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Portfolio Strategies

Vanguard's Dynamic Spending Strategy for Retirees

This hybrid approach adjusts withdrawals within preset limits, allowing retirees to benefit from good markets and more easily weather bad markets.

by Colleen M. Jaconetti, Francis M. Kinniry, Michael DiJoseph, Zoe B. Odenwalder | January 2017

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This article was adapted from the authors’ September 2016 Vanguard research paper “From Assets to Income: A Goals-Based Approach to Retirement Spending.”

A number of spending rules—each emphasizing different goals—have been developed to help retirees deal with changes in their individual circumstances and in the markets.

Each rule places different emphasis on the competing priorities that many retirees are trying to balance: maintaining a relatively consistent level of current spending; and increasing—or preserving—the value of a portfolio to support future spending, bequests, and other goals. Two of the most popular rules are the dollar plus inflation rule (one example of which is William Bengen’s 4% spending rule) and the percentage of portfolio rule. While these rules of thumb are used by many, they may not be flexible enough to provide a tailored solution for each retiree’s unique circumstances.

To provide a customized solution for each retiree, we suggest a hybrid of these two rules, which we call the “dynamic spending” rule. With this rule, annual spending is allowed to fluctuate based on the performance of the markets, while at the same time being sensitive to significant fluctuations in spending from year to year. This is accomplished by overlaying an annual ceiling and floor to each year’s spending amount. As discussed in more detail in this article, the outcomes are significantly affected by the selection of the ceiling and floor percentages; this is where retirees, and their advisers, can tailor the strategy to provide the flexibility each retiree needs to meet his or her unique goals.

Spectrum of Spending Rules

We prefer to see these spending rules as a spectrum of choices based on the relative importance a retiree places on each of their goals. Thus, at one end of the spectrum is the dollar plus inflation rule, which is essentially the dynamic spending rule with a 0% ceiling and a 0% floor. At the other end of the spectrum is the percentage of portfolio rule, which is essentially the dynamic spending rule with an unlimited ceiling and unlimited floor. The dynamic spending rule is positioned in the middle of these two rules in terms of potential outcomes. Figure 1 highlights the trade-offs of each rule more specifically.

For a retiree whose primary goal is spending stability, the dollar plus inflation rule (dynamic spending rule with a 0% ceiling and 0% floor) would likely be preferred. With this rule, upon retirement, a retiree selects the initial dollar amount he or she wants to withdraw from the portfolio in the first year and then increases that sum by the amount of inflation each year thereafter. Although this rule allows for more stable spending from year to year than the other spending rules we discuss, it comes with the risk of either premature portfolio depletion or lifetime under-consumption. This is because the strategy is exposed to sequence of returns risk; that is, it is indifferent to the capital markets, given that the annual spending amount is automatically increased by inflation regardless of whether the portfolio’s market returns are positive or negative. A significant period of market underperformance without an adjustment in spending could result in the retiree running out of money before the end of the investing time horizon. Conversely, a significant period of market outperformance could provide a retiree the opportunity to increase spending if desired. Failure to appropriately tailor spending to market performance could thus mean a retiree either misses out on enjoying retirement to the fullest extent possible or, at the other extreme, overspends and depletes the portfolio too soon.

At the other end of the spectrum, for a retiree whose primary goal is not depleting the portfolio, the percentage of portfolio (dynamic spending rule with an unlimited ceiling and unlimited floor) would likely be preferred. With this rule, a retiree annually withdraws a fixed percentage of his or her portfolio balance so that the annual spending amount is automatically increased or decreased based on the markets’ performance; this rule is thus highly responsive to the capital markets. Although the retiree’s portfolio will not be depleted (even though the spending amount may be substantially reduced through time), the annual spending amount can fluctuate significantly, which may not be an option for retirees whose nondiscretionary or fixed expenses (such as housing or food) are a relatively high proportion of their total expenses. However, for those with very high, if not unlimited, levels of flexibility, this option may be preferred. [For simplicity, we based the percent of portfolio spending amounts on annual ending balances. In practice, it is common to apply three-year smoothing to the percent of portfolio strategy, which would generate similar results (directionally) to those presented here; however, the variance would be truncated.]

