Retirement Spending Assumptions and Net Worth

In my last post, Spending Typically Declines as We Age, I reviewed the results of research by David Blanchett (PDF) and Sudipto Banerjee (PDF) that shows expenditures in retirement typically decline as we age. Most retirement spending strategies assume, as I noted in that post, that future real spending will remain constant throughout retirement.

The amount that we can safely spend from retirement savings in the current year depends heavily on the assumptions we make about future spending trends. If our future spending needs will decline, spending rules that assume constant real spending will be unnecessarily conservative and, of course, if future spending will increase, those spending rules will recommend spending that may not be sustainable.

What assumptions should our retirement plan make about future spending? The two papers I reference offer some clues.

First, Banerjee reports that spending in retirement increased for only 16% of the households in the data he studied, while it declined for 66% of them. It is significantly more likely that your expenditures will decline as you age, but they might not, so our retirement plans should also consider worst case outcomes.

We could assume a worst case, that expenditures will increase perhaps 1% per year on average, but that would significantly increase the predicted cost of retirement. If we assume we will live 30 years or more, that our market returns will be quite conservative by historical standards and that our expenses will grow in retirement, we will quickly realize that hardly anyone could afford that retirement. Making lots of conservative assumptions doesn't make a very good plan.

Blanchett offers additional insights by segmenting the data based on the level of annual spending relative to net worth. He creates four categories of consumption: low spenders with high net worth, low spenders with low net worth, high spenders with high net worth and high spenders with low net worth. By figuring out into which group you best fit, you may be able to narrow the field of spending assumptions for your plan.

The dividing line for high and low spenders was $30,000 per year and the hurdle for high net worth was $400,000 in Blanchett's study. These are the median values for his data sample, not for the population of retirees. In other words, more than $30,000 of annual spending made households in the data sample high spenders relative to other households in the sample, but that amount wouldn't make you a high spender relative to all other retirees in the U.S. today. The breakpoints for the larger population of retirees would likely be much higher. Blanchett is showing that expenditures in retirement depend on the relationship between annual spending and net worth; he is not claiming that these are the dividing lines for all retirees.

Blanchett notes that two of these groups, Low Spending, Low Net Worth and High Spending, High Net Worth retirees, consume efficiently (green), while the other two groups consume too much (red) or too little (yellow).

Following is a diagram from Blanchett's paper plotting these four segments. Please note the very important point, as I explained in Spending Typically Declines as We Age, that these graphs show annual rate of change in spending and not annual spending, itself. With the exception of Low Spending, High Net Worth households (the red squares on Panel B) almost all of the annual changes in expenditures are negative, meaning spending declines throughout retirement for the other three groups. (Double-click the chart for a larger image.)

Notice that the following graphs of annual spending are quite different than Blanchett's graphs of annual spending change above. Because some readers have mistaken the Blanchett "smile" rate-of-annual-change graphs for annual expenditures graphs, I provide both in the examples below.

In fact, Blanchett's paper shows this in his Figure 7, though most of that paper addresses annual spending change and not annual real dollar spending. My graphs will show typical real dollar annual spending that is derived from the rate-of-change graph to its right. I place the spending function on the left because I believe that information will be more meaningful to most of my readers, and I switched Panels A and B in Blanchett's Figure 7 for consistency – the charts on the left always show annual spending.

Let me be very clear about this. The Blanchett smile curves, like Panel A above, show how quickly typical spending changes each year. The spending curves, like Panel B above, show how much spending changes in real dollars and, in most cases, spending goes steadily downward throughout retirement, like the curves in Panel B.

Now, let's look at Blanchett's four spending/net worth classifications.

Low Spending, Low Net Worth households likely spend a large portion of their budget on non-discretionary expenses with little opportunity for reducing expenses later in retirement. We usually give up some discretionary items later in retirement, like extensive travel and sports, and these households have fewer of those to eliminate, so expenditures don't decline a lot with age.

High Spending, High Net Worth households also consume efficiently and will likely see greater declines in spending than Low Spending, Low Net Worth households, because they will have more discretionary spending to eliminate as they age.

Low Spending, High Net Worth households appear to have the highest probability of increased expenditures throughout retirement, but they can afford it. They are underspending. A likely cause for such an increase in expenditures, in fact, is recognition over time that they have the resources to spend more.

This graph also demonstrates the key point that increasing expenditures don't necessarily mean that retirement is getting more expensive and decreasing expenditures don't mean it is getting less expensive. They mean that retirees are spending more or less. Expenditures, the subject of this analysis, are not the same as expenses. Sometimes expenditures change because retirees have to spend less and sometimes it is because they can spend more.

High Spending, Low Net Worth households also consume inefficiently and they are likely to recognize as they age that their level of spending is unsustainable. This realization will eventually lead to declining expenditures later in retirement, as can be seen in the following chart.

The next chart combines all four annual spending curves for comparison. The two curves in the middle result from efficient consumption. Inefficient consumption produces the two extremes.

Your personal ratio of annual spending to net worth should suggest whether your own spending is more likely to rise, fall, or remain somewhat constant throughout retirement.

To summarize this information, Banerjee tells us that two-thirds of retirees will experience declining expenditures as they age and only 16% will see increased spending. Blanchett tells us that spending will likely increase for Low Spending, High Net Worth households as they realize they are able to spend more as they age, as it will likely decrease for High Spending, Low Net Worth households as they realize they are running out of savings. Among households that consume efficiently, those with High Spending and High Net Worth are more likely to spend less later in retirement because they will have more discretionary expenses to "age out of" than will Low Spending, Low Net Worth households.

Some expenditures change for reasons that have little to do with how much annual spending a retiree targets or how wealthy they are. Some changes are the result of aging. Health care expenses tend to increase as we get older but we also become less active and other expenses decline. I recently read that international air travel declines among septuagenarians and domestic air travel declines among octogenarians. I suspect the sales of bungee-jumping and rock-climbing gear decline in those market segments, as well. I spend less on hair care expenses.

These two studies deal with typical retiree spending patterns and assume that expenditures will follow some trend, rising, constant or declining, throughout retirement. They don't, however, deal with the most likely scenario for an individual household, irregular net spending.

