How to develop a "dynamic" approach to retiree spending
As Smart Investing recently discussed, the combination of historically-low yields, expected muted investment returns and growing life expectancies are making it particularly challenging for retirees to calculate how much to draw down from their retirement savings.
A critical issue here is how much retirees can withdraw from their portfolios each year to finance their current spending and to generate future income for the rest of their lives, no matter how long. It's challenging.
Two traditional approaches are to draw down a set percentage each year of a portfolio's value or to set a dollar amount to withdraw in the first year of retirement and then to increase that amount annually by the level of inflation.
One of the difficulties with the set percentage-of-portfolio withdrawal strategy is that the dollar amount withdrawn and spent each year may much depend on how the markets have performed. This makes budgeting even tougher.
While the dollar-plus-inflation strategy may provide the comfort of an inflation-adjusted income, retirees face the risk of spending more than they can afford when markets have underperformed, increasing the risk of depleting their savings. And after markets have performed strongly, the dollar-plus-inflation strategy may lead to retirees spending less than they can afford.
Several Vanguard research papers* discuss a "dynamic-spending rule" as another approach to retirement drawdowns and spending. This provides for retirees to set a maximum and a minimum percentage withdrawal limits for their annual spending limits – in other words, a floor and a ceiling – based on the performance of the markets and a retiree's unique goals.
As the authors of the papers explain: "To implement the dynamic spending strategy, a retiree would first select a spending rate or the percentage of the portfolio that will be withdrawn in the first year, as well as a ceiling and a floor.
"The ceiling is the maximum amount," the authors explain, "that you are willing to allow real (inflation-adjusted) spending in any given year, while the floor is the maximum amount you can tolerate for real spending to decrease in a given year."
It should be emphasised that the actual percentages for a floor and ceiling depends much depends on retirees' circumstances, including whether they are conservative, balanced or more aggressive investors. For instance, a floor might be 2.5 per cent, while a ceiling could be 5 per cent of the portfolio's value in the previous year.
Retirees can spend a higher percentage of their portfolio's value when markets have done well in the previous year and reduce spending to a lower percentage – within these acceptable limits – when markets haven't done as well.
Of course, many retirees receive a superannuation pension with a set aged-based minimum withdrawal rate. By taking a dynamic approach, such members could calculate how much to reinvest, if any, each year.
When a portfolio returns are above a retiree's drawdown ceiling, an opportunity should arise to build up a portfolio in particularly good years. This has a smoothing effect for the years when returns are down.
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* A rule for all seasons: Vanguard's dynamic approach to retirement spending, April 2017, by Michael DiJoseph, Colleen Jaconetti, Zoe Odenwalder and Francis Kinniry.
* From assets to income: A goals-based approach to retirement spending, September 2016, by Colleen Jaconetti, Michael DiJoseph, Zoe Odenwalder and Francis Kinniry.
Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.
Reproduced with permission of Vanguard Investments Australia Ltd
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