The Perks Of Being A Flexible Spender In Retirement
In 1994 Bill Bengen introduced the concept of the 4% rule for retirement withdrawals. He defined the sustainable spending rate as the percentage of retirement date assets which can be withdrawn, with this amount adjusted for inflation in subsequent years, such that the retirement portfolio is not depleted for at least thirty years.
Specifically, Bengen found that a 4% initial spending rate would have been sustainable in the worst-case scenario from US historical data over rolling thirty-year periods with a stock allocation of between 50 and 75%.
Bengen used a number of simplifying assumptions (understandably so) in an attempt to illustrate the importance of the sequence of investment returns on retirement spending outcomes. Among these is the previously mentioned constant inflation-adjusted spending assumption. It was a simplification to obtain a general guideline about feasible retirement spending.
While this assumption may reflect the preferences of many retirees to smooth their spending as much as possible, real-world individuals inevitably vary their spending over time. Retirees will not play the implied game of chicken by keeping their spending constant as their portfolios plummet toward zero. It is an unrealistic assumption.
Being flexible with spending matters a great deal. Constant spending from a volatile portfolio is a unique source of sequence of returns risk that can be partially alleviated by reducing spending when the portfolio drops in value.
With flexibility, the initial withdrawal rate can increase by more than one might think on account of the synergies created through decreasing sequence risk. In this regard, estimates obtained with a constant inflation-adjusted spending assumption may be overly conservative for those willing and able to adjust their spending over time.
Variable Spending Strategies
Our attention now shifts to variable spending strategies for retirement. We still focus on probability-based strategies, which rely on a total-returns investment approach, where the principal value of the portfolio may be spent as needed in addition to any interest and dividends generated by the portfolio.
The mechanism for managing sequence risk, though, is to allow spending to fluctuate over time. Reducing spending in the event of a market decline provides a release valve for sequence of returns risk that can allow the initial withdrawal rate to increase.
Managing sequence of returns risk in this manner allows synergies to develop, making it possible to keep spending more than a constant-inflation adjusted strategy without any flexibility, while maintaining the same overall risk for portfolio depletion.
Sustainable spending rates for retirees depend on many factors: asset allocation, present market valuations (particularly, current interest rates), the desired spending pattern over time, the degree of budget flexibility to adjust spending in response to market performance, the desire to preserve a portion of the portfolio over long periods of time, and the length of the planning horizon.
The assumptions that went into creating the 4% rule represent a number of simplifications for research purposes; the matter explored in great depth now is what happens when spending is not kept constant in inflation-adjusted terms.
A sustainable spending strategy will generally seek to provide a proper balance among three goals:
- Preserve some portion of the underlying portfolio (in inflation-adjusted terms)
- Maximize spending to meet current budgetary needs
- Stabilize spending to keep pace with inflation and meet future budgetary needs with low risk of significant spending cuts
Many retirees place a great deal of importance on preserving the underlying value of the assets so they can support distributions for many years to come.
At the same time, current budgetary needs call for the freedom to spend as much as possible at the present. With a long-term perspective, retirees seek to spend as much as they can on a sustainable basis without risking drastic cuts to future budgets.
There are tradeoffs between these objectives. Most obviously, spending more today creates risk for future asset preservation and/or future spending goals.
In addition, a lack of flexibility to adjust spending from a volatile portfolio uniquely amplifies sequence risk. With inflexibility to adjust spending, a more conservative spending rate is the primary risk management technique for a total-returns investment portfolio.
This spending lever usually leads to an unnecessarily low lifestyle in retirement, and it is also not an efficient solution to sustaining spending. In an investments world, even a little discretion to adjust spending can go a long way toward boosting retirement spending.
The idea is to start with a higher withdrawal rate with the idea in mind to reduce spending if needed at some future point. Flexibility with spending creates synergies that allow for a higher initial spending rate.