To implement dynamic spending, an advisor should calculate each year’s spending by taking a stated percentage of the prior year-end’s real portfolio balance, then calculate a ceiling and a floor by applying chosen percentages to the previous year’s real spending amount, such as a 5 percent ceiling (spending increase) and a -2.5 percent floor (spending decrease).
The advisor then compares the calculations -- if the calculated spending falls below the floor, it can be increase to the floor amount, and if it exceeds the ceiling, it can be limited to the ceiling amount through lifestyle adjustments made by the client.
Portfolio outcomes vary by the selection of ceiling and floor percentages, said Vanguard. Lower floor percentages increase a portfolio’s success rate, and a higher ceiling percentages decrease the portfolio’s success rate.
Flexibility in a spending floor is more impactful than flexibility in the ceiling, according to Vanguard. In other words, the portfolio success rate depends more on reducing the minimum amount of income a retiree wants, rather than by cutting the maximum increase in income.
Vanguard says that with this rule, spending can be made relatively consistent while remaining responsive to financial markets.
Developing a reasonable spending strategy is just part of what makes a retirement plan successful, according to Vanguard — advisors must also offer clients broadly diversified portfolios and implement tax efficient withdrawal strategies to maximize the plan’s effectiveness.