Friday, February 23, 2018

Unraveling Retirement Strategies: Variable Spending from a Volatile Portfolio

 In Unraveling Retirement Strategies: Constant-Dollar Spending (4% Rule), I described retirement funding strategies like the “4% Rule” that base portfolio spending on a calculation made at the beginning of retirement that remains unchanged in real dollars regardless of how the household’s finances unfold over time.

Constant-dollar spending is like the Stephen Colbert joke about a man whose beliefs are constant. He believes the same thing on Thursday that he believed on Tuesday ... no matter what happened on Wednesday.

That doesn't work well for retirement planning, either.

Variable-spending strategies are similar to constant-dollar strategies in that they spend periodically from an investment portfolio but differ in that they spend a periodically updated amount based on portfolio performance – they spend more in good markets and less in bad markets.

This is a huge difference. We have two basic choices in portfolio-drawdown strategies: spend a predictable amount annually and risk depleting our portfolio or spend an unpredictable, possibly painful, amount annually to avoid portfolio depletion.

Spending strategies, including these two, explore ways to draw down a portfolio without outliving it but they do so without considering the expense side of the equation.

Regardless of which of these strategies you choose, you will spend the amount you need to spend after retiring. If you need a kidney operation or a new roof or a check for the IRS, you will pay for those things regardless of what your spending strategy recommends. That will increase your chances of outliving your savings but that risk isn't considered by these "income-side" strategies.

There are many variable spending strategies. I recently attended a webinar in which Wade Pfau identified a half dozen of the better known and in Making Sense Out of Variable Spending Strategies for Retirees[1] he compares several more.

Joe Tomlinson, Steve Vernon and Wade Pfau recently recommended using the spending percentage for Required Minimum Distributions (RMDs) from qualified retirement accounts[2]. Vernon provides a summary of the study in "How to Pensionize Any IRA or 401(k)."[6]

RMD is based on the assumption of a retiree and a spouse 10 years younger. Retirees closer in age to their spouse can perhaps use the Modified RMD strategy and spend 10% more. Your investment company will calculate RMDs for your qualified retirement accounts when the time comes or you can find a calculator online.[3] You are required by tax law to use these calculations on tax-deferred retirement accounts but you can, of course, use them on all types accounts if you choose.

Another strategy is to spend a fixed percentage, say the same 4%, of the new portfolio balance each year, though the safe spending rate actually increases as life expectancy decreases. It makes more sense to spend that gradually-increasing percentage of one’s current portfolio balance each year than to always spend a fixed percentage of a changing portfolio balance. It approaches 10% late in retirement but grows slowly at first.

Most Americans are eligible for Social Security benefits so most have a floor. It may not be an adequate floor in the event that your portfolio is depleted, but it is a floor. The variable spending strategies and the constant-dollar strategies, therefore, technically manage the upside portfolio of a floor-and-upside strategy and will rarely be a standalone strategy.

I recommend, once again, reviewing this strategy in Pfau and Jeremy Cooper’s The Yin and Yang of Retirement Income Philosophies[4]. I particularly recommend the introduction to the work of Blanchett, Mitchell and Frank[6] on dynamic spending at the end of the variable spending strategies review. Their strategy periodically updates the critical assumptions of a retirement plan. (Frankly, I don’t see a rational alternative.)

It effectively says, “When the road in front of you turns or ends, modify your car’s behavior accordingly.”

A light pole oddly stood in the middle of the Sears gravel parking lot in my hometown. Some wise person had painted two arrows on the pole curving away in opposite directions. Below the arrows were the words, “Turn. Go left or right.”

Sounds like sage advice.

Variable-spending strategies make a lot more sense.
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The challenge with the dynamic spending strategy is that it is mathematically complex and will be difficult for most retirees or even planners to implement. I suspect, however, that you would achieve similar results with any variable spending strategy if you updated your spending percentage annually to reflect decreasing life expectancy (strategies like RMD do this for you) and based the spending amount on your current portfolio balance. Blanchett, Frank and Mitchell point out that asset allocation plays a smaller role.

The Blanchett-Frank-Mitchell study shows that life expectancy plays a critical role in determining a safe spending amount. Life expectancy declines as we age. Some variable-spending strategies, like RMD and actuarial approaches, consider decreasing life expectancy in their calculations while others, like spending 4% of remaining portfolio balance, don't. I recommend you choose one that does — it's a key factor.

To implement a variable spending strategy, choose a variable spending rule that suits your fancy[1]. Which you choose probably has less impact on portfolio depletion risk than the act of recalculating it annually, so long as it incorporates changing life expectancy.

I personally prefer the dynamic strategy, Modified RMD for simplicity, Milevsky’s formula[4], and actuarial strategies[5].