Both income and expenses in retirement are likely to vary significantly over time. Income will vary, for instance, as Social Security benefits ramp up for retired couples and more income needs to be withdrawn from savings early in retirement. There may also be large planned expenses later in retirement, like college for a child or grandchild. Net spending is the important consideration, the difference between annual income and annual expenses. Irregular net spending from savings might look like the red bars in the following chart:

These irregular net spending years, whether they are caused by changing income or changing expenses, must be considered when calculating a sustainable amount to spend in the current year. Like steadily rising or steadily declining expenditures, spending rules assume flat future spending and don't accommodate irregular net spending very well.

It is helpful to know that expenses typically decline in real terms throughout retirement, but yours may not. You need to plan for expected spending declines but be prepared for a worse case. Like portfolio returns, total expenditures in retirement are unpredictable.

So, most retirement income strategies assume constant spending throughout retirement and most retirement expenditure studies show that constant spending isn't the norm. What's a retiree supposed to do with that?

In my next post, Spending Rules That Fit the Patterns of Retirement, and Some That Don't, I'll explore spending strategies in light of future spending expectations.

2015 RIIA Practitioner Thought Leadership Award

The Retirement Income Industry Association® (RIIA) today announced that Financial Planner Dirk Cotton, author of The Retirement Café blog and founder of JDC Planning, LLC, is the winner of its 2015 RIIA Practitioner Thought Leadership Award. The Award recognizes his paper, “Sequence of Return Risks: A New Way of Looking at Spending or Saving Scenarios with Path Dependence,” for contributions to retirement thought leadership and RIIA’s Body of Knowledge. The paper appears in the Spring issue of RIIA’s peer reviewed industry publication, the Retirement Management Journal®.

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Spending Typically Declines as We Age

The most common assumption of retirement spending strategies is that real (inflation-adjusted) spending from savings will be flat throughout retirement, yet most studies of actual retiree household expenditures show that constant real spending is atypical. For most retirees, expenditures decline pretty consistently as we age.

Two of my favorite studies on this topic are David Blanchett's Estimating the True Cost of Retirement (2013, PDF) and Sudipto Banerjee's Expenditure Patterns of Older Americans, 2001-2009 (2012, PDF). The results of the studies are quite similar – not surprising since they used the same databases – but each provides unique information.

Blanchett christened his findings the "retirement spending smile", though be forewarned that if you Google "Blanchett smile", you will find a multitude of photos of Cate Blanchett's lovely face with poor David nowhere to be found. (It wasn't a terrible disappointment.)

Following is a chart of the "smile" from Blanchett (2013). (A quick note: you can double-click any chart in my posts to see a larger version. Also, while burnt orange text indicates a link to another website, yellow text indicates a mouse-over. Hover your mouse over the link for more information.)

There are three things I should note about the chart. First, the term "Experience" labeling the y-axis is an "auto-incorrect" for "Expenditures." Second, the smaller smile was added because of limited sample sizes for some tests. Pay more attention to the 30-year smile. My third point is a larger issue.

I suspect that some readers interpret the spending smile as showing that spending is high in early retirement, becomes lower until age 75 and then returns to nearly the level of early retirement near age 90, but this is not a graph of total annual spending. It is a graph of the annual real change in consumption for a typical retiree. In other words, it shows a decrease (and very rarely an increase) in spending at say, age 61 compared to age 60. It shows not the change of spending, but the rate of that change.

The rate of the decrease changes throughout retirement, but because these rates are nearly always negative (below the zero percent line on the y-axis in Blanchett's chart above), spending constantly decreases, but at different speeds. Banerjee shows the data in terms of total spending instead of the rate of annual change in spending and this point is more clear in his chart:

Reconstructing annual total expenditures from Blanchett's annual rate of change data for a retiree with a $100K annual spending target, we see a chart below that is similar to Banerjee's.

Mathematically speaking, the Banerjee curve is an annual spending function and the Blanchett smile curve is the derivative of the spending function. Banerjee shows the spending curve for a typical retiree while Blanchett shows the acceleration of that curve. Both show that expenditures generally decline with age, as have earlier studies. Blanchett additionally shows that expenditures drop more rapidly each year of early retirement and drop more slowly each year of late retirement, but both show that the amount of spending almost always declines.

Medical expenses late in life can increase expenditures significantly, but both studies appear to show that even when medical expenses do increase expenditures at older ages, they are lower than early retirement spending in real dollars.

The Banerjee chart and the Blanchett annual expenditure chart are not identical. Banerjee shows a steeper decline. Part of the reason for this may be, as Blanchett suggests, that he scrubbed the data to eliminate data points that seemed unreasonable, while Banerjee appears to have used the entire dataset.

Another reason is that Blanchett shows that rates of spending decline vary for undersavers and oversavers, while Banerjee provides a single rate of decline for all households.  Regardless, both studies find that typical retiree expenditures decline as we age. They do not remain constant in real dollars as spending strategies generally assume.

Why is this important? It should be obvious that when we try to estimate an amount of our savings that we can safely spend in the current year we must make some assumption about our future spending patterns. Spending strategies assume that our expenditures in real dollars will remain flat throughout retirement. If our actual spending will increase over time, we can safely spend less in the current year than these strategies predict, and the reverse is true if our expenditures will actually decline after we retire.

A 30-year retirement with level real spending of $100,000 a year would cost about $2.4M if we discount future expenses at 2%. Assuming Blanchett's findings for a retiree with a spending target of $100,000 a year, the same retirement would cost about $2.1M. Using the Banerjee 2012 finding that expenditures tend to decline about 2% annually, that retirement would cost only about $1.8M.

The following chart shows the expected annual spending and cost of an initial $100K annual retirement using all three assumptions:

Future spending is difficult to predict with any accuracy, but a spending strategy that assumes flat real spending throughout retirement, as nearly all do, will underspend early in retirement if the retiree's expenditures decline over time as Blanchett, Banerjee and several other researchers believe they commonly do. In these examples, Blanchett predicts a 12.5% less expensive retirement and Banerjee forecasts 25% less. From another perspective, that means a worker would need to save 12.5% or 25% less to fund retirement.

