Spend more than you earn in retirement? Good luck with that!

By Slow Dad - February 10, 2017

Retiring at 40 means you're potentially retired for 60+ years. Don't overestimate your investment growth rates once you stop saving & start spending.
My year 9 science teacher once proclaimed that the difference between magic and science was understanding how things worked. Her sentiment was both valid and admirable, even if she (like so many people) allowed herself to believe in “magic” when it was convenient to do so… like the time that the science lab curtains caught on fire at almost exactly the same time that one of her class favourites managed to singe off his eyebrows!

People who write about Financial Independence go on, and on, and on about the “magic” of compound interest. Except it isn’t magic, it is basic math. Unfortunately most of those personal finance writers actually mean compound returns, such as reinvesting dividends, rather than plain old bank interest.

Albert Einstein famously (didn’t) proclaim that compounding was “the most powerful force in the universe”.

Why does this matter?

Well if you examine the price chart of the S&P500 over the last 30 years in Google Finance or Yahoo Finance or many of the other free stock charting services you will be presented with a very impressive price increase of around 800%. That is represented by the green line on the chart below.

However if you had reinvested any dividends paid out by the stocks comprising the S&P500 over that 30 year period than you’d have achieved a total return of around 1600%. That is represented by the blue line on the chart below.

S&P500 30 year price and total return chart
S&P500 30 year price and total return chart
So clearly the compounding “magic” of reinvesting dividends produces significantly higher investment returns.

For those of you who think in numbers rather than pretty pictures consider the S&P500 return calculator outputs below. The box on the left represents the nominal returns, the one on the right represents the real (i.e. after inflation) returns over that same 30 year period.

S&P 500 30 year nominal and real returns
S&P 500 30 year nominal and real returns
Note the price only returns are roughly half the size of the total returns where dividends have been reinvested.

That is interesting up to a point, but why should you care?

Well if you’ve been happily compounding your returns for a while, you will likely have become accustomed to a certain rate that your net worth figures increase. It is easy to become complacent.

Once you escape the daily grind and head towards retirement things are likely to change somewhat.

For a start the amount of your income that came from wages will cease. Chances are pretty good you were saving a certain portion of that income, so those savings will cease too. You were probably investing some of those savings, so the rate at which your pile of investments was growing will slow down as a result.

Next you’re probably going to want to fill that earnings void, a person has got to eat and pay the rent after all! If you don’t fancy diving back into the work force then the logical place to turn for an alternative income stream would be your investments.

Many investors like the idea of living off the income thrown off by their investments. Under this spending any dividend, interest, rent and royalty income is fine providing you don’t touch your capital. The logic here is that your capital can continue to grow, hopefully outpacing inflation, and provide you with an infinitely sustainable income stream for the rest of your days. Once you don’t need it any more then your nearest and dearest get a nice inheritance to help make their own lives a bit more financially comfortable.

The figures above suggest withdrawing rather than reinvesting dividends over the last 30 years would have seen the annualised rate your portfolio grew reduced by roughly one third.

The average nominal dividend yield for the S&P500 over the last 30 years could not be described as spectacular, around 3%. For much of that period the CPI inflation rate has been higher.

S&P 500 30 year Dividend Yield
S&P 500 30 year Dividend Yield
Therefore disciples of the 4% “safe” withdrawal rate cult would expect to see the rate of growth reduce even further, as not only are they effectively drawing out all the earnings their investments threw off but they are also selling down some of the capital.

Folks pursuing the FIRE dream tend to save hard, live (somewhat) frugally, and throw all their surplus funds into investments. If the market gods smile then those investments grow, and money makes money.

However once the flow of money reverses, trickling out of the investments to support the investor’s cost of living during in their retirement years, then expect that rate of that growth to slow considerably.

Aren't you just stating the bleeding obvious?

Yes. Yes I am.

When you think about it somebody achieving FIRE got there by spending less than they earned, and investing the difference. Pretty simple right?

After retirement however many of these same people seem to think that rule no longer applies, as they then intend to spend (dividends + capital draw down) more than they earn (dividends alone).

They seem to forget that a 4% rule "success" was deemed to still have at least $1 left at the end of a 30 year historical period. That is a whole world of difference from still having the bulk of their capital in tact to sustain them through the next 30+ years potential of their retirement.

So what?

Someone retiring at age 40 could quite conceivably live until they were 100, they should be aiming for their wealth to sustain them at least that long.

It is easy to take for granted an annualised growth rate experienced while the investor is regularly chipping in with savings, but any post-retirement forecasting should be using a lot more conservative view of what would be considered normal from that point forward.

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