Seeking A Fixed Percentage Approach To Retirement Spending
The fixed percentage withdrawal strategy is the polar opposite of constant inflation-adjusted spending. Subsequent strategies we consider will strive to strike a balance between these two. This fixed percentage strategy calls for retirees to spend a constant percentage of the remaining portfolio balance in each year of retirement.
The first advantage of this strategy is that, since it always spends a percentage of what remains, it never depletes the portfolio. Of course, spending could fall to uncomfortably low levels, but the concept of portfolio failure rates are incompatible here. In addition, spending is allowed to increase when market returns outpace the retirement distributions and the portfolio grows.
A second advantage of this rule is that it completely eliminates sequence of returns risk, as Dirk Cotton first pointed out in 2014 at his Retirement Café blog. The fixed percentage approach provides a clear mechanism for reducing spending after a portfolio decline, thus removing such a risk.
As with investing a lump-sum of assets, the specific order of returns makes no difference to the final outcomes realized with this strategy. As such, we can expect the sustainable spending rate to be higher than with constant inflation-adjusted withdrawals.
As for disadvantages, when combined with volatile investments, spending can become extremely volatile with this strategy, making it difficult for retirees to budget in advance. For a fixed retirement budget, managing retirement with this rule could be a particular challenge. Those considering this rule should probably be thinking in terms of applying it to discretionary expenses that allow more flexibility for spending reductions that will not derail a retiree’s standard of living.
Exhibit 1 shows how this rule performed with the same 50/50 portfolio in the sixty-one rolling historical periods from US history since 1926 for a 4% initial withdrawal rate. Occasionally the popular press will mistakenly define the 4% rule this way (withdraw 4% of the remaining account balance each year), but the accepted definition of the 4% rule is the constant inflation-adjustment spending strategy defined earlier.
To be clear, with constant inflation-adjusted spending, the withdrawal rate will change throughout retirement as the portfolio value changes. The withdrawal rate adjusts while spending stays the same. But with the fixed percentage rule, the withdrawal rate stays the same while spending adjusts.
Spending is naturally more volatile with the fixed percentage strategy. After thirty years, spending ranges from $2.67 to $9.10 in real terms, relative to the initial $4 spent from a $100 portfolio. At the same time, remaining wealth is less volatile than before, as the range after thirty years is $76.71 to $230.74.
In both cases, spending and wealth were lower in the worst cases from the middle part of retirement, approaching low points of $2 from a portfolio with $50 left. In the historical data, poor market environments in early retirement (which led to these low points) were followed by better market environments in the latter part of retirement.
Because spending declined along with the portfolio as the spending rate remained constant at 4%, portfolio losses were not locked in and the spending rate was not forced upward to meet the spending goal, thus avoiding sequence of returns risk, helping preserve the portfolio and letting it subsequently grow.
The disadvantage, as Exhibit 1 clearly reveals, is that spending paths were quite volatile with this strategy throughout history.
Exhibit 1 Time Path of Real Spending and Wealth
Fixed Percentage Withdrawals
For 4% Initial Spending Rate, 50/50 Asset Allocation, Rolling 30-Year Retirements
Using SBBI Data, 1926-2015, S&P 500 and Intermediate-Term Government Bonds
On the retirement spending strategy spectrum, these first two strategies represent the opposite extremes. The fixed percentage rule can be seen on the far left with volatile spending but a portfolio that technically cannot be depleted. On the far right is the constant inflation-adjusted rule, offering predictable spending (as long as assets remain), but a portfolio that can be depleted, reducing spending to zero.
In reality, neither end of the spectrum is an ideal place for most retirees. The other strategies we will discuss seek a compromise between these two extremes by including a mechanism to smooth spending adjustments made in response to market volatility. Many strategies seek to obtain some advantages of the fixed percentage rule, while also reducing the frequency and size of spending adjustments and placing bounds on how far spending can increase or decrease.