To quote Blanchett, "While many retirement income models use a fixed time period (e.g., 30 years) to estimate the duration of retirement, modeling the cost over the expected lifetime of the household, along with incorporating the actual spending curve, results in a required account balance at retirement that can be 20% less than the amount required using traditional models."

How does this impact our retirement plan? Clearly our future spending trend assumption has a significant impact on both how much we need to save and how much we can "safely" spend in the current year. Unfortunately, like assuming many other critical retirement unknowns such as future market returns and the length of our own retirement, choosing a future spending assumption is both critical and challenging.

In my next post, Retirement Spending Assumptions and Net Worth, I'll explore these two papers to see what they tell us about how we should choose.

Time to Retire the Probability of Ruin?

The following post originally appeared on Advisor Perspectives, a blog for financial planners, in April 2015.

Perhaps no other retirement finance concept has gotten more ink than the "probability of ruin", which is interesting because few other economic concepts model the real world as poorly. The gist is that a retiree who spends a constant dollar amount throughout retirement is exposed to the risk of outliving her savings. The problem with the economic model is that no one would actually do that.

A constant-dollar spending assumption served us well when William Bengen formalized the notion of path dependence, but it seems that even he didn't anticipate that planners might implement the strategy by rote. In Conserving Client Portfolios During Retirement, Bengen states, ". . . the adviser should examine the projected current withdrawal rate through the entire time horizon of the clients, not just the first year of retirement." He even put it in italics.

Probability of ruin is largely an artifact of those constant-dollar SWR studies.

(Note: You can hover over yellow terms.)

Once constant-dollar SWR escaped the lab, though, the mainstream press and popular retirement newsletters latched onto the belief that constant-dollar spending was OK. These same publications softened their stances quite a bit after retirements were destroyed in the Great Recession, but I recently received a Kiplinger retirement newsletter still espousing the constant-dollar strategy.

Nearly all retirement income strategies avoid the probability of ruin issue in theory by spreading spending thinner and thinner as savings decline – a rational rationing strategy. Annual Recalculated Virtual Annuity (ARVA download PDF), RMD,  Milevsky's formula for sustainable withdrawals without simulation, and the 3D dynamic updating strategy (download PDF) of Frank, Mitchell and Blanchett all spread spending over remaining life expectancy. Constant-percentage SWR doesn't, but won't deplete a portfolio in theory, either.

Unfortunately, these strategies reduce the probability of ruin by reducing spending, our "standard of living."

Life annuities are different because they augment their payouts with a mortality premium and both guarantee a standard of living and provide longevity protection.

I was rereading a study recently about evaluating retirement strategies and noticed the author suggested that retiree's want an income strategy that guarantees they will not outlive their savings. While this is no doubt true, what we really want is an income strategy that guarantees we won't lose our standard of living. That's a bigger ask than avoiding ruin. A strategy that ignores standard of living but guarantees the retiree won't go broke is easy to develop, though perhaps not very useful.

Probability of ruin analyses are not good models of rational human behavior. Michael Kitces has often argued that no one actually implements a constant-dollar SWR strategy. If a retiree's portfolio grows significantly after retirement, any rational person would begin to spend a bit more and surely the reverse is true. What rational person would lose a large portion of their savings and believe they wouldn't need to spend less?

Wade Pfau says it a little differently: constant-dollar SWR is a research technique, not a retirement strategy.

Following this line of reasoning to its logical end, I have calculated the true probability of ruin resulting from consistent overspending with sequence of returns risk for nearly all retirees under nearly all economic conditions.

Zero.

That's the probability I estimate that an actual retiree will just keep spending the same amount every year as she faces clear prospects of ruin. She will, instead, reduce spending and face the prospects of a diminished standard of living. This is a more rational model and the risk that we should be discussing. The probability of a reduced standard of living is more difficult to quantify than probability of ruin with constant-dollar spending, which is why we use the latter in the first place, but ease of calculation doesn't make it a useful metric. 

I have given this question a great deal of thought relative to my own retirement finances and I cannot imagine the impact of outliving my savings, nor can I assign a probability of doing so that I would consider "acceptable." I can say that my number is far closer to zero than to 5%. 

A small probability of a catastrophic outcome is not something that most of us can internalize. We only know that we want to avoid it.

Probability of ruin is a useful research technique that can allow us to compare the relevant benefit of two strategies, but translating that to real-life benefit isn't straightforward. The concept can rarely be communicated with a retiree, unless that retiree has an unusually strong understanding of probabilities, and even then an acceptable probability for losing one's savings late in life is just too big an ask.

I wonder if it's time to retire the probability of ruin, or at least drive it back into the lab. It's not clear to me that we are helping retirees by focusing on it.

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Michael Kitces has posted two outstanding columns (more, actually) on Social Security benefits at his blog, Nerd's Eye View. The first, Valuing Social Security Benefits As An Asset On The Household Balance Sheet, was posted April 8, 2015. This led me to a 2014 post, How Delaying Social Security Can Be The Best Long-Term Investment Or Annuity Money Can Buy.  I highly recommend them, and Nerd's Eye View, in general.

Variable Spending Strategies: Variations on a Theme

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.

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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.

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A Second Look at Time Segmentation Strategies

One of the retirement income strategies that I didn't discuss in my last post is Time Segmentation (TS). (See Unraveling Retirement Strategies: Time-Segmentation for a description of the strategy.)  I have a tough time nailing down my feelings on this strategy and here's why.

I looked at a Time Segmentation strategy portfolio next to a Sustainable Withdrawal Rates (SWR) strategy portfolio and I couldn't tell them apart. I pointed a bright light at the two of them and still couldn't see the difference. I put on stronger reading glasses than I normally wear and when that didn't help, I took off the glasses and squinted really hard. They still look a lot alike to me.

The big idea behind Time Segmentation strategies (sometimes referred to as "bucket strategies") is that retirees who hold five years or so of expenses in cash may be less likely to panic-sell in a market downturn. It appears comforting to many retirees to know that, no matter how the market behaves, their living expenses are covered for the next five years.

