There is No Perfect Retirement Spending Strategy

Lately a few readers have written in asking about strategies for determining how much to spend each year from a retirement portfolio.

Personally, I think there are many parallels between selecting a spending strategy and selecting an asset allocation. That is, in each case you have an endless list of options, and there’s a ton of research on the topic. But no matter how sophisticated the research, nothing can actually tell you the future. Nothing can give you certainty about the best strategy.

In short, as with asset allocation, there is no perfect spending strategy, but there are many perfectly fine spending strategies. So the goal is to understand the pros and cons of each strategy, then pick one that suits you and move on with your life.

The Spectrum of Spending Strategies

I like to think of a spectrum of retirement spending strategies. At one end of the spectrum is a strategy in which you simply spend a fixed percentage of your portfolio balance each year (e.g., spending 4% of your portfolio balance each year). The advantage of this strategy is that you’ll never fully deplete your portfolio. The disadvantage is that your spending can vary dramatically from one year to the next.

At the other end of the spectrum is the strategy used by the classic “4% rule.” According to this strategy, you spend a certain percentage of your portfolio balance in the first year of retirement (e.g., 4%), then you adjust your spending upward each year in keeping with inflation, regardless of how your portfolio has performed. The advantage of this inflation-adjusted spending strategy is that it keeps your spending predictable. The downside is that it can lead to portfolio depletion, if your initial withdrawal rate turns out to have been too high relative to how long you end up living and how well your portfolio ends up performing.

And in the middle of the spectrum are an assortment of hybrid strategies that either:

• Start with the “percent of portfolio each year” strategy, but then add a provision that attempts to control the variation in spending, or
• Start with the “inflation-adjusted spending” strategy, but then add a provision that allows for a modest degree of adjustment based on portfolio performance.

For instance, Vanguard’s Managed Payout Fund uses a “percent of portfolio” strategy, but it smoothes the variation in spending by basing the payout on the average share price over the last three years.

Similarly, Colleen Jaconetti of Vanguard recently wrote about a “dynamic retirement spending strategy” that is essentially the “percent of portfolio” strategy, but with “floor” and “ceiling” amounts that are based on the prior year’s spending level, so as to limit the variation from year to year.

Yet another alternative is to use an inflation-adjusted spending strategy, but with a provision that “ratchets” spending slightly upward or downward if the portfolio grows/falls by a certain percentage.

Broadly speaking, the two principles that are always true are that:

1. Regardless of which spending strategy you choose, selecting a lower annual spending amount at the outset makes you safer.
2. A strategy that adjusts spending downward when portfolio performance is poor is safer than one that does not.

And by “safer” I mean, “less likely to lead to portfolio depletion.” The flip side, of course, is that the safer your spending plan, the more likely you are to die with a pile of unspent money — which may be acceptable or unacceptable to you, depending on how motivated you are by the idea of leaving a bequest to heirs/organizations.