I’ve written several posts on asset allocation and it has been thoroughly discussed in several threads, including Unraveling Retirement Strategies: Constant-Dollar Spending (4% Rule). You won’t go terribly wrong with an equity allocation between 40% and 60% and it’s difficult to prove that another will work better across a broad range of outcomes. The same rules apply to variable spending portfolios.

I recommend a floor to go along with an upside variable spending portfolio to make sure you can survive if the improbable happens.

Constant-dollar strategies tell you to spend the same amount every year and that you probably won't run out of savings over a fixed thirty-year retirement. They don't consider what happens if you do.

Variable spending strategies tell you to spend more when you have more money and spend less when you have less money. The better variable spending strategies also consider remaining life expectancy and tell you that you can spend a higher percentage of your remaining savings as you age. Annual spending isn't predictable but you are unlikely to outlive your savings.

Again, seems like sage advice. Variable-spending strategies are so much more rational that I personally dismiss constant-dollar spending strategies entirely.

Retirees who have a pension, Social Security benefits or have purchased an annuity, which covers practically all American retirees, will actually be building a floor-and-upside strategy and managing the upside portfolio with a variable-spending strategy. Floor-and-upside strategies, however, will focus more on the floor and will likely recommend one higher than Social Security benefits alone are likely to provide.


[1] Making Sense Out of Variable Spending Strategies for Retirees, Pfau.

[2] Optimizing-Retirement-Income-Solutions-November-2017-SCL-Version.pdf, Pfau, Tomlinson, Vernon. (Very lengthy, consider [6], instead.)

[3] Estimate your required minimum distributions in retirement, Vanguard.

[4] The Yin and Yang of Retirement Income Philosophies, by Wade D. Pfau, Jeremy Cooper.

[5] How Much Can I Afford to Spend in Retirement?: Spreadsheets, Ken Steiner.

[6] How-to-pensionize-any-IRA-401k-final.pdf, Steve Vernon.

[7] An Age-Based, Three-Dimensional Distribution Model Incorporating Sequence and Longevity Risks, David Blanchett, Larry Frank, John Mitchell.


  1. I quite like the Boogleheads VPW strategy where you start at 5% (60/40 stock bond portfolio) when 65 and increase the percentage to age 100. I was wondering of any downsides to this method

    1. I have been pondering a somewhat different approach. Conceptually:

      1. Set aside money in ST bonds to replace SS until age 70
      2. Reserve home equity/Roth IRAs for long-term care, major medical expenses etc. later in life
      3. 7%/year 65-68, 6%/year 69-72, 5%/year 72-80, RMDs after that.

      It front loads some spending up front while more active, declines during mid-late 70s, and then follows RMDs as you age. This would essentially match the spending smile that Wade Pfau and others have written about. Delaying SS until 70 provides a reasonable guarantee we won't be poor even if the whole portfolio failed late in life.

      The upfront loading can be reduced if there is a major challenge to it (market collapse, health etc.) but at least some of the up-front spending could be reserved ahead of time by putting some percentage in ST bonds so only some of the money would be subject to sequence of risk. Postponing retirement could push the spending sequence out as well.

    2. Sounds like a prudent plan to me. However, I would use the "spending smile" research cautiously.

      The work was actually done by David Blanchett, not Wade Pfau. You can find it here.

      The "smile" is actually a graph not of spending but of the acceleration of spending (spending's "first derivative"). You can see the difference in Blanchett's figure 4 by looking at the y-axis labels of the two graphs. Spending acceleration is shown in Panel A. Spending is shown in Panel B (more of a "spending sneer").

      I wrote about this here.. In that post, I showed earlier work by Sudipto Banerjee who used the same data as Blanchett.

      Banerjee summarizes that expenses "tend" to decline in retirement and even when they rise at the end of retirement they are usually lower on an inflation-adjusted basis than initial spending. The Blanchett charts tend to be interpreted as "your spending will decrease in the first half of retirement and increase in the last half." In fact, they show that spending "tends" to increase if you live past your life expectancy (except for under-savers). Half of us won't. Unless you live to be quite old, your "spending smile" chart will look a lot like Banerjee's graph. (Cover up the spending smile to the right of age 85, for example.)

      Banerjee uses all the data whereas Blanchett breaks it down further in under-savers, over-savers and just-right-savers. Spending trends "tend" to be different for each of these.

      Blanchett later noted in a private email that this decline is quite volatile on an annual basis (it doesn't follow those curves very precisely.)

      Bottom line, while this is important research about population trends, I wouldn't trust it as a basis for my individual retirement plan. It may not be clear which saving group you will end up in (relative to spending) and there is no guarantee that your spending will be typical for that group.

      Retirement research can be quite enlightening but not adequately predictive to use for an individual retirement plan. Assuming your spending will decline and guessing wrong can have a significant downside. I tend to treat it as a little extra margin in my plan but I don't count on it.

      Thanks for the comment.

