Being frugal is a great way to set yourself up for retirement. But once you’re actually retired, that thriftiness can get in the way of enjoying what should be the most relaxing time of your life.
Many workers carry their financial instincts with them into retirement, which not only leads to them not spending on things they actually want, but also can lead them down a path of risky investment. That's the thesis of Meir Statman, a finance professor and an expert on the intersection of psychology and economics, who described the phenomenon in a recent essay in the Wall Street Journal.
Conventional wisdom states that there are two types of money: income, which includes all your wages and other earnings; and capital, which is all your money tied up in investments. The financially savvy, as the wisdom goes, spend their income but not their capital.
That’s a great way to build up a nest egg. But once your income plummets after retirement (as most do), there is a good chance dipping into your capital a bit is the only way to maintain a happy standard of living.
To use an example Statman discusses: Say a 65-year-old with a $1 million stock portfolio needs $40,000 a year to maintain his lifestyle. If he earns $20,000 a year from a 2% dividend yield on his stock holdings and takes out another $20,000 from a 2% increase in the value of his stocks, he can maintain his standard of living while keeping his net worth steady. But since doing so would require cashing out some of his capital holdings, which would break the “spend income but not capital” rule, he may default back to conventional wisdom and simply keep his money in his stock portfolio. As a result, he will end up making sacrifices in other areas of his life to make up for the shortfall between the $40,000 cost of his standard of living and his $20,000 dividend income.
One factor that plays into why so many retirees are reluctant to spend their money is that they often overestimate how much longer they will live. They also overestimate how much they'll spend as they age, even if they do have long retirements: Generally, the older people get, the less they tend to spend.
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Retirees who grow fearful about outliving their money may try to increase their returns by embracing riskier investment strategies. They may buy high-yield bonds, which default at a higher rate, or dive head first into stocks that promise high dividends but carry risks of their own, and may also make their portfolios less diverse.
Many also fall into the trap of thinking they can use their newfound free time to do a lot of research and try to beat the stock market. Not only is that more than likely a losing proposition, it also fails to take into account the major difference between investing as someone who works as opposed to investing as a retiree.
Younger people have tons of “human capital,” in the form all the earnings they are likely to make over the course of their working life. If they take a hit from the market, their human capital will soften the blow and help them catch up. Retirees, on the other hand, have little or no such capital to fall back on should their market bets blow up.
Statman notes that one option to help retirees avoid these quandaries is setting up a “managed payout” fund, where a percentage of a portfolio’s value is paid out to the retiree in previously arranged installments. Many retirees are getting this automatically thanks to "required minimum distributions," government-mandated withdrawals from certain retirement accounts that kick in once a retiree passes age 70 1/2. The fixed-payout schedule of these plans can help encourage retirees to spend money that they otherwise might have kept tied up in their investments.
Smart and frugal financial decisions are the best course of action in ensuring you’ll have enough money after you have stopped working. But the day you clock out for the final time, you should also be re-evaluating just how tight to keep your purse strings.