Advisers put a considerable amount of effort into talking to clients about accumulating a life savings. But advisers and their clients tend to devote less thought to how to spend that money when it's time.
"If I have $1 million in my retirement account, how I'm going to distribute it is ninth out of 10 steps," said David A. Littell at the American College of Financial Services.
Littell has drawn up a list of 18 risks (http://tinyurl.com/oj5n3uk) that people have to consider. These include some you can control — spending too much — and some you can't, such as living longer than expected or needing expensive health care.
There are two basic ways to calculate what people can spend.
There is the linear calculation, based on a set percentage of the principal taken each year. This is commonly expressed as the 4 percent rule, though recent research has reduced that number to 3.5 or 3 percent. It is simple but fraught with risks.
On the investment return side, it requires people to be lucky and stop working just before their investments are set to rise. If they stop working and their investments fall, their annual draw will be lower.
A more advanced method is probability analysis. Advisers often present this strategy to clients by talking about Monte Carlo simulations that test thousands of probable outcomes to come up with the likelihood that a strategy will succeed.
Of the many other calculation methods, two in particular try to nudge people into the right behavior: the time-segmented approach and the use of funded ratios.
The first works by getting people to think of money lasting for certain time periods: the first 10 years, the next 10 and so on. Aaron Thiel of PNC Wealth Management says he advises clients to set up a series of accounts that will be liquidated over that period and replaced by the next account.
A newer and more dynamic approach is to borrow the concept of funded ratios from the pension fund world. The funded ratio is calculated by doing a present-value calculation of the amount of money someone has saved or will receive — say, from Social Security or a pension — and comparing it with basic and desired expenses and life expectancy.
Timothy Noonan of Russell Investments gives the example of a couple having saved $775,000 by their early 60s and counting on $38,000 a year from Social Security. They're debating between needing $60,000 a year and $72,000 a year (including Social Security) for their expected life expectancies. With the former, they're 152 percent funded; with the latter, that number drops to 98 percent.
Ideally, Noonan said, people should aim to get to 135 percent funded, which would insulate them from most shocks.