A More Dynamic Approach to Retirement Spending
As investors plan for retirement, one of their most difficult tasks is to select a spending strategy that provides them with an ample income stream for their lifetime.
What makes this so challenging is that many of the critical factors in the decision are beyond the investor’s control and are entirely unpredictable. Investors have no control, for instance, over the returns of the investment markets, the rate of inflation, or the length of their planning horizon (their life expectancy). Yet each of these variables has a significant impact on how much an investor can “safely” withdraw from his or her portfolio to maximize current consumption while preserving the potential to generate future income for the rest of the investor’s life, however long.
Many strategies have been devised to help investors deal with these uncertainties, each placing a different emphasis on the competing goals. An investor’s assessment of the trade-offs is key to his or her decision. This article describes two of the most common spending strategies, dollar amount grown by inflation and percentage of portfolio, while also introducing a third strategy that Vanguard has devised—combining aspects of the two others—that we believe is more dynamic and flexible. This third method, which we call percentage of portfolio with “ceiling and floor” (the maximum and minimum percentage increase or decrease, respectively, in real spending) incorporates balance: That is, spending is relatively consistent while remaining responsive to the financial markets’ performance, thereby helping to sustain the portfolio.
Note to readers: We examine here each strategy in its purest form—as though an investor were adhering to it blindly, without making any changes over the investment horizon. In the real world, of course, such a situation could not exist, nor should it. Because circumstances constantly change, investors and their financial counselors need to review portfolio performance and strategy regularly to assess the status of their spending plans. Nonetheless, we believe that examining the strategies in this pure form can help investors evaluate the various factors that need to be weighed.
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Francis M. Kinniry Jr. , CFA, is a principal in the Vanguard Investment Strategy Group.
Michael DiJoseph , CFA, is an investment research analyst in the Vanguard Investment Strategy Group.