Retirement risk: Spending too little on your nest egg

When thinking about how much they should save for retirement, and then how to use that money wisely in retirement, many people worry about the risk of running out of money prematurely. They fear the possibility of overspending.

But financial experts say there’s another danger that’s less recognized. That’s the risk of spending too much money.

“Overspending is risky, but so is underspending,” says Zach Teutsch, a member of CNBC’s Financial Advisor Council and founder of Values ​​Added Financial in Washington.

Data shows that’s what’s happening to many retirees.

A recent study by the Employee Benefit Research Institute, a nonpartisan research group, found that by the time they reach their mid-80s, about one-third of retirees still have more than 100% of their original savings remaining.

“When you see so many people keeping 100% into their 80s, it suggests that some people are being too conservative[with their spending],” said Craig Copeland, head of wealth benefits research at EBRI.

Of course, the opposite is also true, Copeland said: “There are other people who have less than 20%[of their assets left]and are in a different situation where they say, ‘I won’t be able to do anything if I live another five years.'”

According to EBRI research, about one-fifth of people who entered retirement with assets of $500,000 or more had less than 20% of their assets remaining by their mid-80s.

“This is going to be the biggest challenge in retirement: figuring out how to maximize your retirement savings and still have some cushion at the end of the day,” Copeland said.

The risks of overspending are obvious. As you get older and your savings run out, it can be difficult to afford basic necessities, let alone enjoy your later years. This is even more true if you don’t have a guaranteed source of income, such as Social Security.

The risk of underspending may not be so obvious.

But financial advisors say it all boils down to the same thing: you’re not living the full life you want.

“This represents a life not lived, a vacation not taken because you were worried you would run out of money,” said Marianela Collado, a certified financial planner and CPA based in Plantation, Florida. She is also a member of CNBC’s Financial Advisor Council.

Financial experts say it’s a difficult psychological leap for many people to go from a savings mindset where their net worth continues to steadily increase to one where their net worth decreases as they drain their nest eggs.

“Some people spend their entire lives saving money, and then it’s very difficult to switch to drawing down assets,” Copeland says. “It’s not a comfortable feeling.”

Many of the current retirees also lived through “an era of very good capital markets,” with years of double-digit annual stock returns after the 2008 financial crisis, Copeland said.

This dynamic has made it easier to maintain and build wealth in retirement, he said.

Teutsch said he likes to use a customer analogy to explain the risk of underspending. Imagine you are sailing through a strait. The rocks on one side of the waterway represent missing money. On the other side is a rock representing the risk of missing out on the experience.

“Ultimately, if you sail too far in the opposite direction, you will regret it and abandon ship,” Teutsch said.

“I hope people don’t look back and say, ‘I have more than I need, which means I didn’t have to work nights and weekends, or I could have spent more time with my kids and family, or I could have donated more (money),'” he said.

Retirees shouldn’t be afraid to enjoy the money they’ve spent years working hard to save — and rightfully so, financial advisors say. This is especially true in the early years of retirement, when retirees are more likely to be mobile and active than later in life, the researchers said.

Ultimately, that money will likely be inherited or donated to charity on behalf of the retiree, but they won’t get a chance to enjoy it, advisers said.

“As long as the financial plan shows it’s a good idea, I encourage my clients to donate money to their favorite activities, their children, and to live well when they’re alive and able to enjoy it,” Teutsch said. “(For example) when you help someone buy a house, you get a lot of enjoyment out of it.”

Advisers say it’s difficult to assess how best to use your nest egg from year to year because there are so many unknown factors that can greatly influence your success.

For example, it is impossible to predict a person’s lifespan, as is the future return on financial assets.

Retirees must also increasingly rely on 401(k)-type plans, which require them to manage savings rates and investments and decide how to turn that lump sum into future income. Previous generations were more likely to receive a pension and delegate much of its complexity to their employer.

However, financial planners say there are some guidelines for do-it-yourselfers.

For example, the 4% rule is a “very good starting point,” Collard said.

This rule of thumb gives a rough estimate of how much money retirees can withdraw from their savings each year to increase their chances of not running out of money after 30 years.

Retirees would withdraw 4% of their portfolio in the first year and receive a “raise” in the second year based on the rate of inflation. The same applies from the third year onwards. These funds would be stacked on top of other sources of income, such as Social Security.

For example, an investor would withdraw $40,000 from a $1 million portfolio in the first year of retirement, or 4% of the total. If your cost of living increases by 2% that year, your next year’s withdrawal amount will increase by $40,800, or 2%. An additional 2% cost of living increase in year 3 would equate to a withdrawal of $41,616. and so on.

One caveat: Retirees should make sure they’re withdrawing enough from their retirement accounts to at least cover required minimum distributions, the advisers said.

But the 4% rule is not perfect and uses conservative assumptions, which could lead to underspending, advisers said.

Retirees could also consider a “dynamic spending” approach, where they spend flexibly based on market conditions, rather than static spending as the 4% rule suggests, Teutsch said.

For example, in years when stock returns are positive, retirees may withdraw more money (perhaps 7%), and in weak years they may reduce that amount to, say, 2.5%, he said.

Retirees’ spending tends to be more U-shaped than static, he said, with retirees typically spending more early in retirement when they’re more active, cutting back when they inevitably slow down a bit, and then spending more in later life, when the need for expensive long-term care may increase.

A dynamic approach also helps reduce what is known as “chain of return risk.” This puts retirees at greater risk of underfunding their retirement by exiting stocks when the stock market is down. Advisers say this risk increases early in retirement.

In a year like this, retirees may also consider “dynamic earning” strategies, Teutsch said. For example, someone with a side hustle might be able to supplement their portfolio income by working a few hours a week on something like a consulting project, he said.