This is a behavioral strategy, not a financial one, and I will be the first to say that a strategy that lets retirees sleep at night has significant value, even if it isn't financially optimal.

I did a web search and found that I wasn't the first to note that these strategies seem to be "twins separated at birth." Michael Kitces wrote about it back in 2011 in a column entitled, "Research Reveals Cash Reserve Strategies Don't Work… Unless You're A Good Market Timer?"

An SWR portfolio is most often organized into asset classes like stocks and bonds, and perhaps sub-classes like small cap stocks or short term bonds, but it could as easily be organized as a TS portfolio with cash categorized as assets meant to cover immediate spending, bonds categorized as assets meant for intermediate spending, and the remainder listed as stocks for long term spending. The following diagram provides an example of a portfolio organized as a SWR portfolio and the same assets organized as a TS portfolio.

TS strategies also recommend spending first from cash, then from bonds, then from equities, but as the Kitces article explains, that is pretty much what happens when we rebalance a SWR portfolio. Rebalancing results in selling assets that have recently experienced the highest growth. If stock prices have fallen, rebalancing insures that it is other asset classes that will be sold. With rebalancing, stocks are sold after their price goes up, not down.

TS strategies use cash for near-term expenses, bonds for intermediate spending and stocks for growth to cover more distant expenses in a form of duration-matching, though less exact. But, so does an SWR strategy, although the common view of an SWR portfolio doesn't typically categorize its assets in that way.

In a paper entitled, "Sustainable Withdrawal Rates: The Historical Evidence on Buffer Zone Strategies", authors Walter Woerheide and David Nanigan showed that the drag on portfolio returns from holding large amounts of cash can be significant. In other words, the comfort of a large cash bucket can come with a heavy cost. According to the authors, the performance drag imposed by a large cash bucket actually leaves the typical portfolio less sustainable. Large cash holdings mean lower expected portfolio returns, and lower expected returns mean a higher probability of ruin.

As Kitces points out, a retiree with a 4% spending rate would need to hold nearly a sixth of her portfolio in cash to cover four years of spending and that has to be a drag on portfolio returns.

Having lots of money, as usual, helps with this problem. With a low withdrawal rate in the 1.5% to 2% range, a retiree can set aside four years of spending and still have a reasonable cash allocation. The performance penalty only comes when withdrawal rates exceed these.

It has also been argued that TS strategies reduce sequence of returns risk, but Moshe Milevsky showed in "Can Buckets Bail Out a Poor Sequence of Investment Returns?" that this strategy cannot always avoid sequence risk. When a retiree spends all his cash in a market downturn he can be left with an extremely risky all-equity portfolio, possibly before the bear market ends.

(The Milevsky paper is sometimes interpreted as saying that cash buckets cannot avoid a poor sequence of returns. Milevsky, however, simply offers a counterexample argument that shows the strategy doesn't always work.)

You could turn most SWR portfolios into a Time Segmentation portfolio simply by over-allocating cash. But, Woerheide and Nanigan tell us that we would actually hurt portfolio sustainability, not improve it, due to the performance drag of a large cash bucket. Milevsky showed that we can't depend on cash buckets to avoid a poor sequence of returns. This leaves only the behavioral benefit of a Time Segmentation strategy to distinguish it, so it becomes more of a different perspective on a SWR strategy than a unique approach, to my thinking.

If you have a lot of money and a low spending rate, you can hold a cash buffer that covers four or five years of spending without much damage to expected portfolio returns. The benefits will be largely psychological, but will have little or no financial cost. Retirees with a withdrawal rate of 3% or more may find the psychological benefits of this mental accounting worth the financial cost, but need to understand that it comes at a price.

I'm crossing Time Segmentation off my list of sound retirement income strategies, not because it is flawed or dominated, but because I don't believe it is distinct enough from SWR strategies to warrant separate consideration. In the end, it is largely a SWR strategy with perhaps too large an allocation to cash for its own good.

I believe Time Segmentation will provide a useful way for many retirees to view their finances, so just look at your portfolio from both perspectives. And, again, I don't want to minimize the value of making retirees comfortable, even if there are more efficient financial strategies. Over-withholding one's taxes, for example, isn't an efficient way to save money, but some people have trouble saving any other way.

I think a sub-optimal strategy is better than no strategy. Or, as my friend Peter is fond of saying, bad breath is better than no breath at all.

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Please note the sidebar has been updated with a link to a recent New York Times column by Jeff Sommer on how often mutual fund managers beat the market.

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Dominated Strategies, Illogical Strategies, Problematic Strategies and Strategies That Just Make Me Queasy

In Pure and Mixed Strategies, I noted that we can make life simpler for retirees by winnowing out dominated strategies and strategies that are logically unsound. I showed in Dominated Strategies and Dynamic Spending that dynamic updating of sustainable spending amounts dominates the SWR-Fixed and SWR-Variable strategies, so I cross those off my personal list of reasonable alternatives for retirement income plans.

I believe that there are strategies that are flawed, some logically sound strategies with problems, and others that just give me a queasy feeling. So, in this post, I will share my feelings on those three categories of retirement income strategies.

Dominated Strategies: There are strategies that appear to be dominated by better strategies and, according to game theory at least, should not be played. In previous posts, I noted that SWR-Fixed and SWR-Variable strategies are dominated by a dynamic updating strategy. Are there other dominated strategies that are often proposed? 

The RMD Strategy, in which the retiree bases her spending on the required minimum distribution amounts the IRS mandates for IRA’s is also a dominated strategy. (You can read about RMDs here.) Dynamically updating all important variables of sustainable spending will always perform better than a strategy of updating only the retiree’s age and new portfolio balance, as the RMD strategy does.

Logically Unsound Strategies: There are also retirement income strategies that simply aren't logically sound, like the "Spend Dividends Only" strategy. This strategy seems to be based on a misunderstanding of how dividends work.

I won’t devote a lot of explanation here, because the topic has been thoroughly vetted by others. I recently recommended this explanation by Canadian Couch Potato.  But, in short, when a company pays you a dividend on a stock worth $10.00, they pay you perhaps 30 cents in cash and the market immediately reduces your stock’s value to $9.70. You are no better off and no worse off. (You may actually be a tad worse off if you hold the stock in a taxable account because dividend payments can be a taxable event.) Furthermore, investing primarily in dividend-paying stocks will limit your portfolio’s diversification.