Figure 1. Comparison of Various Spending Rules

Figure 1. Comparison of Various Spending Rules

As previously mentioned, our dynamic spending rule is a hybrid of these two rules. With this rule, withdrawals are kept within a maximum percentage increase and minimum percentage decrease in real (inflation-adjusted) spending. The rule allows retirees to benefit from good markets by spending a portion of their gains, while weathering bad markets without a significant reduction in spending. Retirees accomplish this by saving some of their upside returns for use on a rainy day when the portfolio otherwise would have required a more significant reduction in spending (see the box below for an in-depth example of this spending rule).

To implement the dynamic spending rule, a retiree calculates each year’s spending by taking a stated percentage of the prior year-end’s real portfolio balance. The retiree then calculates a ceiling and a floor by applying chosen percentages to the previous year’s real spending amount, such as a 5% ceiling (increase) and a –2.5% floor (decrease). The results are then compared. If the newly calculated spending amount exceeds the ceiling, the spending amount will be limited to the ceiling amount; if the calculated spending falls below the floor, the spending amount is increased to the floor amount. With this rule, depending on the ceiling and floor selected, spending can therefore be made relatively consistent while remaining responsive to the financial markets’ performance—thereby helping to sustain the portfolio to meet future goals.

As Figure 1 illustrates, although the percentage of portfolio rule may have the highest rate of portfolio success and the highest internal rate of return (charts a and b), those come with a cost—namely, higher volatility in annual real spending (chart d). However, by implementing Vanguard’s hybrid approach, a retiree can capture many of the benefits of this approach while still significantly reducing the variation in annual spending that could occur as a result of market movements.

We examined the trade-offs mentioned previously in a multiplier framework [that is, a multiple of initial balance or spending amounts over 35 years for each spending rule (see charts c and d in Figure 1)]. For example, the dollar plus inflation rule produced real ending balances ranging from zero times the initial amount at the 5th percentile to 5.9 times the initial amount at the 95th percentile (chart c). In practical terms, this would correspond to an investor with a starting portfolio balance of $1 million and a 5% withdrawal rate ending with an account balance somewhere between $0 and $5.9 million 90% of the time. As chart c in Figure 1 shows, the two other approaches produced results in a much narrower range.

The most important trade-off when discussing a spending method, however, is spending volatility. Our analysis shows that, on average, the dollar plus inflation rule produces a real annual spending multiplier of 1.0, unless the portfolio depletes, in which case it falls to zero (see chart d in Figure 1). Continuing the example from the previous paragraph, in theory, this simply means real annual spending of $50,000 or $0. In reality, an investor would not let his or her portfolio drop to $0, but would potentially have to make uncomfortable adjustments along the way. The dollar plus inflation rule is thus strikingly insensitive to market conditions.

On the other hand, the percentage of portfolio rule produces real annual spending multipliers ranging from 0.4 to 2.0 at the 5th and 95th percentiles and 1.0 on average, while the dynamic spending rule’s multiples range from 0.5 to 1.8 at the 5th and 95th percentiles and also average 1.0. It bears repeating that, in this latter example using the dynamic spending approach, one’s real spending would never decrease by more than 2.5% or increase by more than 5% in any given year; use of the percentage of portfolio approach, however, could result in real spending decreasing or increasing by a theoretically unlimited amount (although, in reality, bounded by the portfolio’s performance and, hence, that of the financial markets). Ultimately, an investor with endless flexibility would likely choose the percentage of portfolio approach; however, for most retirees this is simply not practical. In that case, dynamic spending can provide many of the benefits of the percentage of portfolio rule without giving up the relatively consistent level of real annual spending.

Tailoring the Ceiling and Floor Percentages

An important point in this discussion is that the outcomes are significantly affected by the selection of the ceiling and floor percentages; this is where retirees, and their advisers, can tailor the ceiling and floor percentages along the spectrum (from a 0% ceiling and 0% floor to an unlimited ceiling and an unlimited floor) to provide the flexibility each retiree needs to meet his or her unique goals. For illustrative purposes, we used the 5% ceiling and the 2.5% floor as an initial starting point because it provided a portfolio survival rate of 85% over a 35-year time horizon; however, we tested hundreds of ceiling and floor scenarios to determine the impact on portfolios’ success rates.

