The Problems With A Constant Retirement Spending Strategy

By September 27, 2016 Retirement Insights No Comments

The first method to be tested is the original constant inflation-adjusted withdrawal strategy introduced in William Bengen’s 1994 article, “Determining Withdrawal Rates Using Historical Data.” This will serve as a baseline for subsequent comparison with other strategies. Bengen’s rule says to adjust spending annually for inflation and maintain constant inflation-adjusted spending until the portfolio depletes.

Annual spending increases by the previous year’s inflation rate and does not otherwise adjust for market returns or the present size of the underlying investment portfolio. The withdrawal rate is defined only in terms of the first year of the plan, and subsequent spending rates are no longer tracked as an input to guide spending. Spending continues to adjust for inflation, regardless of portfolio size, unless and until the underlying portfolio is fully depleted.

Click here to download Dr. Pfau’s fact sheet “The Relationship Between Spending and Aging.”

We have already analyzed how this method performs in historical data. A 4% initial spending rate survived all of the rolling historical periods when using a 50/50 portfolio. Exhibit 1 shows how this plays out, with sixty-one lines (on top of one another, in this case) with real spending of $4, reflecting the sixty-one rolling historical thirty-year periods in the dataset for which the rule could provide a consistent real income.

We have already analyzed how this method performs in historical data. A 4% initial spending rate survived all of the rolling historical periods when using a 50/50 portfolio. Exhibit 1 shows how this plays out, with sixty-one lines (on top of one another, in this case) with real spending of $4, reflecting the sixty-one rolling historical thirty-year periods in the dataset for which the rule could provide a consistent real income.

The bottom part of the exhibit shows remaining wealth throughout retirement for each of the sixty-one rolling historical periods in the dataset. In contrast with the smooth income provided, remaining wealth is much more volatile. It runs as low as $3.36 after thirty years for the 1966 retiree (whose portfolio will deplete in year thirty-one) and up to $463.9 after thirty years for the 1982 retiree.

The volatility in remaining wealth is a byproduct of keeping spending at the same level regardless of portfolio performance. (These numbers are all scalable, as you can just multiply the assumed $100 initial wealth by the factor needed to obtain actual wealth to know the implications for spending and remaining wealth from a different starting point. For instance, spending $5 from wealth of $100 is the same as spending $50,000 from wealth of $1,000,000.)

Exhibit 1: Time Path of Real Spending and Wealth

Constant Inflation-Adjusted Spending Strategy

For 4% Initial Spending Rate, 50/50 Asset Allocation, Rolling 30-Year Retirements

Using SBBI Data, 1926-2015, S&P 500 and Intermediate Term Government Bonds

exhibit1

The benefits of Bengen’s strategy are numerous:

  1. It provides smooth and consistent income as long as wealth remains.
  2. The upcoming budget is more predictable, especially when account balances remain strong.
  3. Those whose lifestyle goals work with a sufficiently low spending rate (whether that be 4% or some other number) and who have a taste for market volatility can meet their goals with a high likelihood for success.
  4. It may be possible to create a large legacy with this strategy through the combination of a low spending rate and an aggressive asset allocation.

But it suffers from a number of disadvantages, too, primary among which is the retiree’s vulnerability to wealth depletion. Spending remains consistent until wealth hits $0. If the retiree has insufficient income sources outside the investment portfolio, this could have devastating implications.

Not only could the retiree’s preferred lifestyle be unattainable, but a minimally acceptable standard of living could prove to be too expensive. This strategy is particularly risky for those lacking sufficient resources elsewhere to cover basic needs.

This strategy also uniquely increases sequence of returns risk by calling for constant real spending from a volatile investment portfolio. Safety-first advocates would argue that this strategy is inherently flawed—those seeking constant spending should use a less volatile retirement strategy, and those who accept portfolio volatility should also accept spending volatility.

A progressively lower spending rate is required to manage the increased sequence risk. As the portfolio declines, a reduction in spending is essential to prevent the discrete drop-off in spending power when the portfolio reaches $0.

The constant strategy is also extremely inefficient. If market performance is in whatever would be considered a “worst-case” scenario when a spending rate is chosen, spending will fall well below what would be feasible and sustainable.

Your wealth will continue to grow unabated as your current spending rate drops (a constant spending amount from an increasing portfolio means a lower subsequent spending rate). On the upside, in good market scenarios, legacy wealth ends up being greater than with most other strategies because there is no mechanism to allow for spending increases in retirement.

While the constant inflation-adjusted spending strategy provides a useful benchmark and baseline for analyzing sustainable retirement spending strategies, it should probably not be viewed as a realistic or reasonable retirement income strategy. Efficient retirement strategies must adjust spending at least somewhat for portfolio volatility. The remaining strategies provide variations on how to make such adjustments.

 

McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.

The information throughout this presentation, whether stock quotes, charts, articles, or any other statements regarding market or other financial information, is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither our information providers nor we shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission there of to the user. MAMC only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. It does not provide tax, legal, or accounting advice. The information contained in this presentation does not take into account your particular investment objectives, financial situation, or needs, and you should, in considering this material, discuss your individual circumstances with professionals in those areas before making any decisions.