Retirement is being squeezed on one side by a growing population and increasing longevity, and from another by historically low yield levels from fixed-income and equity portfolios.
Yet the costs of retirement remain and aren’t decreasing, wrote analysts from Valley Forge, Penn.-based Vanguard Group in a recent white paper -- making an effective, flexible spending strategy core to a successful retirement plan.
“The stakes in retirement are high, and the impact of suboptimal decisions can be severe, particularly taking into account the unknowns, such as market returns, life span, and health issues,” said Colleen Jaconetti, CPA, CFP, a senior investment strategist at Vanguard and co-author of the paper, in a released statement. ”Vanguard’s framework can help investors negotiate the inevitable trade-offs between spending sustainability and stability,”
In “From Assets to Income: A Goals-Based Approach to Retirement Spending,” Vanguard recommends two different strategies depending on where an investor holds their retirement assets.
For retirees who have most of their assets in tax-deferred accounts, Vanguard recommends that assets be converted to income via an automatic withdrawal plan or by purchasing an investment designed to provide regular distributions.
For retirees who have most of their assets in taxable accounts, a goals-based spending strategy developed with an advisor is more useful.
Goals-based spending begins with establishing a spending rule that balances the multiple goals a retiree might have and differentiates the outcomes a retiree needs from the ones he or she wants. Vanguard proposes three different spending rules: the dollar plus inflation rule, the percentage of the portfolio rule, and the dynamic spending rule.
For retirees who desire spending stability, the dollar plus inflation rule would likely be preferred — retirees choose an initial dollar amount to spend from their portfolios annually and increase that sum by the amount of inflation each year thereafter, similar to the 4.5% rule pioneered by advisor Bill Bengen. The rule does come with the risk of premature portfolio depletion and lifetime under-consumption due to sequence risk, warns Vanguard.
The percentage of portfolio rule works best for retirees whose main goal is to avoid depleting their portfolios. With this strategy, a retiree spends a fixed annual percentage of his or her portfolio, most commonly between 3 and 5 percent, which produces annual spending that automatically increases or decreases as the markets fluctuate. Vanguard says the percentage of portfolio rule’s drawback is that spending amounts can fluctuate significantly from year to year, which may not suit retirees whose fixed expenses are a high proportion of their household income.
Vanguard’s dynamic spending rule combines the two other rules. Annual withdrawals are increased by a maximum percentage or decreased by a minimum percentage, depending on market performance. This approach smooths withdrawals, but also allows retirees to benefit from good markets by spending a portion of their gains. The rule also helps a retirement portfolio weather bad markets without causing a significant reduction in annual spending, which is accomplished by allowing the portfolio to retain some of its upside returns for use during down years.