Figure 2 highlights two scenarios. The first scenario (chart a) held the ceiling constant at 0%—meaning any excess returns were reinvested in the portfolio (as opposed to increasing the spending amount)—and tested the impact on portfolio success rates of different floor percentages in –0.5% increments between 0.0% and –12.0% (0.0%, –0.5%, –1.0%, –1.5% . . . –11.5%, –12.0%). The second scenario (chart b) held the floor constant at 0%—meaning spending could not decrease—and tested different ceiling percentages between 0.0% and 12.0% in 0.5% increments.

Figure 2. Dynamic Spending Floor and Ceiling Sensitivity

Figure 2. Dynamic Spending Floor and Ceiling Sensitivity

Our analysis found that the more flexibility retirees have in their floor—meaning, the more they are able to reduce spending when the markets are performing poorly—the higher their success rate, meaning the lower the chance that they will deplete their portfolio or be required to significantly reduce their spending before the end of their planning horizon. In fact, retirees’ ability to accept changes in their floor helps their portfolio more than increasing their ceiling hurts it. For example, a ceiling/floor combination of 0% and –1% is about 12 percentage points more successful, as measured by success rate, than a ceiling/floor combination of 0% and 0% (i.e., dollars plus inflation). On the other hand, a ceiling/floor combination of 1% and 0% is about four percentage points less successful than a ceiling/floor combination of 0% and 0%. This is shown in chart a of Figure 2, where the absolute slope of the line when keeping the ceiling constant (chart a) is much steeper than that of the line when keeping the floor constant (chart b).

This concept has implications for retiree withdrawal rates, as shown in Table 1. The table shows portfolio withdrawal rates for both a 0%/0% ceiling/floor rule and a 5.0%/–2.5% ceiling/floor rule using different time horizons and asset allocations assuming an 85% success rate. As the table shows, retirees who can incorporate flexibility into their annual spending needs are able to set higher initial portfolio withdrawal rates, which can help them be in a better position to meet their near-term financial goals. (We assume that a conservative asset allocation corresponds to a 20% stock/80% bond portfolio, a moderate asset allocation corresponds to a 50% stock/50% bond portfolio and an aggressive asset allocation corresponds to an 80% stock/20% bond portfolio.)

Table 1. Portfolio Initial Withdrawal Rates (%) for Various Asset Allocations and Time Horizons

  0% Ceiling/0% Floor 5.0% Ceiling/2.5% Floor
  Time Horizon (Years) Time Horizon (Years)
Asset Allocation 10 20 30 35 40 10 20 30 35 40
Conservative 10.1 5.4 4.0 3.6 3.3 11.2 6.7 5.3 5.0 4.7
Moderate 10.0 5.6 4.3 3.9 3.7 11.1 6.7 5.3 5.0 4.7
Aggressive 9.7 5.5 4.3 3.9 3.7 10.7 6.3 5.0 4.7 4.4
Notes: Rates are gross of taxes. Any tax is assumed to be paid from the withdrawn amount. Portfolio allocations are: Conservative—20% stocks/80% bonds; Moderate—50% stocks/50% bonds; Aggressive—80% stocks/20% bonds. Withdrawal rates were determined using data from the Vanguard Capital Markets Model (VCMM); see our original study at personal.vanguard.com/pdf/ISGELR.pdf for a description.
Source: Vanguard.

For example, a moderate investor who wants stable inflation-adjusted spending (that is, a 0% ceiling and a 0% floor) with a 35-year time horizon can set an initial portfolio withdrawal rate of 3.9%, assuming an 85% chance that he or she will not run out of money. If that same retiree can cut spending back by 2.5% in years when the market is performing poorly, and if he or she can limit increases in annual spending to 5.0% in years when the markets are performing well, the retiree could set the initial portfolio withdrawal rate at 5.0%, which is 1.1 percentage points higher than the previous example.

In short, when choosing a floor and ceiling combination, there are trade-offs between maintaining the desired level of current spending (spending percentage) and preserving the portfolio to support future spending/goals (success rate). In selecting a floor and ceiling, retirees and their advisers must have a solid understanding of their income and expenses; the more they can tolerate some short-term fluctuations in spending, the more likely they are to achieve their longer-term goals.

