Three Functions of Retirement Savings

OK. So you’ve built up this nice big pot of assets on which to retire. As you embark on the difficult quest of adopting a retirement spending plan—your scheme for determining how much you’re going to allow yourself to spend each year—your allowance, as it were—it’s helpful to consider the three main functions of that cache. Here they are in order of importance, at least for most people:

1. A source for your annual retirement spending. Duh.
2. A reserve for unanticipated emergencies.
3. An inheritance for your heirs, usually your kids.

Let me dwell on these functions in reverse order.

Inheritance. Not so important for most people. You’re struggling just to maintain your own lifestyle, so how can you give any weight to luxuries for the next generation? So function #3 is strictly on the back burner. But two points are worth noting.

First, at some point, if the pot is large enough, the marginal utility of spending another dollar on your standard of living is just not enough to outweigh the pleasure you’d get from leaving—or giving—something to your kids. Maybe you’d rather help them make a down payment on their first house than buy yourself that pearl-handled backscratcher you admired in the window at Tiffany’s.

Second, as discussed in March 20’s post, leaving an inheritance is an inevitable, if unintended, by-product of not knowing how long you and your spouse are going to live.

Emergency Reserve. Stuff happens. You plan to spend your assets roughly equally each year, but then the roof springs a leak. Or Bowser contracts canine chilblains. Whatever. Even if you do your financial planning perfectly, and your investments perform just as you project (which they won’t; I’m just making a point here) life will hit you with your own personalized pig bladder. So you need to keep a reserve for the inevitable unexpected. (Is it correct to call the inevitable “unexpected”? Probably not.)

Note, however, that your need for an emergency reserve shrinks with your shrinking life expectancy. One year older? That’s one less year of financial curveballs ahead of you.

Retirement Spending. The main function of that pot you’ve accumulated (the financial one; not the one hanging over your belt) is to provide a stream of spending for your indeterminate lifetime. While you don’t know how much you’re going to need for the future, you have a rough sense that it shrinks as you get older: fewer years left to spend on yourself; fewer years to get stung by crummy financial markets. So perhaps the percentage of assets that you spend should somehow—slowly and conservatively, but somehow—grow with the passing years. Maybe an 85-year old can prudently spend a bigger percentage of her assets than a newly superannuated 65-year old.

So those are the three main functions of your treasure trove. (What have I left out? Send me an email or post a comment.) Now the tricky part is to translate these generalizations into a scheme for spending your assets prudently. More to come on this—much more.