  2. Increase the percentage by how much?

    1. 0.1% a year in your 60s, 0.2% in your 70s, 0.4 in your 80s goes to about 2% a year early 90s then very big increases through the rest of your 90s to finally end at 100% when you are 100.

    2. Do you mean what would the risks be other than the obvious (living to 101)?

      Or, other than the less obvious risk of forgetting a very complicated formula in you dotage?

      I guess the risk would be that it spends significantly more aggressively than "Milevsky" would when targeting 95% survival. If I understood you correctly, it recommends 6.8% at age 80 compared to 5% from "Milevsky" and 12.4% at age 90 compared to 7.8%.

      I personally would be less aggressive. I'm not sure why anyone would spend all their money at age 100.

    3. Thanks for your reply, yes the strategy relies on most people not reaching the age of 101. However the recommendation is that you could use say the withdrawl amount for a 55 year old (4.5%) when you are 65 thereby increasing the final year to 110 . Yes the formula is annoying in its use of small percentage increases each year but you could use simpler increases like withdraw 5% for 60s decade, withdra 6% for 70s decade etc. Yes I do take you point about it being aggressive but it is designed to maximise all your money while you are still here.

    4. When you maximize (increase) spending you also increase the probability of outliving your savings.

  3. Yes thats true but because you are always taking a percentage from your fund you cant outlive your savings unless you live to 111 as in my previous example. It might be more of having a very small pot in your 90s. Thats the only downside i can see. Thanks again for replying to my questions.

    1. That is true for every variable-spending strategy but the more aggressively you spend with a V-S strategy, the more likely you are to end up with very small withdrawals. (I should have said that instead of "outliving your savings").

      You're welcome and thanks for asking!

  4. When you use a variable spending strategy, how do you know when your portfolio is large enough for you to retire?

    1. That’s a good question, Steve. A variable-spending strategy doesn’t tell you any more or any less about how well your retirement is funded than a constant-dollar strategy would. The cost of your retirement, its length and your portfolio’s future returns are all unknowable.

      The variable-spending strategy makes it highly unlikely that you will prematurely deplete savings but leaves spending unpredictable. The constant-dollar spending strategy makes spending predictable but introduces the possibility that you will outlive your savings.

      I like to use life annuity payouts to estimate this. Currently, they pay about 4.5% with a 2% COLA. Assume that you could use your entire retirement savings to purchase one. Multiply that by .045 and you can see what lifetime income you could receive. If you have saved $1M, you could generate $45,000 of annual income with a 2% COLA no matter how long you live.

      I’m not recommending that you do or not actually buy an annuity, let alone that you annuitize 100% of your savings, but I do think that the calculation provides a good benchmark for your decision.

      This test works better as you approach retirement age because it’s also impossible to predict annuity payouts many years in advance.

      Thanks for writing!

  5. Dirk, I always benefit from your pieces, so thanks for another good one. Here's what will probably seem an odd question: how often have you seen people who actually pay attention to things in retirement like spending,"floor", withdrawal rates, and the like, actually end up in a near-disastrous state later in retirement? My experience is that most people who look at the issues closely enough to consider different strategies do pretty well. Not necessarily optimally, and not necessarily without having to make some significant adjustments along the way, of course. My question/comment is not to suggest that all approaches are equally valid, though, or that these issues shouldn't be considered. Maybe I'm just wondering whether the chief value in such discussions for many (most?)people isn't what method they end up using, but rather that it gets them to think about the essential issues. (apologies if I am not being clear.)

    1. Pat, that's not an odd question at all. First, I should say that I don't speak to a lot of retirees who have had disastrous outcomes. Statistics show that only about half a percent do.

      Because I write a blog on the topic I am sometimes contacted by those who do.

      So let me answer in two parts. First, if your thought is that most people who have a plan and pay attention to it do better than those who don't, I suspect that is correct.

      If your second thought is that people who have a plan and pay attention will avoid disaster by doing so, I'm afraid that isn't correct.

      Some people have disastrous outcomes resulting from bad economic decisions but bankruptcy statistics show that most succumb to spending shocks and primarily to healthcare shocks. A good financial plan won't stop that. Most of these households had health insurance when the crisis began.

      Here's an example I heard and believe to be authentic.

      A wealthy, retired executive was bankrupted by his wife's dementia. No planning prevents that, especially if you don't qualify for LTC insurance, and he didn't make bad economic decisions. So, planning and paying attention is much better than not but it doesn't preclude disaster. Hence, the floor.

      Does that answer your question?

    2. It does, thanks. And no, I wasn't thinking/claiming that people who have a plan and pay attention to it can count on avoiding disasters. My experience is similar to yours: namely, healthcare shocks as the source of many (most?) bankruptcies.

    3. Elder bankruptcy studies say it's "most." Especially if you include the number of credit card bankruptcies that began as health care shocks.