Retirement spending: 3 strategies

This challenging topic regarding spending rules to help retirees who want to generate a paycheck from their portfolios. Two of the most popular are the “dollar plus inflation” and the “percentage of portfolio” rules. One alternate solution: is the “dynamic spending” strategy.

The dollar plus inflation strategy is just what it sounds like. Upon retirement, you select the initial dollar amount you’d like to spend each year and increase that amount annually by inflation. The well-known “4% rule” follows this approach (Bengen 1994[1]). While this strategy allows for rather stable real spending from year to year, it also requires a trade-off: a higher risk of premature portfolio depletion. The chink in the armor for this strategy is that it’s indifferent to the returns of the portfolio, which can be problematic in both bear and bull markets. The result is you could potentially run out of money (or at least have to substantially reduce your spending since you’re not likely to continue spending down to your last $1) in the event portfolio returns are negative, or you could potentially live well below your means and not enjoy retirement to its fullest if portfolio returns are much better than expected.

The percentage of portfolio strategy, on the other hand, may be too sensitive to returns, creating significant income volatility based on market movements. With this strategy, the annual spending amount is a consistent percentage of the portfolio’s value. This approach ensures that the portfolio won’t be depleted, but as the portfolio’s value rises and falls, the income amount will rise and fall as well—sometimes dramatically. Yes, it’s this last part—income falling in response to negative returns—that people often struggle with.

The dynamic spending strategy is a more flexible approach that moderates the other two strategies’ weaknesses, as summarized in Figure 1.

With dynamic spending, you would calculate each year’s spending in three steps:
Use the percentage of portfolio approach (e.g., 5%) to calculate a spending level based on the portfolio’s value at the prior year-end.
Determine a range of acceptable spending levels based on the prior year’s actual portfolio value. To find the range, increase the prior year’s spending by 5% (the ceiling) and reduce it by –2.5% (the floor).[1]
Finally, compare the results. If this year’s spending amount based on the percentage of portfolio:
Exceeds the ceiling amount, spend the ceiling.
Is less than the floor amount, spend the floor.
As you can see, the dynamic spending strategy is a bit more involved and may require a little more discipline and oversight to follow compared with the other two strategies. Given that, this is certainly one area where working with a financial advisor can make a lot of sense and may even pay for itself.
— Read on vanguardblog.com/2019/08/08/sustaining-retirement-income-in-a-lower-return-world/