I cross Spend Dividends Only off the list because it is illogical and, as Wade Pfau recently put it, simply isn’t a valuable strategy. 

SWR is another logically unsound strategy when applied literally. It ignores conditional probabilities of failure. A common counter-argument is that no one implements SWR literally. I hope that is correct, but I doubt it.

Problematic Strategies: Now, let’s look at an example of a strategy that has not been shown to be dominated and that is logically sound, yet still problematic. The Bond Ladder and Longevity Insurance (BLLI) strategy proposed by Professor S. Gowri Shankar, for example, is logically sound but suffers from two problems.

(If the BLLI strategy is unfamiliar, there is a nice summary of it and several other strategies in this paper by Wade Pfau and Jeremy Cooper.)

The BLLI strategy proposes building a 20-year TIPS Bond Ladder and funding later years (beginning age 85 for someone retiring at 65) with Deferred Life Annuities (DLAs). The idea is that the retiree won’t have to give up control of his capital for the first 20 years – a common complaint with annuities – and that deferred life annuities are cheaper than immediate life annuities. (See Wade Pfau's Why Retirees Should Choose DIAs Over SPIAs.)

The BLLI strategy, however, has an inflation problem. Because DIAs will provide income well into the future, insurance companies typically won’t offer them with inflation protection and, of course, "well into the future" is when inflation takes its biggest toll. When inflation protection is offered, it does not cover the period from purchase to the first payout, in this example 20 years.

This is different than funding half of your retirement income with a TIPS bond ladder and the other half of the income with annuities. BLLI suggests exclusively funding the first half (or so) of retirement with a TIPS bond ladder and the second half exclusively with annuities.

The idea of maintaining control of capital and liquidity is also somewhat problematic, since the retiree will need the money in her bond ladder for living expenses to age 85 and can’t really spend it in an emergency. Funding the entire 30 years with a TIPS bond ladder and prematurely spending the most distant rungs is problematic enough, but it is possible that she won't live the full 30 years and may not need to spend that money ever. Diverting funds meant to meet living expenses during the first 20 years of retirement is significantly riskier.

Nonetheless, it is neither flawed nor dominated and stays on the list.

Strategies that Make Me Queasy: Some strategies can be logical and not dominated and perhaps not problematic to some, but still make me feel uncomfortable. To wit, the Floor-leverage Rule and Zvi Bodie's floor-and-upside strategy of 90% TIPS bonds and call options (LEAPS). Both are known as "barbell strategies" because they invest in extremely safe and extremely risky assets with nothing in between.

As I suggested in Hope and Your Retirement Portfolio, most retirees won't be comfortable with the possibility of losing all or most of their upside "hope" even with a comfortable floor in place. Retirees who purchase call options will often see those options expire "out of the money", in other words, worthless. The financial argument will be that the options served their intended purpose, even the ones that expired worthless, and that is correct. Most of the retirees I know, however, will find that cold comfort when they see a few ten thousand-dollar call positions disappear in a poof of smoke. Actually, it isn't even that dramatic. It's just not there, anymore.

Zvi Bodie's friend, Jeremy Siegel, seems to agree (download PDF). On multiple occasions Siegel has said, "You know, I find it a little strange — Zvi says he’s giving conservative investment advice, and then advising all your clients to buy call options."

The Floor-leverage Rule makes the LEAPS approach look tame in comparison. The idea for its upside portfolio is to employ triple leverage at the equity end of the barbell. The typical investor can't purchase a stock portfolio with triple leverage. It's illegal. But, as Sharp and Watson point out, they can purchase shares of a 3x leveraged ETF like UPRO.

I'm crossing Floor-leverage off the list of reasonable strategies not because it makes me queasy to apply huge leverage to my entire upside portfolio (it does), but because the upside strategy doesn't work. The problem is that these ETFs are not the same as a triple-leveraged stock index fund. In fact, they aren't portfolios of stocks, at all. They're portfolios of derivatives that only track stock indexes for short periods of time. They're best suited to short term investments, which shouldn't be part of a retirement income plan.

Bodie's options strategy stays on the list. It's riskier than I can accept and I don't think it will fit the temperament of most retirees, but it isn't flawed. It will outperform other strategies in some scenarios, so it isn't dominated.

Some of the strategies I've crossed off the "sound" list may fit your individual financial situation and may be bets you're willing to take. Some of them will even be recommended by advisers. I would pare down the list of reasonable retirement income strategies by at least a third, as shown in the following table. This is my personal perspective and not everyone would agree.

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Glide Paths

Retirement researchers Michael Kitces and Wade Pfau published papers on glide paths in the Journal of Financial Planning in 2014 and 2015, including Retirement Risk, Rising Equity Glide Paths, and Valuation-Based Asset Allocation, suggesting a rising glide path for retirees beginning with a low equity allocation early in retirement and rising throughout. Researcher David Blanchett has published contradicting studies that show better performance from declining equity glide paths throughout retirement, which has been the traditional recommendation, in Revisiting the Optimal Distribution Glide Path.

As you can imagine, these conflicting recommendations have caused more than a little anxiety among advisers and do-it-yourselfers and experts like William Bernstein have even entered the discussion.

Ultimately, the research has left some retirees asking whether they should follow a rising glide path or a declining glide path.

The correct answer is "none of the above" – they should follow their personal financial situation as retirement progresses. (See Dominated Strategies and Dynamic Spending.)

Imagine two 90-year old retirees. Rising glide paths would suggest that they both hold large equity positions, while declining glide paths would suggest they both hold large bond positions. Now imagine that one still has tons of savings left, more floor income than she needs and is, as William Bernstein puts it, investing for her heirs. The other has barely enough wealth left to cover another five years of expenses. Should both invest with the same asset allocation because they are the same age? A similar argument can be made at any age and the correct answer is that we need to consider more than age or retirement date when determining our asset allocation.

