# Making Sense Out of Variable Spending Strategies for Retirees

*Originally published in the Journal of Financial Planning*

**Executive Summary**

- Variable spending strategies can be situated on a continuum between two extremes: spending a constant amount from the portfolio each year without regard for the remaining portfolio balance, and spending a fixed percentage of the remaining portfolio balance.
- Variable spending strategies seek a compromise between these extremes by avoiding too many spending cuts while also protecting against the risk that spending must subsequently fall to uncomfortably low levels.
- This paper reviews two basic categories for variable spending rules: decision rule methods and actuarial methods.
- Ten strategies were compared using a consistent set of portfolio return and fee assumptions using the following PAY Rule™ to calibrate initial spending: the client willingly accepts an X percent probability that spending falls below a threshold of $Y (in inflation-adjusted terms) by year Z of retirement.
- This paper provides 13 numbers to summarize the performance of a strategy, including the initial spending rate, the evolution of real spending over 30 years at different points in the distribution of outcomes, and the distribution of remaining real wealth after 30 years.

Bengen (1994) introduced the concept of the 4 percent rule for retirement withdrawals. He defined the sustainable spending rate as the percentage of retirement date assets that can be withdrawn, with this amount adjusted for inflation in subsequent years, such that the retirement portfolio is not depleted for at least 30 years. Specifically, Bengen found that a 4 percent initial spending rate would have been sustainable in the worst-case scenario from U.S. historical data over rolling 30-year periods with a stock allocation of between 50 percent and 75 percent.

In an attempt to illustrate the importance of the sequence of investment returns on retirement spending outcomes, which highlighted how it is wrong to base a sustainable spending rate on a fixed average return assumption plugged into a spreadsheet, Bengen (1994) used a number of simplifying assumptions. Among these was the previously mentioned constant inflation-adjusted spending assumption. This was a simplification to obtain a general guideline about feasible retirement spending.

Although the assumption may reflect the preferences of many retirees to smooth their spending as much as possible, typical clients can be expected to vary their spending over time. Clients will generally not keep their spending constant as their portfolios plummet toward zero. And constant spending from a volatile portfolio is a unique source of sequence of returns risk that can be partially alleviated by reducing spending when a portfolio drops in value.

But how exactly should clients adjust their spending patterns in response to changes in the value of their retirement portfolios? Countless variations on spending rules are discussed in outlets ranging from research papers to internet discussion boards. The purpose of this paper is to identify and classify key variable spending strategies, and to develop simple metrics to evaluate and compare the strategies on an equal basis.

**Forget the “Failure Rate”**

As will be discussed, the frequently used “failure rate” metric should not be applied to variable spending rules. Other approaches are needed. The aim here is to assist financial planners and their clients in figuring out which sort of variable spending strategy will be most appropriate for their situations. This holistic evaluation is important for a number of reasons.

To begin with, variable spending rules are usually described and evaluated using different data and assumptions. As such, if one rule suggests a 6 percent withdrawal rate while another suggests a 3 percent withdrawal rate, it is difficult to know whether the first rule is really twice as powerful. The difference could just reflect different underlying assumptions, such as higher market returns. It is important to use the same set of capital market and fee assumptions to properly compare strategies.

Financial planners must also worry about where clients are situated in the distribution of possible spending and wealth outcomes. Many trade-offs are involved with building a retirement income strategy, and one metric cannot summarize the overall performance of a strategy. Spending more at the start of retirement creates a greater risk for having to spend less later. A more aggressive asset allocation creates greater upside potential for spending growth and legacy, but it leads to greater downside risk as well. Naturally, regarding legacy, greater spending implies that fewer assets will remain. Spending can evolve differently depending on the random sequence of market returns. Clients must decide where to focus their concerns.

The traditional failure rate measure often employed by safe withdrawal rate studies (those that calculate the probability of portfolio depletion) cannot be used to compare variable spending strategies. This approach only tracks portfolio depletion, and different variable strategies may imply different spending levels just prior to wealth depletion. For instance, a 6 percent variable spending strategy may cause spending to fall to $20,000 per year in the period leading up to portfolio depletion, while a 3 percent strategy might result in spending at $50,000 until depletion. Failure rates ignore this important distinction because the depletion event is all that matters. This is important because it reflects a general theme in the variable withdrawal rate literature: the more the client is willing to let their spending drop in retirement, the higher the initial spending rate they may use.

A related problem is that some variable spending strategies can technically never fail. For instance, when calculating spending as a percentage of remaining assets, even a 99 percent withdrawal rate never runs out. Portfolio failure rates also do not reflect a client’s entire household balance sheet of assets for income generation. Cutting spending from a portfolio may not be so disastrous for clients who receive plenty of income from other sources such as Social Security, pensions, and income annuities. It is important to consider how potential spending reductions from a portfolio will impact the overall lifestyle of the client after also incorporating all of their other non-portfolio sources of income. Failure, defined strictly as investment portfolio depletion, is not the whole story.

The failure rate is also an extreme outcome measure that puts weight only on financial wealth depletion. Client spending potential is irrelevant. Clients must find an appropriate personal balance between the aims of spending more and then having to make potentially larger subsequent cutbacks in the event of a long life and a sequence of poor market returns. By focusing only on the failure rate, clients may end up bequeathing a large amount of assets and not enjoying their retirements as much as possible.

**An Alternative to Failure Rates**

As an alternative to failure rates, this paper suggests comparing the distribution of outcomes for spending and remaining wealth for different strategies, and calibrating initial spending rates using the following customized “PAY Rule™” determined by the financial planner and client:

**PAY Rule™** = Client willingly accepts an** X percent** probability that spending falls below a threshold of **$Y** (in inflation-adjusted terms) by **year Z** of retirement.

For instance, instead of accepting a 10 percent chance of failure within the first 30 years of retirement, the PAY Rule™ could be that the client accepts a 10 percent chance that their spending level falls below an inflation-adjusted $60,000 by the 30th year of retirement. This calculation can incorporate Social Security and other income sources as well, and it provides a way to compare strategies while otherwise dealing with the reality that higher initial spending rates can be justified if spending is subsequently allowed to drop more steeply.

The formula provides a controlled anchor for those spending drops. When combined with consistent market assumptions and a view of the entire distribution of outcomes, financial planners can compare different variable strategies on an equal footing.