How exactly should retirees adjust their spending in response to changes in the value of their retirement portfolios? Countless variations on spending rules are discussed everywhere from research papers to internet discussion boards.
I want to bring clarity to the discussion by identifying and classifying key variable spending strategies, and developing simple metrics to evaluate and compare the strategies on an equal basis. The goal is to assist in the process of figuring out which sort of variable spending strategy will be most appropriate for your personal situation.
When comparing different spending strategies, there are a number of useful metrics to consider. Of primary importance is the range of spending outcomes over time and the value of remaining wealth at the end of the planning horizon.
For these aspects, strategies will be calibrated to have comparable downside risk using the PAY Rule™ described below. It is also important to consider the direction of spending over retirement: Does a strategy tend to keep spending level over time? Does spending start high and decrease over time? Does spending start low and increase over time? The final consideration is the degree of spending volatility created by a strategy. How much does spending change on a year-to-year basis?
Those with fixed budgets may be willing to accept lower average spending in order to create more stability for annual expenditures.
Variable spending rules are rarely evaluated with matching data and assumptions, making it difficult to adequately compare the downside risks for different strategies. If one rule suggests a 6% withdrawal rate while another suggests a 3% withdrawal rate, it doesn’t necessarily mean the first rule is twice as powerful. It might simply be based on higher market return assumptions. In order to properly compare different strategies, we must begin with the same set of capital market assumptions.
We should also look at where we are situated in the distribution of possible spending and wealth outcomes. Building a retirement income strategy involves numerous tradeoffs, and one metric (such as the probability of failure) cannot summarize the overall performance of a strategy.
Higher spending upfront means running a greater risk of having less to spend later. More aggressive asset allocation means greater upside potential for spending growth and legacy, but downside risk would increase as well. Naturally, greater spending means fewer assets for a legacy.
Spending evolves differently depending on the random sequence of market returns, and retirees have to decide where to focus their concerns.
The traditional failure rate (which calculates the probability of portfolio depletion) often employed by safe withdrawal rate studies cannot be used to compare variable spending strategies as it only tracks portfolio depletion. Different variable strategies may imply different spending levels just prior to depletion.
For instance, a 6% variable spending strategy may cause spending to fall to $20,000 per year as portfolio depletion nears, while the 3% strategy might maintain spending at $50,000 until depletion. Failure rates ignore this important distinction and focus solely on the depletion event.
This reflects a general theme in variable withdrawal rate literature: the more the retiree is willing to let their spending drop in retirement, the higher the initial spending rate they may use. Technically, some variable spending strategies will never fail.
For instance, when spending is always calculated as a percentage of remaining assets, even a 99% withdrawal rate never runs out (though it may be tough to slice up that last remaining penny).
In addition, portfolio failure rates do not account for other income generating assets you might have in your portfolio. Cutting spending from a portfolio may not be disastrous if you already receive plenty of income from other sources such as Social Security, pensions, and income annuities.
The bottom line should be how potential spending reductions from a portfolio will impact the overall lifestyle of the retiree, with all non-portfolio sources of income taken into consideration. Failure—defined strictly as investment portfolio depletion—is not the whole story.
The failure rate is an extreme outcome measure that only considers financial wealth depletion. Retiree spending potential is irrelevant. Retirees must find an appropriate personal balance between spending more and making potentially larger subsequent cutbacks in the event of a long life and poor market returns.
By focusing only on the failure rate, retirees could end up leaving behind an unintentionally large legacy and not enjoying retirement as much as possible.