Finally, once a spending strategy and a withdrawal amount have been selected, possible implementation strategies include:

  • Setting up an automatic withdrawal plan from current holdings,
  • Purchasing an investment that is specifically designed to provide regular distributions, and
  • Working with an adviser to develop a spending strategy tailored to meet your unique goals.

Dynamic Spending Rule Illustration

The process for using the dynamic spending rule is:

  1. Calculate each year’s spending by taking a stated percentage of the prior year-end’s portfolio balance. For example, a retiree with a $1 million portfolio and an income need of $40,000 per year would start by taking 4% of the portfolio in year one.
  2. Calculate a ceiling and a floor by applying chosen percentages to the prior year’s inflation-adjusted spending amount, such as a 5% ceiling and a 2.5% floor. In Figure 3, given a 3% rate of inflation, the ceiling and floor would be calculated as $42,000 and $39,000, respectively. The percentage of portfolio amount, after accounting for investment gains and the prior year’s spending, would be $42,400.
  3. Compare the results. If the newly calculated spending amount exceeds the ceiling, limit spending to the ceiling amount; if the calculated spending is below the floor, increase spending to the floor amount. In the example, since the $42,400 percentage of portfolio amount exceeds the ceiling of $42,000, spending would be constrained to the ceiling.

In short, this rule helps retirees maintain income for basic expenses while allowing for more discretionary income if market returns are favorable.

Figure 3. Dynamic Spending Strategy Example: Percentage of Portfolio With Ceiling and Floor

Figure 3. Dynamic Spending Strategy Example: Percentage of Portfolio With Ceiling and Floor

Discussion

Henry Hanau from NY posted over 9 years ago:

Has anyone done a study of setting aside 5 years worth of spending in a separate account? Using the funds from that account and adding to that account when there is growth in the investment portfolio. A person has an after tax portfolio of $1milion. They spend $100k per year. $500k goes into one account invested in TBills or similar. $500k is invested for growth. In down years no money is moved, In up years the growth account is used to transfer to the spending account to replenish it. Any excess remains in the growth account to be invested.


Doug from NY posted over 9 years ago:

Henry, This is generally called a "bucket approach". There have been references to it in the AAII journal, including this one from October 2013: http://www.aaii.com/journal/article/using-the-bucket-approach-with-your-retirement-portfolio


Charles Rotblut from IL posted over 9 years ago:

Doug, Jim Cloonan discusses a similar such strategy in his book, Investing at Level3. Specifically, he discusses having two- and four-year reserves. -Charles


Joseph Crowley from AZ posted over 9 years ago:

Henry, that system works best if you hold down the withdrawal to 4% To afford to replenish 100,000 per year, the fund should be 2-2.4 million


Donald Licatovich from TX posted over 9 years ago:

why not do this....spend less than you make and you will never run out of money. occasionally you can have a large medical expense or a disaster but in general these can be accomodated so back to the spend less and recover.


Andrew Shuman from ME posted over 9 years ago:

I am reading this article as part of the "Weekly Digest" email, along with other withdrawal strategy articles. It surprises me that one important point is missed in each of these articles, and that is doing a proper retirement cash flow analysis just before retiring to help come up with a potential annual income need figure. These articles seem to want an investor to "back into" retirement by figuring out a withdrawal amount and then adapting the retirement lifestyle to the amount of income available. Other benefits of a cash flow analysis include helping to determine if you CAN retire, how you will take distributions, determining when to take Social Security, and many others. Once a good estimated need figure is determined, then you can design a proper withdrawal strategy.


Ed Ehrhart from CA posted over 9 years ago:

Live on your income, and reinvest whatever of that income which you can save, just like when you were working.


Mike from CA posted over 9 years ago:

A factor rarely mentioned is the income tax impact from a floating withdrawal scheme. If one is attempting to stay in the (current) 15% federal bracket and is taking withdrawals to avoid jumping into the 25% bracket the goal is generally to stay within a particular income level to avoid a tax increase. The alternative is to take advantage of an up year in the market to raise realized income with a substantial increase in tax owed on the additional income. Individual circumstances will vary, but for many a $4000 increase in income taxed at %25 (not even going to consider state income taxes, but you should) may not be as attractive as letting the potential "extra" disbursement (up to the predetermined ceiling) remain invested to be used in the future during a down market. For those with plenty of "headroom" before they hit the next highest bracket the floating disbursement strategy might be more appealing.


