Safe Withdrawal Rates and Certainty-Equivalent Spending
by Druce Vertes
"Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery." —Mr. Micawber (From Charles Dickens’ “David Copperfield,” 1850)
Financing a safe retirement with a risky portfolio depends on trade-offs. Increasing spending today is desirable, but it increases the risk of shortfall in the future. High variation in spending is undesirable, but upward adjustments let you increase spending when investments outperform, while downward adjustments after underperformance reduce risk of even deeper future cutbacks. Finally, accepting future spending variation enables higher spending today, if you invest in higher-risk, higher-return portfolios, or accept a thinner buffer against downward adjustments.
William P. Bengen (1994) pioneered safe withdrawal literature by studying a constant spending strategy. Using this strategy, the retiree determines an appropriate spending amount at retirement, and adjusts it annually for inflation to achieve constant real spending. The model I discuss in this article is a generalization of the Bengen approach to incorporate a variable spending term (a fraction of a smoothed portfolio value, adjusted for remaining life expectancy). If you recalculate a Bengen rule and update spending every few years, or after significant portfolio changes, you approach a smoothed variable spending strategy. Everything that follows will use real, inflation-adjusted values.
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