### Making Sense Out Of Variable Spending Strategies For Retirees

The American College

**Abstract: **

Variable spending strategies can be situated on a continuum between two extremes: spending a constant amount from the portfolio each year without regard for the remaining portfolio balance, and spending a fixed percentage of the remaining portfolio balance. Variable spending strategies seek compromise between these extremes by avoiding too many spending cuts while also protecting against the risk that spending must subsequently fall to uncomfortably low levels. Two basic categories for variable spending rules explored include decision rule methods and actuarial methods. Ten strategies will be compared using a consistent set of portfolio return and fee assumptions, and using an XYZ formula to calibrate initial spending: the client willingly accepts an X% probability that spending falls below a threshold of $Y (in inflation-adjusted terms) by year Z of retirement. Presenting the distribution of spending and wealth outcomes for different strategies in which the initial spending rate is calibrated with the XYZ formula will allow for a more meaningful comparison of strategies. The article provides a framework for identifying appropriate spending strategies based on client preferences.

### Making Sense Out Of Variable Spending Strategies For Retirees

Bengen (1994) introduced the concept of the 4% rule for retirement withdrawals. He defined the sustainable spending rate as the percentage of retirement date assets which can be withdrawn, with this amount adjusted for inflation in subsequent years, such that the retirement portfolio is not depleted for at least 30 years. Specifically, Bengen found that a 4% initial spending rate would have been sustainable in the worst-case scenario from US historical data over rolling 30-year periods with a stock allocation of between 50 and 75%.

In an attempt to illustrate the importance of the sequence of investment returns on retirement spending outcomes, which highlighted how it is wrong to base a sustainable spending rate on a fixed average return assumption plugged into a spreadsheet, Bengen reasonably used a number of simplifying assumptions. Among these is the previouslymentioned constant inflation-adjusted spending assumption. It was a simplification to obtain a general guideline about feasible retirement spending.

While the assumption may reflect the preferences of many retirees to smooth their spending as much as possible, real clients can be expected to vary their spending over time. Clients will not play the implied game of chicken by keeping their spending constant as their portfolios plummet toward zero. As well, constant spending from a volatile portfolio is a unique source of sequence of returns risk which can be partially alleviated by reducing spending when the portfolio drops in value.

But how exactly should clients adjust their spending patterns in response to changes in the value of their retirement portfolios? There are countless variations on spending rules which are discussed in outlets ranging from research papers to Internet discussion boards. The purpose of this article is to identify and classify key variable spending strategies, and to develop simple metrics which are able to evaluate and compare the strategies on an equal basis. As will be discussed, the frequently used ‘failure rate’ metric should not be applied to variable spending rules. Other approaches are needed. The aim here is to assist advisors and their clients in figuring out which sort of variable spending strategy will be most appropriate for their situations. This holistic evaluation is important for a number of reasons.

First, variable spending rules are usually described and evaluated using different data and assumptions, and so if one rule suggests a 6% withdrawal rate while another suggests a 3% withdrawal rate, we cannot necessarily know whether the first rule is really twice as powerful. The differences could just reflect different underlying assumptions, such as higher market returns. We must use the same set of capital market and fee assumptions to properly compare strategies.

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