Welcome to retirement at the beginning of the 21st century: People are living longer, return expectations are muted for the foreseeable future, and employer-funded pension plans are becoming a thing of the past. This is not your parents' retirement.
One of the biggest challenges facing most of us is knowing how to spend safely in retirement. Spend too much and we risk outliving our savings; spend too little and we could miss out on many of the things we've worked and saved to enjoy.
In a previous blog post, Sustaining retirement income in a lower-return world, I introduced our dynamic spending strategy. It incorporates the best parts of two traditional strategies—percentage of portfolio and dollar plus inflation. To recap, here's a snapshot of each strategy:
Percentage of portfolio strategy
Each year, you withdraw a fixed percentage of your portfolio balance based on its value at the end of the prior year. When you use this strategy, you aren't likely to deplete your portfolio prematurely because you're only spending a percentage of your balance each year. On the other hand, the amount you withdraw each year depends a lot on market returns, which can make it hard to budget.
Dollar plus inflation strategy
You choose a dollar amount to spend in your initial year of retirement and increase that amount annually by inflation. This approach allows you to calculate a stable, inflation-adjusted amount to withdraw each year. However, you risk spending more than you should (and potentially depleting your savings) when markets perform poorly—and spending less than you could when markets perform well.
Dynamic spending strategy
For many retirees, this strategy offers the best of both worlds. It's responsive to market changes without causing big fluctuations in the amount you can withdraw every year. This strategy allows you to set controlled maximum (ceiling) and minimum (floor) spending limits. You can spend more when markets perform well or cut spending when they don't—within limits you can plan for.
Since publishing my initial blog post about our dynamic spending strategy, I've received many requests to provide a detailed example of how retirees can implement this strategy ... so here you go.
Dynamic spending strategy at a glance
This is the condensed version of how to implement a dynamic spending strategy:
- Identify your spending rate and ceiling and floor percentages.
- Spending rate: the percentage of your portfolio that you'd like to withdraw each year.1
- Ceiling percentage: the percentage by which you'd like to increase your annual spending if the markets had a positive return the previous year.
- Floor percentage: the percentage by which you're willing (and able) to reduce your spending if the markets had a negative return the previous year.
- Multiply your year-end portfolio balance (from the previous year) by your spending rate to get your initial annual spending amount.
- Calculate your spending range, which includes ceiling and floor amounts. To find the range, increase your actual spending amount from the previous year by the ceiling percentage, and reduce it by the floor percentage.
- Compare the results. If this year's initial annual spending amount (calculated in step #2):
- Exceeds your ceiling amount, spend your ceiling amount;
- Is less than your floor amount, spend your floor amount;
- Is between your ceiling and floor amounts, spend your initial annual spending amount (calculated in step #2).
The numbers in action
Here's an example of how a hypothetical retiree implemented a dynamic spending strategy for 3 years. A summary of the retiree's finances is below:
- Starting balance: $1 million
- Year 1 portfolio growth: 10%
- Year 2 portfolio growth: 5%
- Year 3 portfolio growth: 5%
- Spending rate: 4%
- Ceiling percentage: 5%
- Floor percentage: 2.5%
- Inflation: 0%
Annual spending amount = $40,000.
Starting balance ($1 million) x spending rate (4%).
Ending balance = $1,060,000.
Starting balance ($1 million) + investment earnings ($100,000) – annual spending amount ($40,000).2
Initial annual spending amount = $42,400.
Starting balance ($1,060,000) x spending rate (4%).
Ceiling amount = $42,000.
[Year 1 annual spending amount ($40,000) x ceiling percentage (5%)] + year 1 annual spending amount ($40,000).
Floor amount = $39,000.
Year 1 annual spending amount ($40,000) – [floor percentage (2.5%) x year 1 spending amount ($40,000)].
Determine spending amount by comparing your results.
Your initial annual spending amount ($42,400) exceeds your ceiling amount ($42,000), so you'd spend your ceiling amount ($42,000).
Year-end balance = $1,071,000.
Starting balance ($1,060,000) + investment earnings ($53,000) – annual spending amount ($42,000).
Initial annual spending amount = $42,840.
Starting balance ($1,071,000) x spending rate (4%).
Ceiling amount = $44,100.
[Year 2 annual spending amount ($42,000) x ceiling percentage (5%)] + year 2 annual spending amount ($42,000).
Floor amount = $40,950.
Year 2 annual spending amount ($42,000) – [floor percentage (2.5%) x year 2 annual spending amount ($42,000)].
Determine spending amount by comparing your results.
Your initial annual spending amount ($42,840) is between your ceiling amount ($44,100) and floor amount ($40,950), so you'd spend your initial annual spending amount ($42,840).
Ending balance = $1,081,710.
Starting balance ($1,071,000) + investment earnings ($53,550) – annual spending amount ($42,840).
If you're itching to get out your calculator after reading through this example, go for it! Or you might decide that partnering with a financial advisor might be a better choice for you. Either way, once you feel confident about your spending strategy, you can focus on more important things—like enjoying retirement
Editor's Note: This is a paid post from Vanguard.
1 See From assets to income: A goals-based approach to retirement spending for more information on selecting an appropriate spending rate.
2 This example assumes end-of-year spending and a 0% inflation rate. To see this example using a 3% inflation rate, see From assets to income: A goals-based approach to retirement spending.
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