We could easily name ten or twelve retirement income strategies but several of them are really just variations on a theme. When you're trying to choose one, it may help to visualize them that way.
In a recent post, Dominated Strategies and Dynamic Spending, I showed that fixed-dollar sustainable withdrawal rates (SWR-Fixed), fixed-percentage rate SWR (SWR-Variable), and Required Minimum Distribution strategies are all dominated by a dynamic updating strategy. Game theory tells us that dominated strategies should never be played and that guideline should narrow the field of choices.
In A Second Look at Time Segmentation, I argued that the benefits of time segmentation strategies may be largely behavioral. Holding large allocations of cash will reduce expected returns and Moshe Milevsky has shown (download Word doc) that the strategy cannot be counted on to bail us out of a bad sequence of returns, though it sometimes will.
Nevertheless, many retirees appear to find comfort in time segmentation strategies, knowing that any spending problems are at least five years into the future. I'm always in favor of sacrificing a little economic efficiency if it helps the retiree sleep at night.
I’m now going to argue that these are actually the same strategy applied to different degrees.
A dynamic updating strategy, or dynamic spending strategy as I have sometimes referred to it, tells us to modify our spending periodically (typically annually), to reflect our ever-changing portfolio value, diminishing life expectancy, new expectations about market returns and risk, and any changes to our personal risk tolerance and risk capacity.
If we calculate a sustainable spending amount once at the beginning of retirement, we have an SWR-Fixed strategy. This strategy's attraction lies in its simplicity of implementation and maintenance, but it condemns the retiree to spend based on conditions that might have existed two or three decades earlier. In other words, it ignores any new information after retirement begins – a foolhardy approach.
Michael Kitces argues that no one really implements SWR-Fixed because retirees eventually realize they must spend less or can spend more and do so, and he has an excellent point. Wade Pfau argues that SWR-Fixed is a research technique and never was a retirement income strategy. I think he’s right, too. Yet, I don't completely buy the idea that no one tries to use the SWR-Fixed strategy by rote.
For a decade or more, Money magazine touted the SWR-Fixed strategy, relenting only after many retirements were trashed in the 2008 market crash. I recently received a sample Kiplinger newsletter suggesting the strategy. With so much ink in the popular press for so long, it’s hard for me to accept that no one believes it. I hope Pfau and Kitces are correct, but I have a nagging suspicion that they are not entirely. If you’re implementing a SWR strategy by rote, please stop.
In a post entitled, Sequence of Returns Risk and Payouts, I showed that an SWR-Variable strategy, in which a retiree spends a fixed percentage (like 4%) of remaining savings portfolio balance each year, eliminates the possibility of ruin inherent in an SWR-Fixed strategy. It provides variable annual spending but a more constant risk of failure than SWR-Fixed. SWR-Variable moves risk from longevity (running out of money) to payouts (perhaps needing to spend less), where it seems to do less harm.
SWR-Variable reduces sequence of returns (SOR) risk by reducing spending when portfolio value declines. If we recalculate a sustainable spending amount annually, instead of once at the beginning of retirement like SWR-Fixed, and only update portfolio balance, we have an SWR-Variable strategy. Because it uses more new information, it dominates SWR-Fixed, but because it doesn’t update life expectancy, market return expectations and risk tolerance and capacity changes, it is dominated by dynamic updating.
So, calculate spending once at the beginning of retirement and you have SWR-Fixed. Apply it annually, updating only your savings balance, and you have SWR-Variable.
Basing spending on IRA Required Minimum Distributions (RMDs) also exposes us to less SOR risk than SWR-Fixed because spending will be reduced when portfolio values decline. RMD bases spending on an annual updating of portfolio balance and remaining life expectancy (updated annual spending is roughly current portfolio balance divided by remaining life expectancy), but ignores changes to expected market returns and changes to risk tolerance and capacity. As a result, it is also dominated by dynamic updating.
Still, studies show that the RMD strategy is a reasonable approximation of dynamic updating strategies and a lot simpler. To quote David Blanchett, et. al. from a 2012 paper entitled, Optimal Withdrawal Strategy for Retirement Income Portfolios, "As a practical matter, for retirees who can’t replicate the results presented here or don’t have access to them, the RMD method emerges as a reasonable alternative to the more common constant dollar and constant percentage of assets withdrawal strategies."
Dynamic updating strategies calculate a new sustainable spending rate each year incorporating all critical factors of the probability of ruin: current savings balance, remaining life expectancy, market return expectations and current risk tolerance and risk capacity. Spending is no longer tied to your personal financial situation as it existed at the beginning of retirement, or even the previous year.
Lastly, let's look at time segmentation strategies. Time segmentation strategies hold four or five years of expenses in cash, the next five to seven years of expected spending in intermediate bonds, and the remainder in stocks to cover long term spending.
As I argued in A Second Look at Time Segmentation, this strategy is largely an SWR strategy with perhaps too large an allocation to cash for its own good. It could be an SWR-Fixed strategy if the retiree calculates spending once, an SWR-Variable strategy if the retiree recalculates spending periodically based on a current portfolio balance alone, or a dynamic updating strategy if the retiree updates all critical variables periodically. If we look at the portfolio holdings alone, it may be impossible to distinguish an SWR strategy from a time segmentation strategy. (A larger than expected cash holding tips us off that it is probably the former.)
The more critical parameters we consider in our retirement income strategy, the better the approximation of sustainable spending.
The following table summarizes the variables considered by each strategy. Time segmentation is not included because it dictates an asset allocation but can use any of these spending strategies.
How does this help a retiree? It should help by simplifying the broad array of retirement income strategies available. A retiree will always be better off updating her spending as her financial situation changes and the more critical information she updates in the process the better.
SWR-Fixed, SWR-Variable and RMD strategies simplify sustainable spending calculations by ignoring critical new information. Time segmentation can be added to any of these strategies, but the financial justification for it is much weaker than the behavioral justification.
What is the benefit of ignoring relevant new information? Only that it simplifies the math and reduces the management process a tiny bit – spending is recalculated just once a year in any case, except for SWR-Fixed, of course.
Retirees unwilling to do that little bit of extra work will likely be better off with a set-and-forget strategy like TIPS bond ladders and life annuities.
The sidebar shows a link to a recent post by Wade Pfau at Advisor Perspectives entitled, The Hidden Peril of Sequence of Returns Risk. SOR risk is complicated and nuanced. In several ways, it is unlike any other form of retirement financial risk, and certainly different than investment risk. No retirement income strategy is perfect, but the risks of SWR strategies are more difficult to understand than the rest. A great read.