• Financial Planning
  • A More Dynamic Approach to Retirement Spending

    by Colleen M. Jaconetti , Francis M. Kinniry Jr. and Michael DiJoseph

    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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    Colleen M. Jaconetti is an senior investment analyst in the Vanguard Investment Strategy Group.
    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.


    Herb Schrayshuen from NY posted over 2 years ago:

    It would be interesting to use this model to test the impact of Required Minimum Distributions. I believe that required minimum distributions, which force tax expense to occur early and limit overall returns, will increase the risk of running out of money. It would be interesting to get the authors opinion on this point. If the authors have a different conclusion, and perhaps have already tested this, it would be useful to know.

    David Dudley from CT posted over 2 years ago:

    I like the hybrid approach. You need to adjust it for those that retire before full SS. - a suggested fixed portion equal to the projected Social Security value. So that is a fixed withdrawal from years potential especially for years 62 1/2 to retirement age. Then the kick in to the high and low values at full social security

    John Morgensen from NV posted over 2 years ago:

    I strongly object to the assumption:

    No taxes: They are assumed to be paid from the withdrawn amounts.

    There is no correlation between income for tax purposes and withdrawal amounts. If you have annual returns for each asset class, you should be able to calculate the tax consequences and deduct from assets rather than from the distribution.

    Thank You,
    John Morgensen

    Norm from Massachusetts posted over 2 years ago:

    Pursuant to Herb's comment on RMD's. Given this mandate on withdrawals from retirement accounts which starts( if my calculations are correct) at a floor level at age 70 of 3.65% rising to a level of 5.13% by age 79 with continuous incremental increases each year thereafter. Therefore one's flexibility in following all the wise advice of these studies seems to be limited to only taking more than the required RMD. Not the choice many of us would make.

    Nathan Busch from MN posted over 2 years ago:

    Yet another article positing that you will run out of money or will not run out of money before you die. All have the same basic assumption, a 4% withdrawal rate, and then go on to say why the particular tweak used by this investment advisor or that investment advisor will be the cure all. All of this is complete nonsense and unusable in the real world.

    Assume that you have a known time horizon until fully retired. The question that needs to be answered is the following: how much money will you need to have invested today in a given investment strategy to maintain your current living standard, inflation adjusted, including medical costs, adjusted by a different inflation standard, such that you will run out of money, in that part of your portfolio, at age "X"? I may be going out on a limb on this next statement: but I will put $5.00 on the table that says not one commentator, financial adviser, investment advisor, or anyone at AAII can answer this question. That, even though this is precisely the question that everyone wants answered.

    Surprisingly, the arithmetic to answer this question is straightforward, and some relatively simple computations using Monte Carlo simulation techniques will give you both the amount of money required and the probability of success.

    Come on, let us get real and throw the 4% rule and its myriad of variations into the garbage heap where these belong and start publishing articles that answer the question your readers want answered.

    I hope that this helps.

    Nathan A. Busch

    George Pitonyak from NC posted over 2 years ago:

    I agree with Nathan.
    Everyone's needs are different and the charts in this article provided me with very little useful information. I am 71 and have about 8 years left on my mortgage. With SS and retirement, I still must pull more than the required amount yearly from my IRA, and have for years even before the required distributions were mandatory.
    Will I run out of money? Possibly, but I have many options to slow the depletion process down and will reevaluate the situation every few years. My biggest concern is a President who is determined to keep the lower 50 % of the population in poverty, as he brings the upper 50% into that category. We are all playing with Monopoly Money!

    Keith Shadrick from IN posted over 2 years ago:

    Nathan, the answer is unanswerable. I agree the 4% rule is absurd. Every retirees circumstances are inherently different.

    Monte Carlo simulations are garbage-in garbage-out based on a number of assumptions and probabilities . It's a good place to start but I wouldn't suggest relying on the output. Most importantly, outcomes can't be managed, only risk can be managed. Outcomes are really a function of luck and the vagaries of the capital markets. Focus on what can be managed, the inherent risk of a portfolio. The real world is one of constantly adapting to the surrounding world. My point is that if you base your real life on some model, be prepared to adapt. Also realize a little humility is always valuable - investment dogmas and financial plans are only as good as the paper they're written on. They are constantly changing!

    H Kinsling from CA posted over 2 years ago:

    I pretty much concur with Herb's comments relative to the Minimum Required Distribution (MRD). All the other analysis purely hypothetical without the analysis relative to the MRD. Who is knowingly going to incur additional taxes and take a distribution smaller than the MRD without a projection of the tax effects. Without any analysis at all I really doubt the tax effect can be ignored as the studies have done. So in the real world rendering the minimum sides of the analysis useless when the amount withdrawn is below the MRD.

    Mike from OH posted about 1 year ago:

    The amount withdrawn from the IRA is not the amount withdrawn from the portfolio.

    The article says in a couple places that taxes are included in the withdrawal amount. In other words, your maximum annual withdrawal (i.e., typically 4% or less of your portfolio) must pay for all your taxes.

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