This research aims to isolate one factor, the retiree's planned retirement date (or, roughly speaking, the retiree's age), and to determine its effect on the retirement investment problem. The question it attempts to answer could be framed in a number of ways, like:

• What would be the best asset allocation pattern for a retiree if we only knew that retiree's planned retirement date and nothing more?


• What allocation should we recommend to a retiree who wants to do little or no investment planning? (Note that this person is unlikely to be a reader of this blog.)


• What glide path should be implemented by a target-date mutual fund that serves a broad target market of retirees who happen to share the same planned retirement date?

I feel certain that all of the authors of these papers would agree that a customized, individual retirement plan will always be preferable to one based entirely on the retirees age/retirement date. (One of the authors actually told me this, so it isn't entirely a guess.)

As explained in Wade's post of March 2^nd on RetirementResearcher.com, To Rise or Not to Rise, the authors are currently comparing notes to understand why their results differ. Initial thoughts are that the differences are explained by different capital market expectations. Both sets of expectations, or assumptions about future markets, are imperfect predictions and either (or neither) might turn out to be right.

As Wade explains, "… The choice of glide path is not always fixed, as it does vary with the stock market valuation level at the time of retirement."

So, which glide path is best if we ignore everything about a retiree except the planned retirement date? We're not sure, but the research does seem to show that it depends on stock market valuations and interest rate expectations at the time of retirement (no surprise).

How does this information help the typical retiree invest her savings if she doesn't really care how the mechanisms of retirement funding work? It doesn't help much, in my opinion, at least not at this point. As Blanchett suggests, more research is needed.

More importantly, this information won't apply to most advisers or do-it-yourselfers because they will be willing to do more work than to simply write down a planned retirement date. They can find a much better fit.

An individual household's optimum asset allocation should be estimated by considering several more factors, including how well their retirement is funded and the maximum loss they could stomach in a bad market crash. By continually managing asset allocation based on current conditions of the retiree's finances, at the end of retirement that retiree's glide path will have followed some curve that will probably look like one of the half dozen or so currently recommended glide paths simply because they pretty much cover the entire range of possibilities. (The 2014 Investor's Guide issue of Money magazine identified six glide path recommendations that had little in common. Pozen's has a tongue sticking out the end. What's up with that???)

We will not know in advance which glide path that retiree will end up following. It will be determined by a random walk through market returns, how long we live, our expenses, the decisions we make and many unpredictable factors.

It's important to understand that research of any kind is new information, or a new argument, that we should consider in light of what we already believed to be true. It doesn't automatically replace what we thought we knew. (See Think Like a Bayesian Pig.)

When this evidence conflicts, it gives us a chance to learn more. This research doesn't tell us that one glide path is better or worse — both sides make good arguments — but it begins to tell us under what conditions one glide path might perform better. That doesn't necessarily mean one is right and the other wrong or even that a well-planned retirement needs one. Please keep that in mind when you read academic papers. They are usually new evidence or new arguments and not universal truths that dispel old beliefs.

What should a retiree do with this information about glide paths? Probably nothing. You should customize your asset allocation instead of following a glide path. There are a couple of interesting points you can use, however. First, it turns out that a 60% equity portfolio throughout retirement isn't a bad "couch potato" allocation.

Second, as Wade points out, you might give more consideration to cash and short bonds than to intermediate bonds. "Another important point in that summary is that we did look at both short-term (6 month or 1 year) bonds as well as 10-year bonds in our analysis, and we found that the shorter-term bonds were of much greater help than longer-term bonds. When the focus is on protecting from downside risks, the additional volatility caused by the 10-year bonds hurt retirement outcomes by more than could be compensated by their higher average yields. This ties into David’s article as well, since his bond allocation was 75% to (I believe) 10-year bonds, and 25% to cash."

This is an important point to remember when you think about taking on more risk to increase the return of the bond portion your retirement portfolio. Bonds and cash are there to protect against downside risk, not to maximize portfolio return.

You can also just follow the ongoing research. I find the discussion quite enjoyable. It's a work in progress.

Pure and Mixed Strategies

In a few recent posts, I suggested how game theory might be used to gain a different perspective on the Social Security claiming decision (Game Theory and Social Security Benefits) and why updating your sustainable spending amount periodically (Dominated Strategies and Dynamic Spending) will always perform better than spending a fixed amount based on your initial portfolio balance in retirement (SWR-Fixed), or by spending a fixed percentage of remaining portfolio balance each year but ignoring other determinants of portfolio survival like decreasing life expectancy (SWR-Variable).

The benefit of the spending strategy analysis it that is allows us to winnow out inferior strategies when we choose our retirement income plan. SWR-Fixed and SWR-Variable are dominated strategies. Game theory tells us never to play a dominated strategy, which only makes common sense.

I admit two motives for these posts. The first is that I am fascinated by game theory and believe it provides valuable perspective on the retirement planning problem and the second is that I'm convinced we can simplify retirement planning. 

How does this simplify the retirement income strategy choice? By eliminating dominated strategies as game theory recommends, and eliminating other strategies that aren't logically sound, we can winnow a dozen or more proposed strategies to a significantly smaller number of truly valuable strategy choices. 

In this post, I'll consider another concept of game theory, pure and mixed strategies, and how they might be useful for analyzing retirement income strategies.

According to GameTheory.net, a pure strategy defines a specific move or action that a player will follow in every possible attainable situation in a game. A mixed strategy is created by playing members of a set of available pure strategies at some proportion of each.

Assume a tennis player has two pure strategies available: serve to her opponent's forehand or to her opponent's backhand. She might also attempt to keep her opponent guessing with a mixed strategy by randomly serving to her opponent's backhand or to her opponent's forehand.

Game theory will use the server's success rate serving and the opponent's success rate returning serve from both sides to calculate the optimum proportion of serves to each. Based on probabilities of success for both pure strategies and responses, game theory might tell her, for instance, that the optimum strategy is to randomly serve to a particular opponent's forehand 30% of the time. This is a mixed strategy.

