increase — or preserve — their portfolio ’ s value so they can support future spending , bequests and other items . What ’ s worse is that they ’ ll have to make decisions about these two different goals while also dealing with circumstances beyond their control — market forces , the rate of inflation and their life expectancy — all variables that affect their safe withdrawal rates .
Retirees dealing with these challenges can turn to the numerous spending strategies developed by academics and advisor thought leaders . One of these is called the “ dollar plus inflation ” strategy ( one variation of which is the “ 4 % spending rule ” developed by advisor William P . Bengen ). Here , an individual spends an initial percentage of their portfolio balance at retirement and increases this amount by inflation annually . This strategy provides stable , inflation-adjusted spending but is indifferent to the performance of the capital markets . As a result , the approach can run into problems given the sequence of returns : If there are several years in which the market performs poorly — especially at the onset of somebody ’ s retirement when they are also starting to take portfolio withdrawals — there is an increased risk that the portfolio will be depleted or that spending will need to be significantly reduced at some point in the future .
Spectrum Of Spending Strategies
DOLLAR PLUS INFLATION RULE
0 % Ceiling 0 % Floor
Source : Vanguard
DYNAMIC SPENDING RULE
5 % Ceiling – 1.5 % Floor
MARKET PERFORMANCE
Another strategy calculates withdrawals based on a percentage of the portfolio . Under this approach , market performance is taken into account so that the annual spending amount is a function of the portfolio ’ s value . While it ensures that the portfolio won ’ t be depleted , unfortunately it doesn ’ t solve the problem of sequence-of-returns risk . If a person ’ s portfolio suffers negative returns at the same time they ’ re starting portfolio withdrawals , it can still meaningfully reduce their portfolio ’ s value and erode their future spending .
The Dynamic Approach
That leads us to consider instead a “ dynamic ” approach : essentially a hybrid of the two others . In this approach , annual spending will vary from year to year based on the markets , but it is not allowed to go beyond a set range ( ceiling and floor ) as long as assets remain , so it helps investors with their short-term
Ignores Somewhat Responsive Highly Responsive
Stable Fluctuates Within Limits Variable SHORT-TERM SPENDING STABILITY
Less Flexible More Flexible Highly Flexible SPENDING FLEXIBILITY
Unpredictable + or – More Stable Portfolio Cannot Be Depleted PORTFOLIO VIABILITY
Generally , the greater the proportion of expenses that could be eliminated or minimized in any given year , the greater the level of spending flexibility .
PERCENTAGE OF PORTFOLIO RULE
Unlimited Ceiling Unlimited Floor planning . A “ dynamic distribution ” strategy such as this one offers an effective way to manage sequence-of-returns risk in that poor investment returns are at least partially offset by reductions in current spending , which helps to preserve the portfolio value and thereby sustain future spending .
The floor is the key : The more someone can reduce spending when the markets are not performing well , the more likely they are to meet their long-term spending goals .
All these options lie on a spectrum , and the strategy advisors choose will likely depend on what their clients ’ most important goals are ( something illustrated in the chart ). At one end of the spectrum is the dollar-plus-inflation strategy — essentially , a dynamic distribution with a 0 % ceiling and floor . At the other end is the percentage-of-portfolio strategy — essentially , dynamic distribution with an unlimited ceiling and floor . Between those two poles is a dynamic strategy with different outcomes .
Advisors can help their retiree and near-retiree clients by recommending dynamic annual spending plans somewhere along this spectrum and devising ways for the clients to have spending flexibility — coming up with a proportion of total expenses that can be attributed to either discretionary or non-discretionary spending . That means asking how much a client needs to “ keep the lights on ” after accounting for ongoing income sources such as Social Security .
Generally , the greater the proportion of expenses that could be eliminated or minimized in any given year , the greater the level of spending flexibility . For example , if travel takes up a large portion of a client ’ s expenses each year , they may be better able to endure a reduction in their portfolio-based income than a client whose mortgage makes up the bulk of their monthly spending . By keeping their fixed expenses low , clients have more room to limit the withdrawals from their portfolios during periods of poor market performance , and they can at least
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JUNE 2023 | FINANCIAL ADVISOR MAGAZINE | 51