One common but mistaken idea out there is that one should never spend their principal. At first glance, this sort of thing might make sense.
“Well, if I never spend principal, I’ll never run out of money. So, I’ll just spend the income.”
If I really pin them down about where the principal will go, they admit it will go to their heirs. I then ask if I can be their heir, which sometimes gives them pause. In this post, I’ll explain just how costly this idea of only spending principal really is.
Let’s come up with a hypothetical but reasonable situation, and then we’ll run some numbers.
What Usually Happens
First, we need to consider the impact of Sequence of Returns Risk (SORR). One can run out of money in retirement, despite having solid average returns, if the crummy returns come first. That’s SORR. Combining a shrinking portfolio with regular withdrawals can do a real number on a nest egg, especially with higher inflation (which is when SORR really shows up).
However, SORR does not show up most of the time. So, the lower portfolio withdrawal rate people use to deal with the possibility of SORR is too low most of the time. In fact, historically speaking, if you withdraw the classic 4% of the original portfolio adjusted for inflation each year for 30 years, you are left with 2.7X more than what you originally had. Not only did you not run out of money before death, but you were almost three times as rich at death as at retirement. That’s what usually happens.
More information here:
Fear of the Decumulation Stage in Retirement
The Silliness of the Safe Withdrawal Rate Movement
What If You Spent Less?
If you spend even less than 4%, what would happen on average? You would leave even more behind than the 2.7X. Just spending the principal usually means spending less. Consider the recent yields on these popular investments:
VTI (Vanguard Total Stock Market ETF): 1.16%
VXUS (Vanguard Total International Stock Market ETF): 2.74%
BND (Vanguard Total Bond Market Index ETF): 4.25%
Let’s make up a random but reasonable asset allocation using these three funds. Let’s say 50% VTI, 25% VXUS, and 25% BND. What is the yield of this portfolio? It’s 2.33%. It should be more or less indexed to inflation, so we’ll just compare this straight across to the classic 4%.
If you need $200,000 from your portfolio in retirement and you are willing to spend 4% of it a year, you need a $5 million portfolio. If you save $75,000 a year and earn 5% real on it, you will get to $5 million in:
=NPER(5%,-75000,0,5000000) = 30 years
However, if you’re only willing to spend 2.33%, you’ll need $200,000/2.33%= $8.6 million. How much longer will it take to build an $8.6 million portfolio vs. a $5 million one?
=NPER(5%,-75000,0,8600000) = 39 years
It will take nine more years.
Which 9 Years?
But wait, it gets worse. Let’s talk about those nine years. Which ones are they?
Let’s say you came out of training at age 31, like I did. That means you hit your 30 years at age 61. So, those extra nine years are from age 61 to age 70. Basically, it’s the entire decade of your 60s. Now, I don’t want to tell you how to spend your 60s. Maybe you would prefer to spend them working hard. Maybe I will, too. Who knows? But I bet plenty of people would prefer NOT to spend their 60s that way.
The Go-Go Years
Retirement is often divided into the “go-go years,” the “slow-go years,” and the “no-go years.” My wife’s parents are in the go-go years. They’re 70ish and are frequently traveling and doing fun stuff. Sure, their bodies aren’t 50 anymore, much less 30, but they’re having fun, spending money, seeing the world, watching our kids while we see the world, etc. I don’t know how long these years last, but let’s say, on average, they last until you’re 75.
The Slow-Go Years
My parents are in the slow-go years. They’re 80ish, and they would like to travel a bit more. But they don’t really feel up to it. They’re constantly dealing with medical problems. They still get on a plane to see family, but that’s mostly if they can get non-stop, daytime, first-class flights and then some help in the airport. Perhaps the slow-go years last a decade, from 75-85.
The No-Go Years
My wife’s grandpa is in the no-go years. He’s in his 90s. He has even more medical problems than my parents, and I’m not sure he travels once every two years. Perhaps these years last from 85-95—probably well less than 10 years on average. They’re already over for all four of my grandparents and three of my wife’s four.
If the go-go years end at 75, someone who retires at 61 gets just 14 of them. Someone who retires at 70 only gets five of them. Basically, believing that you can only spend principal will cost you 2/3 of your go-go years.
They’re the best years of retirement, the real “Golden Years.” You spend them in the office, grinding it out to get a little larger nest egg you won’t be able to spend anyway. Your heirs may thank you, but more likely, they’ll share your regrets that that time/money wasn’t used in a way that led to more happiness and time together.
More information here:
We Keep Saying, ‘We Can Afford It, Spend the Money!’: Real Life Examples of How WCIers Live, Worry, and Withdraw Money in Retirement
Comparing Portfolio Withdrawal Strategies in Retirement
Are You Immortal?
“Never spend principal” only makes sense if you’re immortal. And maybe not even then. Frankly, a 3%-4% withdrawal rate will probably last indefinitely. Spending even less than that by only spending principal will definitely keep you from running out of money. But you’re trying to balance the risk of running out of money before you run out of time with the risk of running out of time before you run out of money.
Chasing Yield Has Its Downsides
“Au contraire,” you argue. “My portfolio has a much higher yield than 2.33%.” Maybe that’s fine, but an awful lot of portfolios with yields higher than that have a real problem. They’re not good portfolios. Remember, the 4% rule assumes you have a reasonable portfolio with solid long-term returns. Many “high-yield” portfolios do not.
People believe they’re spending yield when, in reality, they’re spending principal—and too much of it. Or there isn’t enough return left in the portfolio to index that yield to inflation, so the real yield falls over time. Chasing yields has its downsides. Even if you’re a master of real estate investing and somehow build a portfolio of properties with a 6% yield that is still increasing in value with inflation, you’re still spending less than you could if you just figured out a way to spend some of that principal along the way, too.
What do you think? Have you heard of “never spend principal?” Have you ever run the numbers on what that means? Is it worth sacrificing your 60s to your employer to be able to only spend principal?