Adam Gallucci from MA posted over 9 years ago:

As delineated in the article, there is no mechanism for evaluating on a concurrent basis what the market in general and what ones' portfolio is doing. I wonder if there is value to assessing current, intra-year performance and adjusting withdrawals from the portfolio, especially in a severe drawdown situation (e.g. 2009)


David Vigil from CO posted over 9 years ago:

The entire complexity of withdrawal from portfolio is perplexing to me. It appears that the base assumption for all strategies is that the portfolio is tax-free until distribution. That may well not be the case for many people who have not invested the bulk of their investment capital in tax-deferred accounts, such as IRA's or 401-K's. If the bulk of the retirement investments is in taxable accounts, then any interest, dividends and capital gain distributions would be taxable to the retiree without regard to the amount he withdraws from the portfolio on which to meet his retirement lifestyle and needs. How can he effectively make use of any of these withdrawal plans?


Joe Weishaupt from PA posted over 9 years ago:

This maybe oversimplifying the process, but what would be the downfall of having the majority of a persons retirement assets in a well diversified portfolio of dividend paying & growing dividend equities/ETFs,REITs? With the right combination, it wouldn't be too much of a stretch to earn 3% in dividends, sent to a Checking/spending account. $1,000,000 @ 3% = $30,000 first year, not a lot, but with a person fortunate enough to have a pension plus Social Security, definitely livable. Assuming roughly 6-8% return on the portfolio, this would cover inflation & practically guarantee a raise every year. The market & cost basis will fluctuate, but who cares? The dividends will keep coming. This strategy is below the 4% withdrawal often quoted to prevent out living your income. In addition this also leaves an inheritance or charitable donation after death if desired. Very minimal time managing your portfolio & more time in the sun sipping on that umbrella drink! My very first post ever! Feed back welcome please


Gary Ryba from MN posted over 9 years ago:

Mr. Weishaupt I am with you. If we are in good health with good family genes that increase our probability of living longer in retirement having the majority, or at more of assets, in dividend paying equities, growth, income producing real estate, etc. seems to position us better if we should enjoy a long life. This is presuming we have sufficient retirement income from pensions, social security, etc. that can cover the majority of one's living expenses.


Gary Ryba from MN posted over 9 years ago:

Mr. Weishaupt I am with you. If we are in good health with good family genes that increase our probability of living longer in retirement having the majority, or at more of assets, in dividend paying equities, growth, income producing real estate, etc. seems to position us better if we should enjoy a long life. This is presuming we have sufficient retirement income from pensions, social security, etc. that can cover the majority of one's living expenses.


Joseph Dixon from VA posted over 9 years ago:

Does anyone know whether Vanguard has produced a spreadsheet that allows individuals to actually implement their withdrawal strategy. I personally have not been able to duplicate their nominal end of year 1, 2 or 3 balances utilizing simple 10%, 5% and 5%, respectively, annual returns. I also don't understand the value of utilizing "real" withdrawal amounts, when I live in a nominal return world. The approach appears perverse, as in year 3 it would have you withdraw $41,543--less than the $42,000 allowed for year 2--even though the nominal portfolio balances continue to increase! It would be more clear it the approach was to withdraw less after a year in which the portfolio sustained a loss--or did not increase enough to cover the amount withdrawn at the beginning of the year. This isn't the first time I've failed to duplicate Vanguard's numbers utilizing the approach advocated in this article. Vanguard has previously issued a less thorough article on their website (and I believe on Morningstar as well). However, I remain confused. Am I missing something?