Let's consider some pure retirement income strategies including sustainable withdrawal rates (the dynamic kind, since game theory tells us that SWR-Fixed and SWR-Variable are dominated), a Social Security benefits strategy, an annuity strategy, a time-segmentation strategy and a TIPS bond ladder strategy. Other strategies have been proposed, but let's go with this shorter set of pure strategies for now.

Why isn't the floor-and-upside strategy on the list? Glad you asked. Because floor-and-upside is a mixed strategy consisting of some mixture of pure floor strategies and pure upside strategies.

The floor strategy could consist of life annuities, TIPS bonds held to maturity, Social Security benefits or some combination of these.

The upside strategy contains risky assets like stocks and bonds. SWR portfolios typically recommend something like 50% stocks and 50% bonds. Jason Scott's and John Watson's floor-leverage rule (download a PDF) recommends 15% of assets be invested in a triple-leveraged ETF of derivatives. Zvi Bodie and Nassim Taleb have recommended an upside portfolio of 10% of assets invested in long term index options (LEAPS).

Note that a mixed strategy can allocate zero percent to some available pure strategies, so for instance, an SWR strategy can be considered a floor-and-upside strategy allocated 100% to the upside portfolio and 0% to the floor strategy. More importantly, because nearly all Americans have some Social Security income or public pension income, it will be very rare that a retiree plays a pure upside strategy.

An exception to this observation is retirees who postpone claiming Social Security benefits and spend from a stock and bond portfolio until those benefits start, but by age 70 at the latest, they will likely have a floor-and-upside strategy, though they may not think of it that way.

While it will be rare for a retiree to implement a pure upside strategy with no floor, it is easy enough to implement a pure floor strategy with no upside portfolio. A retirement income plan based solely on pension or Social Security income would qualify as a 0% upside/100% floor portfolio, as would any strategy comprised solely of Social Security benefits, TIPS bond ladders and life annuities.

In other words, nearly all of us will have a floor. Those of us with adequate retirement savings can choose to add more floor, add an upside strategy, or implement some combination of the two. This is the first decision in choosing a retirement income strategy. It answers the question, "how much of your retirement savings are you willing to risk in the stock market in hopes of being able to spend more?"

For those who answer that they wish to take no risk with their standard of living, the next step will be to determine how to most effectively build a floor of income. For the rest, the next step will be to determine how much of their desired standard of living should be locked in with a floor portfolio, with the remainder put at risk in the market.

Viewed from this perspective, sustainable withdrawal rates is a floor-and-upside mixed strategy with a floor consisting of Social Security or pension benefits. A TIPS Bond Ladder strategy is a floor-and-upside mixed strategy of Social Security or pension benefits and a TIPS Bond Ladder with zero percent upside portfolio strategy. Floor-leverage rule is a floor-and-upside mixed strategy with a floor consisting of 85% of our portfolio plus Social Security or pension benefits and an upside portfolio strategy consisting of investing 15% of assets in a triple-leveraged derivatives portfolio.

Most strategies can be viewed as a form of a mixed floor-and-upside strategy and understanding this may simplify your decision of which strategy to implement.

Pure upside strategies will be rare, because most Americans will have Social Security benefits or public pension income at some point. That leaves a floor strategy or a mixed floor-and-upside strategy as the options available to most retirees.

This, of course, is the root of the "safety first" versus "probabilities" divide, but I don't see the divide so much as a disagreement on whether or not to put standard of living at risk as one of how much of our standard of living we should bet in the market. Because most of us are going to have a floor and probably a mixed strategy, the big question is, "how much floor?"

I think this is a far more reasonable approach than having retirees read about a dozen or so strategies to pick the one with which they feel most comfortable.

If you're interested in game theory, William Spaniel has an outstanding series of tutorials on YouTube entitled Game Theory 101.  If the academics of the subject interest you, Yale filmed Professor Ben Polak teaching Econ 159 Game Theory. He is an amazing professor and, although it doesn't use modern on-line teaching technology, it is probably the best on-line class I have ever taken.

Made me wish I'd gone to Yale. Go figure.

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Dominated Strategies and Dynamic Spending

Sharp-eyed readers will notice that I have tweaked my blog format to include some of my favorite posts from other retirement blogs. Retirement blogs may not be the best place to find sharp-eyed readers and I have three pairs of reading glasses here by my keyboard, just in case. Nevertheless, you will find these posts in the sidebar. This week, I included one from the Canadian Couch Potato blog on Spending Dividends Only and another from Wade Pfau's new website. I hope you enjoy them both.

In my last post, Dominated Strategies, I showed that for retiree's who want to keep their risk below a maximum level throughout retirement, game theory tells us that the variable sustainable withdrawal rate strategy (SWR-V) never provides worse payoffs than fixed-dollar withdrawals (SWR-F) and SWR-V provides better payoffs if the portfolio grows.

Game theory principles tell us that SWR-V weakly dominates SWR-F and that we should never play a dominated strategy, so I cross SWR-Fixed off my list of strategies to consider. (As I mentioned in my previous post, even William Bengen stated that SWR's should be revisited throughout retirement and not set in stone.)

SWR-F underperforms SWR-V, which prescribes spending a fixed percentage of an ever-changing portfolio value rather than a fixed dollar amount, because SWR-V uses new information as it develops over time, the current value of a retiree's savings. SWR-F only calculates a spending amount that was safe on the first day of retirement (an a priori expectation).

As conditions change, like our portfolio value, SWR-V takes advantage, increasing spending when it is safe to do so. By decreasing spending when it becomes riskier, SWR-V reduces sequence of returns risk. SWR-F ignores this new information.

There are other important changes besides portfolio balance to the key determinants of the probability of ruin as retirement progresses, including market return expectations, remaining life expectancy, spending needs, and risk tolerance.

As David Blanchett and Sudipto Banerjee have written (both links download PDFs), retirement spending typically declines over time, about 3% a year on average. A retiree's risk tolerance and capacity can also change over time as dependents need less support, for example, or a spouse is lost. And, of course, life expectancy constantly declines at a rate of a little less than a year per year of life. Neither the SWR-F nor the SWR-V strategies account for any of these important changes, leaving open the possibility that there is a strategy that dominates SWR-V.

