Worried about running out of money during retirement? Well, that's a legitimate concern. But "running out of money" isn't a very exact term.
Most retirees will never run out of income. They will always have “permanent income” from Social Security (and maybe a pension). What retirees need to worry about is running out of investments and investment income.
Few retirees will be able to live on permanent income (Social Security and pensions) until they die. At some point, expenditures will exceed permanent income. Retirees then need to start withdrawing from their investments to supplement permanent income. The Investment withdrawals need to last as long as the retiree is alive.
Investments are not guaranteed to last forever. If too much is withdrawn, the investments are exhausted and investment income stops. Retirees must then reduce expenditures to the level of their permanent income.
There are three phases during this process. Here is a hypothetical example:
- Surplus: Social Security and pension payments exceed expenditures. No investment withdrawals are needed.
- Deficit: Expenditures exceed the retiree’s income. Investment withdrawals are used to supplement payments from Social Security and pensions.
- Investments exhausted: Investments decline to zero. Investment income ends and expenditures must decrease to the amount provided by the permanent income.
Retirees are more likely to exhaust investments if
- They live a long time
- Investment returns are too low
- Investment withdrawals are too high
- They need long-term care and don’t own long-term care insurance.
One purpose of a financial plan is to estimate whether your investments are sufficient to fund your retirement or whether they might be exhausted while you are still alive.