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How Should Retirement Spending Adjust to Investment Portfolio Performance?

A natural starting point for discussions about retirement spending is the 4% rule. William Bengen look at all the different 30 year periods in US history and found that withdrawing 4% of retirement date assets, and then subsequently adjusting the spending amount for inflation over the next 30 years, would have worked historically as a sustainable strategy.

But his assumption about inflation-adjusted spending is really just a research simplification.  Real people will adjust their spending in response to portfolio performance. As well, spending adjustments help by reducing exposure to what’s known as sequence of returns risk. Nonetheless, retirees generally do wish to maintain a consistent spending level, and so the question becomes when should one make spending adjustments in retirement? Countless answers to this question have been provided in the form of recommended variable spending strategies. Potential strategies can be found on Internet discussion boards and in research publications.

But it can be hard to compare different variable spending strategies to one another for several reasons. Suppose strategy A says one can initially spend 6% from their portfolio, while strategy B says one can initially spend 3% from their portfolio. Is strategy A twice as good? We can’t really answer this without more information. The withdrawal rate in strategy A may be higher simply because the researcher who created strategy A assumed higher investment returns for the underlying portfolio. Another concern is that strategy A might simply start with a high amount of spending in early retirement, but that spending will drop dramatically later in retirement, whereas strategy B might be able to maintain a relatively consistent amount of spending for a longer amount of time.

To try and bring some rigor to attempts at comparing different variable spending strategies, I recently completed a research article called “Making Sense Out of Variable Spending Strategies for Retirees” which is available online at SSRN and is now forthcoming at the Journal of Financial Planning. In the article, I compare 10 different spending strategies using the same underlying market return simulations. I also attempt to deal with the issue about how spending may evolve over retirement by looking at a number of different metrics about the strategy performance, and by calibrating strategies to what I am calling the PAY Rule™ for Retirement Spending. That formula is:

PAY Rule™ = Retiree Willingly Accepts an X% probability that spending falls below a threshold of $Y (in inflation-adjusted terms) by year Z of retirement

This allows for different variable spending strategies to be compared on a more equal basis. Strategies which I investigate include constant inflation-adjusted spending, spending a fixed percentage of the remaining portfolio, spending a percentage subject to floor and ceiling dollar amounts, using the Guyton and Klinger Decision Rules, letting spending be determined by the IRS Required Minimum Distribution rules, and using actuarial formulas which account for the expected return, remaining time horizon, current amount of assets, and the desired amount of remaining assets at the end of retirement.

These strategies do have different implications for feasible initial spending rates, spending patterns throughout retirement, and remaining wealth later in retirement. It’s important to consider all of this information when deciding on the best approach for one’s circumstances. There is no easy way to summarize the results, but I will plan to provide a deeper investigation of how these strategies perform, including some charts about spending and wealth, in subsequent columns at Forbes. In the mean time, the full research article does provide a richer discussion about how to compare different variable spending strategies for retirement.

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