While retirement has always signalled a big change in people’s lives, there was a time when the financial decisions surrounding retirement were less complex.
Spend your career working for the same company and retire with your family home loan repaid. Perhaps you had some savings in the bank earning a decent interest rate, and your employer’s defined benefit plan would provide a reliable income stream in retirement, supplemented by the age pension. Perhaps you had made some of your own contributions into superannuation which could be accessed free of tax without exception.
Today the population and life expectancies of retirees are increasing, portfolio yields remain at historically low levels and a defined contribution pension system is placing the risk of financial decision-making squarely on the individual. In addition, financial circumstances are becoming more complex with ATO data showing an increasing number of households retiring with debt.
The stakes are high and there are consequences to poor financial planning, resulting in retirees outliving their savings at one end of the spectrum or experiencing an unnecessarily frugal retirement at the other extreme. A well-structured financial plan that takes account of retirement goals, and sets an appropriate spending rule, is critical to navigate these challenges.
Money goals
The first step to choosing a prudent spending rule is to define your goals. The retirement goals will need to be scaled and prioritised, which the following categories can assist with:
- Basic living expenses: the base amount of retirement income to cover non-discretionary, recurring living expenses.
- Contingency reserve: maintain a sufficient amount to address surprise events throughout retirement or other uncertain needs such as end-of-life care.
- Discretionary spending: enable a level of spending beyond basic living expenses to maintain a preferred lifestyle.
- Legacy: transfer wealth to heirs or charities.
There are elements out of the retiree’s control, not least market returns or the length of the planning horizon (ie, life expectancy). Yet each of these affect how much can be safely withdrawn to meet current consumption while preserving the potential to generate future income for the rest of your life.
Spending rules
An appropriate spending rule can help balance these unknowns, each of which places a different emphasis on the competing priorities: maintaining a relatively consistent level of current spending; and increasing (or preserving) the value of a portfolio to support future spending, bequests and other goals.
The two most popular rules are:
- The “dollar plus inflation” rule. Upon retirement, a retiree selects the initial dollar amount they want to spend from the portfolio and then increases that sum by the amount of inflation each year thereafter. The benefit is that income payments are regular and predictable, though unresponsive to changes in market conditions. If markets return less than expected, the risk of running out early increases, or if markets deliver more than expected, you may be living an unnecessarily frugal retirement.
- The “percentage of portfolio” rule. A retiree annually spends a fixed percentage of the portfolio balance so that the annual spending amount is automatically increased or decreased based on the markets’ performance, making this rule highly responsive to capital markets. This requires more flexibility and potentially painful adjustments in spending during periods of poor market returns.
- While these rules of thumb are used by many, the trade-offs between portfolio viability (the chance your portfolio may not last the distance) and spending flexibility (the need to make regular adjustments to consumption) represent two extremes. Our research has found there can be a middle ground – the elusive happy medium.
An alternative rule researched by Vanguard’s investment strategy group is a hybrid of these two approaches, which we call the “dynamic spending” rule.
With this rule, annual spending is allowed to fluctuate based on the performance of the markets while at the same time moderating fluctuations in spending from year to year. This is accomplished by placing an annual ceiling and floor around each year’s spending amount, relative to the amount spent the previous year. The outcomes are affected by the level of the floor and the ceiling. A very narrow floor and ceiling will act more like the “dollar plus inflation” spending rule, and a wide floor and ceiling like the “percent of portfolio” rule.
How it works
Take the example of a retiree turning a portfolio of liquid assets into an income stream over a 35-year horizon.
Let’s assume a portfolio balance of $1 million, an initial withdrawal rate of 5 per cent, and a -2.5 per cent floor and a 5 per cent ceiling. Over the first year, $50,000 would be withdrawn from the portfolio, representing the 5 per cent withdrawal rate.
In year two, the withdrawal amount would be determined by first multiplying the new asset balance by the withdrawal rate of 5 per cent. If it had been a very good year for the markets and the balance was now $1.1 million, the payment under the percent of portfolio rule would be $55,000 (5 per cent of $1.1 million). However, if we apply our ceiling of 5 per cent it limits the amount withdrawn to $52,500, representing a 5 per cent increase on the prior year’s payment of $50,000. If the market environment had been very negative, we would have applied our floor and withdrawn an amount of $48,750 ($50,000 less 2.5 per cent).
Balancing the trade-offs between the “dollar plus inflation” and “percent of portfolio” rules can materially improve the potential for retirees to meet the variety of goals required for a fulfilling retirement.
For example, longevity risk can be magnified for the “dollar plus inflation” rule if market returns are not as favourable as anticipated. Using the same scenario and assuming a portfolio mix of 50 per cent equities and 50 per cent bonds, the success rate (which measures the likelihood that the portfolio goes the full distance) increases by around 25 per cent when using the dynamic spending rule with a 5 per cent ceiling and -2.5 per cent floor.
What about the other trade-off – spending flexibility? The “percent of portfolio” rule may never see your balance run down as you are only ever spending 5 per cent of the current balance each year, but the volatility in income from year to year for our scenario will be high, averaging around 7 per cent. For the retiree where a large portion of spending goes to non-discretionary expenses, this could be too much variation to tolerate. Following the dynamic spending rule brings the volatility down to around 3 per cent.
Developing a financial plan that can best meet the highly unique circumstances of each retiree is far from simple, and advice is likely to play an important role for most.
Critical to success is categorising goals in retirement, assessing the resources at your disposal to both meet these and balancing the risks that could derail them. Converting assets to income in retirement is subject to trade-offs that can be balanced by a well-constructed spending rule.