Spend Your Principal in Retirement – Savings Mastery: Your Guide to Building a Strong Savings Account

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By Dr. Jim Dahle, WCI Founder

I heard an interesting statistic at the Bogleheads Conference last year. Here it is:

“Only 1 out of 7 retirees spends any of their principal.”

Wild, right? Everyone is worried about running out of money in retirement. The truth is that few retirees are running out of the money they saved up for so many years. Granted, lots of people never had any, and they are living on Social Security combined with the goodwill of friends, family, and neighbors. Don’t believe me? Check out these charts from Vanguard’s How America Saves Study.

That’s right, the median 401(k) balance is about $33,000. That’s less than two years of the maximum contribution. Even among the 55 and older crowd, the median is only around $80,000. What kind of income does an $80,000 401(k) provide you? That’s $267 per month. Basically, it’ll pay for Netflix, your cell phone bill, and one tank of gas. Hope Social Security covers the rent, groceries, and healthcare.

Why don’t people have any money in their 401(k)s? It seems pretty obvious once you look at this chart:

That’s right, nobody is saving anything. Only about half of those making > $150,000 are maxing out their 401(k)s. When you include everyone, only 12% are maxing out their 401(k)s. So, when I’m talking about those who are actually saving something significant for retirement, we’re only talking about a small percentage of investors. (If you maxed out your 401(k) this year, give yourself a pat on the back.) But of those who actually save something for retirement, almost nobody runs out.

Not Running Out of Money During Retirement

There are a few reasons for this:

#1 Adjustments

Nobody withdraws blindly. They adjust as they go. When hard times come for their investments, they spend less.

#2 Huge Portfolios

Tons of retirees have “oversaved” with regard to their actual need to spend. They are perfectly comfortable and content to spend less than they could be safely spending. Katie and I wouldn’t be anywhere close to a 4% withdrawal rate if we quit working right now, and we’re still working and probably will be for a while. Lots of people don’t quit just as soon as they have “enough.”

#3 Caution

People are cautious about how much they withdraw from portfolios. Historically, if you blindly withdrew 4% per year from your portfolio (adjusted upward with inflation each year) for 30 years, you would, on average, have 2.7X the amount you retired with still in your portfolio. Only in a small percentage of historical scenarios do you (after 30 years) have less than you retired with, much less run out of money.

#4 Death

People plan for a long life, but most of them don’t get it. I refer once again to the classic chart titled “Rich, Broke, or Dead” from engaging-data.com.

At 90, 80% of people are dead, and less than 5% are out of money. Of those still alive at 90, far more of them are rich than broke. For you to run out of money, two “bad” things have to happen: crummy returns AND a long life. If either of them doesn’t happen, you don’t run out of money.

#5 Never Spending Principal

Finally, this is what I want to talk about today. I think a lot of people have an illogical fear of spending principal. I don’t know who said it first, but “Never Spend Your Principal” has been spouted as investment wisdom for many years. It’s totally wrong, of course.

It does have four very nice benefits, however.

You will never pay capital gains taxes (although mutual funds could pass some gains through).
It will be extremely easy to see how much you can spend.
You will never run out of money.
You will be sure to leave a very nice inheritance (can I be your heir?).

Despite the benefits, it’s the wrong thing to do. You ABSOLUTELY CAN spend (some of) your principal for two reasons.

You are constantly making more principal as you go throughout your retirement, and
You are not going to live forever.

Typical growth (i.e. risky) investments, such as stocks and real estate, gain in value over time. Yes, some of the return is paid out as income, but there is additional return that is not paid out, often even more than the rate of inflation.

More information here:

Some Sobering (and Scary) Statistics on People’s Retirement Preparedness

Income Investing Is Behaviorally Smart?

spending principal in retirement

However, the statistic that 1 out of 7 investors do not spend principal in retirement is still staring us in the face. There is something powerful there. Even if it is not MATHEMATICALLY optimal to not spend principal, perhaps it is BEHAVIORALLY optimal to just spend the income. Many investors have a very hard time switching from being accumulators to being decumulators. After a lifetime of saving, saving, saving, it’s psychologically tough to actually spend that money. In fact, doing so requires you to admit two difficult things to yourself. First, you are no longer earning enough income to cover your (appropriately) desired level of spending, and second, you will not live forever. Neither is psychologically easy. But that income rolling off the investments . . . that feels an awful lot like that paycheck you used to have. That is easy to spend.

As much as the purist in me hates to tell a retiree to have a portfolio more focused on income so they FEEL better about spending an appropriate amount of it each year, the truth is that personal finance is both personal (80%) and finance (20%). It’s often a good idea to do the “wrong” thing (focus on income) if it leads to the “right” outcome (spending an appropriate amount of your portfolio). Plus, the tax aspects don’t matter as much if you’re actually spending the money (although they should still be taken into consideration.) Still, don’t go hog wild and build a portfolio of junk bonds, extreme value stocks, and annuities just to boost yields. But if you want to pay off your real estate mortgages to increase the income from the properties, allocate some money toward something like a real estate debt fund, put a little more in bonds, or add a value/dividend tilt to the stock portfolio, I think that’s all fine.

More information here:

How to Spend in Retirement

Spend Those RMDs

Another financial advisor at the conference said almost all of his elderly clients simply reinvest their Required Minimum Distributions (RMDs). That is, they take the money out of their traditional IRA, pay the taxes due on it, and reinvest it in their taxable account. I wasn’t surprised. My parents mostly do the same thing. We tease each other a lot about finance and politics. My dad complains an awful lot about poor market performance for someone who doesn’t even spend his RMDs.

Maybe if I publicly shame them here, they’ll start spending them—even if this might not be the best year to do it!

As far as portfolio withdrawal strategies go, just spending your RMD is far from the worst. Yes, RMDs can get pretty big as you move into your 80s and 90s. But your life expectancy is also getting pretty small in those decades, and as a percentage-based method, you’ll technically never run out of money spending your RMDs.

Setting a Spending Minimum

For those of you having trouble spending as much as you can during retirement, here’s another idea. Set an amount that you have to spend each year. Put a penalty on it. Maybe if you don’t spend it, it has to go to the national committee for the political party you don’t support, for instance. Or perhaps, better yet, it goes to your favorite charity. Maybe that will help you to spend some principal.

More information here:

The Risk of Retirement

Doing Some Simple Math

Still struggling to spend principal? Think about it this way. The long-term return on the stock market is 10% a year. Maybe we can’t expect that in the future. Fine. Let’s make it 8%. Or even 7%. Now, the yield on the market is about 2%. That still leaves you a 5% increase per year on average. While inflation is high right now, it averages around 3% in the long run. So, you can easily spend 2% of principal in addition to that 2% income and still expect your money to grow at the rate of inflation. This is going to work out just fine.