A common misconception about retirement planning is that once you have enough savings, you can "live on the interest payments" in retirement, without dipping into the principal.
For example, see the following comment by Ron Pearson, a financial planner who practices in Virginia Beach, Va., as quoted in Financial Planning magazine:
My biggest challenge is to help my clients understand the total return concept and how best to take an inflation-adjusted income stream. Many of them are still in the "spend interest, don't touch principal" mindset.
This shows that many people are not aware of the real impact of inflation over many years. I will use a simple example to illustrate this. Consider the case of someone with a $300,000 nest egg, who needs a $1000 monthly income to supplement income from other sources like pension or social security. (By the way, this also happens to be my income goal for "early retirement" as explained in an earlier post).
Let us assume that the savings are invested to give 5% investment return (close to the recent yield of 10-year treasury notes). If we go with the "spend interest, don't touch principal" strategy, and withdraw 5% every year, this would yield more than the required amount in the first year of retirement.
First, consider the case where the inflation rate is at 3%. The result will be as shown in the table below.For the first year, the monthly income is well over the $1000 target. By the 15th year however, the "real" monthly income (inflation-adjusted) has shrunk to a little over $800.
So, what is a better strategy? It consists of two things:
- Start with a conservative withdrawal rate not related to the investment return rate. Most financial planners agree that this rate cannot be more than 4%.
- Adjust the withdrawal rate in the following years so that the income remains fixed in inflation-adjusted terms.
Now let us revisit the two cases above, using the "4%-with-inflation-adjusted-increases" strategy.
First, with 3% inflation:
Next, with 6% inflation:
This strategy gives a fixed "real" income stream for many years. Exactly how long the money will last depends on the inflation rate, and your investment returns.
In the case of 6% inflation, note that the withdrawal rate has gone up to almost 11% by the 15th year. This is clearly not sustainable -- you will run out of money within a few more years. This is not a surprise, since you can't expect to survive for long on 5% investment return when inflation is at 6%.
In case you were curious, the withdrawal rate for a given year is calculated in terms of the withdrawal rate in the previous year using the following formula:
wn+1 = wn * (1 + f)/(1 + r - wn)where wn is the withdrawal rate for year n, f is the inflation rate, and r is the investment return rate. In practice, both your investment returns and the inflation rate can fluctuate considerably during retirement, so this formula only provides a guideline.