rich Slowly, my aim is to get people to spend less. From my experience, most people struggle with spending too much rather than spending too little. That said, I've certainly seen the opposite. In fact, sometimes the reluctance to spend borders on hoarding.
Ultimately my advice comes back to my long-time motto at this site: “Do what works for you.” Obviously, you don't need to spend more money. Nobody needs to spend more. But be aware that if you've been a prodigious accumulator of wealth, you do have the freedom to put that money to use — whether for yourself or for others.