An old adage says retirees should “never spend principal,” but today you’re more likely to hear this from a grandparent than your financial advisor.
With dividend payments and fixed-income yields close to record lows, the trickle of income may not be enough. Meanwhile, stock prices hit peak after peak. If gains come through rising asset prices rather than interest and dividends, what’s wrong with dipping into principal for the groceries?
Nothing, according to most financial advisors. If that’s where the money is, that’s where you need to go — so long as you understand the trade-offs.
“The rule of never spending your principal is out of date,” says Mike Falco, financial advisor at Falco Wealth Management in Berwyn, Pennsylvania. “You can spend it, but it’s a question of how much you can spend before you run out of money. You have to know that number before going into retirement.”
The biggest consequence to dipping into principal is that you reduce the foundation on which future growth is based.
[See: The Best ETFs Retirees Can Buy.]
Jamie Hopkins, professor of retirement income at the American College of Financial Services in Bryn Mawr, Pennsylvania, says it is an issue of “sequence of returns” — even if you average 8 percent a year, you’ll run into trouble if you have poor returns due to a market crash at the start. After that, every dip into principal would be a larger portion of your nest egg.
Taking $40,000 a year from principal may seem quite safe when you’re worth $1 million, but would look like too much if a combination of withdrawals and market declines cut your nest egg to $500,000 and you expected to live another 20 years.
Another issue is that spending everything you earn in dividends and interest, and taking principal as well, will likely throw your investment assumptions out the window.
Many investors look at history to estimate the returns they’ll earn in the future. But the historical returns you find for mutual funds and other holdings show results for investors who not only left principal intact but also reinvested all interest and dividends. So holdings you’d assumed would return 6 percent or 7 percent a year will grow much slower if you’re not holding for the long-term and reinvesting.
Again, the smaller your returns going forward, the more you’ll have to dip into principal to have enough money to live on, with your accounts shrinking faster and faster as the years go by.
So although the rule “never spend principal” may be unrealistic today, it still makes sense to spend as little as possible. Taking less will always make your assets last longer.
Many experts use a rule of thumb that says retirees can withdraw 4 percent of their nest egg the first year, and increase the dollar amount by the inflation rate each year afterward. That assumes a 7 percent annual return and 3 percent inflation, says Michelle Brownstein, director of private client Services at Personal Capital in San Francisco.
“One thing that is key is flexibility,” she says. “For example, taking a bit more income in a strong portfolio year and taking less in a down year can help with portfolio longevity as you’re putting less strain on already depressed asset prices in the down years.”
Most experts say taking more in the flush years doesn’t mean spending more, but putting the excess aside for the lean years.
[See: 6 Reliable Dividend Stocks Paying Out for 100 Years or More.]
It also makes sense, Brownstein says, to plan to live a few years longer than the standard life-expectancy tables would suggest, especially if you’re healthy and have or had parents who lived to be very old. A couple sharing a retirement portfolio has an even greater chance that one, if not both, will live a long time, she says.
Jeffrey E. Bush, managing partner at Informed Family Financial Services in Pottstown and Norristown, Pennsylvania, says he urges clients to buy annuities, which provide set income for life in exchange for an upfront payment. That allows the investor to tap other holdings more safely.
“An annuity allows you to spend your principal, as well as your interest,” he says.
Financial software and tools you can find online by searching for retirement calculators can help you play with assumptions on investment returns, inflation and your lifespan.
And if you’re having trouble making the numbers work, think about ways to economize so you can save more before retiring and spend less afterward. Working longer may be a solution, Bush says. That gives investments more time to grow and reduces the number of retirement years to fund.
“The best strategy is to reduce your expenses before retirement,” Falco says. “The more time you have to do this, the better off you’ll be.”
Brownstein says the most impactful change is to downsize to a less expensive home or move to a less expensive city or state.
“In many cases, having a smaller home is beneficial from both a financial and lifestyle standpoint as you age,” she says. “A smaller house can mean less upkeep and maintenance. Additionally, in some cases renting makes more sense than owning, and selling a home can be a way to access additional liquidity.”
Bush says finding ways to cut taxes pays.
“Are you claiming Social Security and utilizing Roth IRAs? “Many times, our clients can cut taxes to save more money,” he says. “And other times, it is a matter of altering lifestyle habits. It is important for retiring parents to look at how they are helping their children. We have a lot of clients who help their children out financially with college education.”
Most experts urge careful budgeting before and during retirement, as that can often identify costs that can be cut. Incidentals can add up, and there may be some big expenses that can go, too.
“Cut out the non-fixed, non-essential expenses,” says Stephen Ng, author of “10 Financial Mistakes You Should Avoid: Strategies Designed to Help Keep Your Money Safe and Growing” and founder of Stephen Ng Financial Group in Short Hills, New Jersey.
[See: 9 Ways to Avoid 401(k) Fees and Penalties.]
“For example, traveling, eating out, or overly supporting your children and grandchildren,” he says.
More from U.S. News
10 Great Ways to Buy Emerging Markets
8 Cheap ETFs That You Won’t Regret
7 Pharma Stocks and the Prognosis for Profits
Is Spending Principal OK in Retirement? originally appeared on usnews.com
