A better approach to retirement spending
Last time in this space, we talked about the challenge of coming up with a spending strategy that will deliver an adequate income stream during retirement.
What makes this so difficult is that many of the critical factors in the decision are largely unpredictable, warns Colleen Jaconetti, a senior analyst at The Vanguard Group.
You really have no control, for instance, over the returns on your investments, the rate of inflation, or just how long you actually have to plan for.
Yet each of these variables has a significant impact on how much you can “safely” withdraw from your nest egg to live comfortably while preserving the potential to generate future income for the rest of your life — however long that may be.
One rule of thumb assumes that you can simply spend up to four per cent of your savings annually, adjusted for inflation, without too much trouble.
While popular, the problem with the strict application of this rule is that it has little to do with the real world.
If you do well, you forgo the chance of increasing your retirement income and enjoying life a little more.
On the other hand, if you experience significant losses, you run the risk of exhausting your retirement savings prematurely — with little opportunity to catch up.
To address these problems, some advisors opt for more of an endowment approach where your retirement paycheque is limited to four percent of the assets remaining at the beginning of each year — in other words, no annual raises, regardless of inflation.
This way, you'll have to adjust your retirement spending up or down to reflect the investment gains or losses you experience. And, for some people, that’s no easy task.
An alternative method, which Jaconetti favours, calls for adding a “ceiling and floor” to your spending so that it’s consistent with the actual results you realize.
For example, she found that a portfolio based on the inflation-protected approach would have survived only 78 per cent of the time, meaning that in 22 per cent of the scenarios reviewed you would have simply run out of money.
And while basing spending on a set proportion of the portfolio’s value at the end of the prior year mutes this risk, it creates other challenges — especially if the majority of your retirement costs are fixed.
While the portfolio survival rate was 100 per cent for the endowment approach compared with 78 per cent for the indexed method, the annual income stream still fluctuated sharply.
So much so, that roughly half of the time it fell below the initial target of four per cent, actually flirting with zero in a few instances.
To remedy this, Jaconetti suggests using a hybrid approach. While you’d still calculate each year’s spending by taking a set percentage of the prior year-end balance, you’d also build in limits — in this instance, she used a five per cent ceiling and a 2.5 per cent floor.
If the newly calculated spending amount exceeds the ceiling, you throttle back to that threshold; if the calculated spending is below the floor, you can at least bring it up to the floor amount.
This strategy allows you to benefit from good markets by increasing spending, while in less favourable periods it forces you to hold back, thereby supporting the portfolio’s longevity, she says.
After running the numbers, she found that applying the ceiling and floor helped create some equilibrium. More importantly, using such limits produced fewer scenarios in which annual spending fell below the target level — in this instance, four per cent.
The most important consideration for the ceiling and floor strategy is the selection of the upper and lower percentages that will be applied to the prior year’s spending, she notes.
The narrower the spread between them, the more the results started to look like the indexed four per cent strategy. And the greater the likelihood that the portfolio could reach a crisis point at some future time.
Here’s the problem. While they may seem straightforward, spending strategies that are insensitive to returns are actually quite risky, in that they assume a portfolio will recover before a crisis point is reached.
Rigid spending rules don’t eliminate investment volatility, Jaconetti explains, they simply push its consequences into the future. And an uncertain future is actually what most retirees are looking to avoid.
Got a question about investing, saving or retirement? Send Gordon an email and we might answer your question in a future column.
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