If considering more data and more timely information improves retirement income spending strategies, then a strategy that considers more new information than SWR-V takes into account could be expected to dominate it. I will refer to this new strategy as "Dynamic Spending."

(David Blanchett and Larry Frank have written about this strategy previously in A Dynamic and Adaptive Approach to Distribution Planning and Monitoring, as has Ken Steiner. Larry Frank provides a nice explanation in a blog post entitled, "How income may compare between Dynamic and Safe approaches.")

Let's consider a version of the Safety First game from Dominated Strategies as a strategic game in which the retiree wishes to maximize available spending while ensuring that risk of ruin never exceeds a desired level. The SWR-Fixed strategy assumes some acceptable probability of ruin, typically 5% to 10%, at the beginning of retirement, but lets the risk drift throughout retirement in order to ensure a predictable, fixed amount of annual spending. Retirees who are happy to see steady spending even when their portfolio declines may not understand that it comes at the cost of increased probability of ruin.

SWR-Variable fixes the variable risk problem of SWR-Fixed but generates unpredictable annual spending. (A retiree spending from a volatile portfolio can have constant risk or constant income, but not both.) In fact, SWR-V "over-fixes" the risk problem because it doesn't consider a declining life expectancy. Over time, risk will decline with SWR-V and SWR-F as the retiree's remaining life expectancy declines. A retiree who thinks a 5% risk of outliving savings is acceptable, for example, might see risk decline to 3% as she ages, which means she will be spending less than she could safely spend.

A Dynamic Spending strategy will recalculate a sustainable withdrawal rate annually by considering updated portfolio balance, an updated life expectancy, changes in risk tolerance over time, changes in expected future returns and changes in spending.

Whether the retiree's portfolio balance trends downward or upward, Dynamic Spending will provide a better payoff than either SWR strategy because it considers remaining life expectancy. As remaining life expectancy declines throughout retirement, risk of ruin is reduced and the sustainable withdrawal rate increases. (The sustainable withdrawal amount will decrease if portfolio losses exceed the benefit of the life expectancy decrease.)

Spending gains due to decreasing life expectancy increase exponentially. Even if portfolio value remained flat throughout retirement, decreasing life expectancy would more than double spending by the end of a long retirement (see chart). SWR-V and SWR-F ignore this increase.

When portfolio values trend upward, Dynamic Spending will have a larger payoff than SWR-V because it will be augmented by a declining life expectancy contribution. When portfolios trend downward, Dynamic Spending will limit increasing risk of ruin by reducing the spending percentage and by adding the declining life expectancy contribution.

As I mentioned in Dominated Strategies, SWR-Variable "over-fixes" risk reduction. Spending a percentage of remaining portfolio balance and ignoring the life expectancy contribution with a declining portfolio eventually lowers risk too much, unnecessarily lowering spending. By considering both, Dynamic Spending adjusts spending to the retiree's current risk tolerance and maximizes spending at that level.

Now, let me try to simplify this rather lengthy post. All three of these strategies use the same basic mechanism. They calculate a sustainable spending amount using Milevsky's formula, simulation or historical data and all three are based on the same information regarding the retiree's financial situation.  The difference is when we recalculate using new data.

SWR-Fixed makes a single calculation at the beginning of retirement and ignores any new information thereafter, no matter how critical that information might be. (Intuitively, this should feel like a bad idea.) The information to calculate the SWR-Fixed sustainable spending amount should include initial portfolio value, expected market returns, life expectancy, and asset allocation based on risk tolerance.

SWR-Variable uses the same information except it recalculates the sustainable spending amount every year, taking into consideration changes to the portfolio value from the previous year, but nothing more. And it assumes that the withdrawal percentage calculated at the beginning of retirement remains the best one. Doing so reduces sequence of returns risk, but it doesn't maximize sustainable spending.

Dynamic Spending recalculates sustainable spending every year, too, but it doesn't stop with updating portfolio values, as does SWR-V. It also updates a decreasing life expectancy, changes in risk tolerance and capacity, and expectations about future market returns. Dynamic Spending maximizes the sustainable spending amount given the retiree's current risk tolerance.

Dynamic Spending always provides better payoffs when risk is considered appropriately than does SWR-Fixed or SWR-Variable. SWR-Fixed and SWR-Variable are strategies that are dominated and should never be played. That's a stronger message than "some of these strategies are sometimes better than others."

One of my hobbies is shooting sporting clays, so the following analogy works for me. Hopefully, it will help you visualize the comparison of strategies, too. In sporting clays, the objective is to break a clay target with a shotgun.

Trap and skeet throw targets in predictably similar paths all the time, but sporting clays can come from anywhere and go anywhere, relatively speaking. In retirement finance, breaking the clay is symbolic of reaching the end of retirement with at least a little money to spare. That's our target.

SWR-Fixed is analogous to aiming where targets have ended up most often in the past, yelling "pull" and shooting in that direction.

SWR-Variable adds some data to the calculation: the changing value of your savings over time.

SWR-V is like deciding that you will track every target through its path and shoot a foot in front of it (lead it).  A foot will work for some shots that quarter away from you, but it won't be enough for a target that crosses directly in front of you or is farther away. Nonetheless, you are a bit more likely to hit the shot than by aiming where a lot of targets have gone in the past because you are now considering more information, that being where the target currently is and not just where targets have historically been.

Dynamic Spending is like tracking the target, knowing where it has been and where it is, and consequently where it is likely to soon be, estimating its vertical and horizontal speed and meeting the target with the correct lead. If the target is falling, you shoot below it. If it's a crossing target, you shoot farther ahead. You adjust your aim constantly. You hit a lot more targets that way.

Although all three of these strategies are proposed as viable alternatives, game theory tells us that Dynamic Spending dominates the other two and should always be our choice from among these three.

The explanation may be complex, but the advice is straightforward. If you're going to fund retirement by spending from a volatile portfolio of stocks and bonds, recalculate a sustainable withdrawal amount every year based on your revised expectations of future market returns, life expectancy, risk tolerance and capacity and estimated future spending needs.

Even if you ultimately decide to spend more, you'll at least know how much risk you're taking.

Next, I'll consider the application of game theory's Pure and Mixed Strategies.

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