Unraveling Retirement Strategies: Variable Spending from a Volatile Portfolio

 In Unraveling Retirement Strategies: Constant-Dollar Spending (4% Rule), I described retirement funding strategies like the “4% Rule” that base portfolio spending on a calculation made at the beginning of retirement that remains unchanged in real dollars regardless of how the household’s finances unfold over time.

Constant-dollar spending is like the Stephen Colbert joke about a man whose beliefs are constant. He believes the same thing on Thursday that he believed on Tuesday … no matter what happened on Wednesday.

That doesn’t work well for retirement planning, either.

Variable-spending strategies are similar to constant-dollar strategies in that they spend periodically from an investment portfolio but differ in that they spend a periodically updated amount based on portfolio performance – they spend more in good markets and less in bad markets.

This is a huge difference. We have two basic choices in portfolio-drawdown strategies: spend a predictable amount annually and risk depleting our portfolio or spend an unpredictable, possibly painful, amount annually to avoid portfolio depletion.

Spending strategies, including these two, explore ways to draw down a portfolio without outliving it but they do so without considering the expense side of the equation.

Regardless of which of these strategies you choose, you will spend the amount you need to spend after retiring. If you need a kidney operation or a new roof or a check for the IRS, you will pay for those things regardless of what your spending strategy recommends. That will increase your chances of outliving your savings but that risk isn’t considered by these “income-side” strategies.

There are many variable spending strategies. I recently attended a webinar in which Wade Pfau identified a half dozen of the better known and in Making Sense Out of Variable Spending Strategies for Retirees[1] he compares several more.

Joe Tomlinson, Steve Vernon and Wade Pfau recently recommended using the spending percentage for Required Minimum Distributions (RMDs) from qualified retirement accounts[2]. Vernon provides a summary of the study in “How to Pensionize Any IRA or 401(k).”[6]

RMD is based on the assumption of a retiree and a spouse 10 years younger. Retirees closer in age to their spouse can perhaps use the Modified RMD strategy and spend 10% more. Your investment company will calculate RMDs for your qualified retirement accounts when the time comes or you can find a calculator online.[3] You are required by tax law to use these calculations on tax-deferred retirement accounts but you can, of course, use them on all types accounts if you choose.

Another strategy is to spend a fixed percentage, say the same 4%, of the new portfolio balance each year, though the safe spending rate actually increases as life expectancy decreases. It makes more sense to spend that gradually-increasing percentage of one’s current portfolio balance each year than to always spend a fixed percentage of a changing portfolio balance. It approaches 10% late in retirement but grows slowly at first.

Most Americans are eligible for Social Security benefits so most have a floor. It may not be an adequate floor in the event that your portfolio is depleted, but it is a floor. The variable spending strategies and the constant-dollar strategies, therefore, technically manage the upside portfolio of a floor-and-upside strategy and will rarely be a standalone strategy.

I recommend, once again, reviewing this strategy in Pfau and Jeremy Cooper’s The Yin and Yang of Retirement Income Philosophies[4]. I particularly recommend the introduction to the work of Blanchett, Mitchell and Frank[6] on dynamic spending at the end of the variable spending strategies review. Their strategy periodically updates the critical assumptions of a retirement plan. (Frankly, I don’t see a rational alternative.)

It effectively says, “When the road in front of you turns or ends, modify your car’s behavior accordingly.”

A light pole oddly stood in the middle of the Sears gravel parking lot in my hometown. Some wise person had painted two arrows on the pole curving away in opposite directions. Below the arrows were the words, “Turn. Go left or right.”

Sounds like sage advice.


Variable-spending strategies make a lot more sense.

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The challenge with the dynamic spending strategy is that it is mathematically complex and will be difficult for most retirees or even planners to implement. I suspect, however, that you would achieve similar results with any variable spending strategy if you updated your spending percentage annually to reflect decreasing life expectancy (strategies like RMD do this for you) and based the spending amount on your current portfolio balance. Blanchett, Frank and Mitchell point out that asset allocation plays a smaller role.

The Blanchett-Frank-Mitchell study shows that life expectancy plays a critical role in determining a safe spending amount. Life expectancy declines as we age. Some variable-spending strategies, like RMD and actuarial approaches, consider decreasing life expectancy in their calculations while others, like spending 4% of remaining portfolio balance, don’t. I recommend you choose one that does — it’s a key factor.

To implement a variable spending strategy, choose a variable spending rule that suits your fancy[1]. Which you choose probably has less impact on portfolio depletion risk than the act of recalculating it annually, so long as it incorporates changing life expectancy.

I personally prefer the dynamic strategy, Modified RMD for simplicity, Milevsky’s formula[4], and actuarial strategies[5].

I’ve written several posts on asset allocation and it has been thoroughly discussed in several threads, including Unraveling Retirement Strategies: Constant-Dollar Spending (4% Rule). You won’t go terribly wrong with an equity allocation between 40% and 60% and it’s difficult to prove that another will work better across a broad range of outcomes. The same rules apply to variable spending portfolios.

I recommend a floor to go along with an upside variable spending portfolio to make sure you can survive if the improbable happens.

Constant-dollar strategies tell you to spend the same amount every year and that you probably won’t run out of savings over a fixed thirty-year retirement. They don’t consider what happens if you do.

Variable spending strategies tell you to spend more when you have more money and spend less when you have less money. The better variable spending strategies also consider remaining life expectancy and tell you that you can spend a higher percentage of your remaining savings as you age. Annual spending isn’t predictable but you are unlikely to outlive your savings.

Again, seems like sage advice. Variable-spending strategies are so much more rational that I personally dismiss constant-dollar spending strategies entirely.

Retirees who have a pension, Social Security benefits or have purchased an annuity, which covers practically all American retirees, will actually be building a floor-and-upside strategy and managing the upside portfolio with a variable-spending strategy. Floor-and-upside strategies, however, will focus more on the floor and will likely recommend one higher than Social Security benefits alone are likely to provide.


REFERENCES

[1] Making Sense Out of Variable Spending Strategies for Retirees, Pfau.

[2] Optimizing-Retirement-Income-Solutions-November-2017-SCL-Version.pdf, Pfau, Tomlinson, Vernon. (Very lengthy, consider [6], instead.)

[3] Estimate your required minimum distributions in retirement, Vanguard.

[4] The Yin and Yang of Retirement Income Philosophies, by Wade D. Pfau, Jeremy Cooper.

[5] How Much Can I Afford to Spend in Retirement?: Spreadsheets, Ken Steiner.

[6] How-to-pensionize-any-IRA-401k-final.pdf, Steve Vernon.

[7] An Age-Based, Three-Dimensional Distribution Model Incorporating Sequence and Longevity Risks, David Blanchett, Larry Frank, John Mitchell.

 


Originally posted at http://www.theretirementcafe.com/2018/02/unraveling-retirement-strategies_23.html

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