A friend of mine just bought her dream house. Despite the bigger mortgage and higher property tax bill, she and her husband took the leap. The thing is, though, my friend is not a young woman. In fact, she and her husband are on the cusp of retirement, staring squarely at their “golden years.”
Certainly, my friend’s decision doesn’t follow textbook financial advice. At a time when most people think about cutting back, she’s taking on more. So what exactly is going on here? Has my normally prudent friend taken leave of her senses? Is she headed for financial ruin?
As I pondered this rather startling possibility, I realized that my friend’s situation is hardly unique. As millions of Americans head into their retirement years, they are faced with similar decisions. Spend now, or save for later? Enjoy the present, or prepare for the future? The answer, of course, includes a bit of both. And the correct answer will be different for you than for my friend, or anyone else.
Of course, you will find things to spend your money on when you’re retired. So the question is: How can you feel more confident about your spending decisions? By taking a step back and objectively evaluating your entire financial situation. Yes, there are many variables you can’t predict—your health, your longevity and future market conditions, to name just a few—but there are also many factors that can lead you to an informed decision. As you grapple with the “spend or save” dilemma, here are some things to consider:
Start with an overview of what you have to spend
As you approach retirement, calculate how much you’ll be able to spend each year from all your predictable income sources, such as: a pension, real estate income or Social Security benefits.
It’s a rare retiree whose income from such sources is sufficient, so next look to your portfolio and calculate how much you’ll need to withdraw to cover anything predictable income sources won’t. The standard recommendation is to withdraw no more than 4% in the first year of retirement (with adjustments for inflation thereafter) if you want your money to last for 30 years or so. In other words, if you’ve saved $1 million, you could withdraw $40,000 in the first year from your portfolio. However, if you expect your retirement to last more than 30 years, you could reduce your withdrawals (and conversely, if you anticipate a shorter retirement, you can reasonably withdraw more).
Once you’ve completed these two steps, add up your numbers. The sum represents the best prediction of your retirement income.
Next, look at your expenses
Now look at the spending side of your equation. Starting with the essentials, add up your costs for housing, insurance premiums, health care and basic living expenses like food and utilities. Once you have that number, you’ll have a much clearer sense of how much will be left over for the nice-to-haves.
Be prepared to adjust for market conditions
The 4% withdrawal rate is a guideline for long-term planning, not an absolute. If you can cover most of your essential expenses with your fixed income streams, consider withdrawing less than 4% from your portfolio (or not adjusting for inflation), at least when the market is down. Conversely, if the stock market is doing well, you can think about taking a little more.
Appreciate that your life will continue to evolve
Many retirees find that their lifestyle is much more costly in the early part of their retirement while they’re still relatively young and active. If you’re confident that you will be cutting back as you age, you can budget accordingly. Don’t forget, though, that your medical expenses will likely increase, so be sure you have adequate insurance coverage.
Evaluate your priorities
To spend with confidence, you need to think carefully about what’s most important to you and where you’re willing to make trade-offs. If you’re married, of course discuss your priorities with your spouse. Hopefully, you’ll be able to come up with a plan that satisfies you both.
Review your investments
While you’re looking at your portfolio, make sure you’re invested appropriately for this time in your life. As you move into your 60s and 70s, it’s generally wise to begin taking a more conservative approach. That said, in addition to your income-producing investments, it’s important to own some stocks. If you want your portfolio to last for decades, it still needs to have the opportunity for growth. Just as an example, Schwab recommends that people in their 70s who want a moderately conservative allocation should consider a portfolio that consists of 40% stocks, 50% fixed income and 10% cash.
So where does all this leave my friend with the new house? I’m pleased to report that she and her husband had followed all of these steps to a T. Yes, their mortgage takes a bigger chunk of their resources every month. And yes, they plan to cut back on other expenses to compensate. But the beauty is that it’s all part of their overall plan—which includes living life to its fullest.