Many retirees have an interest-only approach to spending their retirement savings. My own grandfather — who experienced the Great Depression as a young adult –invested his entire savings in certificates of deposit (CDs). Even when as he approached his 90th birthday, he was anxious about spending more than the interest his CDs could generate. So he lived an extremely frugal retirement lifestyle.
Unfortunately, the yields on CDs have been terrible for most of this decade. Yields on 3-month CDs averaged under 3% for four straight years, in 2002-2005. They briefly rebounded to 5% in 2007, but they have fallen rapidly in 2008. Living off of CD interest is a hard way to live.
There is a better way to calculate how much of your savings you can afford to spend. Treat your retirement nest egg like a long-term reverse mortgage. Plan on spending the interest — and some of the principal too — over a period of, say, 40 years, or longer if there is a reasonable chance of you living past that. In the first few years, most of your spending will come from the interest you earn. In the last few years, most of your spending will come from the principal. Just like a mortgage.
To calculate the mortgage-like expenditures your retirement savings can sustain, you can use an online mortgage calculator or Excel’s PMT() function. For example, if you expect to consistently earn at least 4% interest/year on $1,000,000 invested in CDs over 40 years (480 months), enter “=PMT(Rate = 0.04/12, Nper = 480, $1,000,000)” into an Excel spreadsheet. The formula would return -$4,179, meaning your $1 million portfolio would let you spend $4,179/month for 480 months.
Unfortunately, in 40 years, inflation will likely take a big bite out of that $4,179/month. You would be wiser to spend less in the beginning, so that you could increase your retirement withdrawals with inflation.
It is easy to calculate the inflation-adjusted expenditures your retirement savings could sustain. If you expect to consistently earn at least 4%/year in CDs, but you expect inflation to average 3%, you are expecting– roughly– only about a 1% real return on your investments per year. Enter “=PMT(Rate = 0.01/12, Nper = 480, $1,000,000)” into an Excel spreadsheet, and it will return a value of -$2,529, meaning you could withdraw $2,529/month the first month, and increase that amount by 3%/year for 40 years. This approach to retirement spending would smooth out the purchasing power of your retirement savings over your retirement.
Unfortunately, $2,529/month on a $1 million portfolio over a 40-year time span isn’t too exciting. But that’s what you may be stuck with if you stick to CDs.
Why loan the banks your money at such a low rate of interest? Why let them keep most of the profits from your capital?
So drop the CDs. And get some TIPS — that is, Treasury Inflation-Protected Securities — for your portfolio. As of Nov. 1, 2008, TIPS boasted a real yield of more than 3%/year. Try plugging “=PMT(Rate = 0.03/12, Nper = 480, $1,000,000)” into an Excel spreadsheet. A portfolio of TIPS consistently yielding 3%/year over a 40-year time frame would support inflation-adjusted retirement withdrawals of $3,580/month. This is 40% more than the inflation-adjusted withdrawals that the same portfolio, if invested in nominal 4% CDs, and assuming a 3% inflation rate, would sustain.