Charles Rotblut from IL posted over 9 years ago:

Hi Joseph, Here are the instructions Vanguard gave me: Year 1: 1) Calculate spending amount using percent of portfolio method 2) Add earning and subtract spending to arrive at ending balance *inflation has no impact in year one (assumed to be 0%) Year 2: 1) Calculate spending amount using percent of portfolio method and year 1 ending balance 2) Calculate spending amount given ceiling and floor by multiplying the previous years spending amount by 1.05 and .975 respectively 3) Compare all three spending amounts and choose the middle amount 4) Apply inflation to spending amount by multiplying by cumulative inflation 5) Calculate nominal ending balance by adding earnings and subtracting nominal spending amount 6) Calculate real ending balance by dividing nominal ending balance by cumulative inflation Year 3: Repeat *Remember spending amounts should be calculated using the real ending balance then adjust the chosen spending amount for inflation Hope this helps, Charles


Mel Meyer from IL posted over 9 years ago:

Many of the above comments sound a touch patronizing. Could they come from older retirees with defined benefit pensions? For those of us with only IRA, Roth, and 401k/403b plans, it's just not as simple as "live on less than you make." We have the task of wisely turning the total return from a diversified portfolio into cash we can live on. For me and many others, "live on income, don't touch the principal" is archaic advice with 2-3% equity and debt yields. As we sit atop one of the longest domestic bull markets in history (thanks Obama), it is not likely that near-future equity returns will approach the historic averages. We all know what bond yields are like. So I for one appreciate Vanguard's approach. They keep refining it, and it is executable in my experience, in fact much more executable than the "bucket" strategy if one wants to minimize capital gains on taxable accounts.


Mitch from HI posted over 8 years ago:

I like the K.I.S.S. (Keep It Simple Stupid) method: Build up a solid portfolio of Dividend Aristocrats or buy into a low cost Dividend Aristocrat ETF throughout your working career, then live off only the dividends and other passive income streams if/when you retire. Leave the principal alone. It is your insurance policy in case you have severe financial problems in your old age. If not, it becomes part of your financial legacy and an insurance policy against financial problems in your loved ones in their golden years. Don't eat the goose that lays the golden eggs!


Chris from California posted over 8 years ago:

Henry, Charles and Doug, While not an investment professional, CFP or CFA, as a civil engineer, I do have a pretty good math background. I also purchased and read Jim Cloonan's book. So called bucket strategies, mathematically, mimic traditional asset allocation strategies, with declining equity allocations. If you think about it, refilling more conservative buckets requires reducing your equity positions, which, in turn, causes the portfolio to become more conservative each year. Psychologically, this may be appealing but it will reduce returns, maximum potential withdrawals and, potentially, outcome. As for the "cash buffer zone" approach -- a 2 bucket strategy -- mentioned above and advocated by Mr Cloonan, it doesn't hold water, mathematically, either. For example, if one were to employ Mr Cloonan's strategy in the late 1960's, your savings would not make it through the 1980's. (for example, SP500: 743 in 1966 and didn't make it back up there until 1992). For those of you more mathematically inclined, here's a reference: https://www.onefpa.org/journal/Pages/Sustainable%20Withdrawal%20Rates%20The%20Historical%20Evidence%20on%20Buffer%20Zone%20Strategies.aspx The appealing part of the Vanguard strategy is that it is dynamic. Given that none of us know what's coming, such strategies make the most sense.


Richard Shaw from AZ posted over 8 years ago:

One key item missing from this discussion (and many similar ones) is the IRS RMD requirement at 70 1/2 if IRA/401k etc type funds are a significant part of your retirement assets. Would it not be better to start with the RMD amount for a year and then decide whether more could/should be taken out?


Victor from NC posted over 8 years ago:

Combine this dynamic withdrawal scheme with the bucket approach, perhaps include an annuity so that SS delayed to 70 and the annuity cover the essentials? We could be onto something. Makes more sense than going on autopilot blindly following some rule-of-thumb.


Doug from NY posted over 8 years ago:

Chris wrote: "If you think about it, refilling more conservative buckets requires reducing your equity positions, which, in turn, causes the portfolio to become more conservative each year." Not if your equity bucket is both large and aggressive enough so that it, on average, generates more than enough money to cover withdrawals from the conservative buckets.


Gregory Boger from FL posted over 8 years ago:

Doug, correct, but not always possible. Richard, exactly what I was planning, although everything I put in now is into Roth 401k or taxable accounts (with the company match obviously being regular pre-tax 401k money, but negligible in comparison). Have yet to run numbers, I'm 48 now and no end in sight yet.


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