IT is the season for spending.
While an undisciplined approach to shopping over Christmas can easily lead to a January credit card hangover a lack of planning around your spending when you retire can have much longer term impacts.
The beauty of regular income is just that – it is regular and means you can rebuild savings from future earnings. But when you are retired the challenge is to chart a spending strategy that balances the competing needs of maintaining a desired level of spending and preserving a portfolio to fund future spending needs.
Put aside the “ski” notion – spending the kid’s inheritance – the true challenge for most people is ensuring your super savings last through the retirement years that can span two or three decades.
Financial advisers commonly use two contrasting spending plans – drawing down a set dollar amount with an inflation adjustment each year or alternatively drawing down an income which is a set percentage of the portfolio’s value.
There are pros and cons of both approaches and a research study done by Vanguard in the US recently highlighted the different outcomes by simulating more than 10,000 different portfolio outcomes.
The dollar amount plus inflation adjustment provides a stable spending ability (at least in the short term) but it ignores market performance and the affect on the portfolio’s value so in the longer term it could see the portfolio totally depleted.
Drawing down a percentage of a portfolio each year – which is in line with super pension drawdown rules – has the advantage of being very responsive to market performance and the impact on the portfolio’s values but that comes at the cost of having your spending ability fluctuating significantly in the short term.
The detailed simulation into both these strategies was done in order to understand the trade-offs they entail and added a third hybrid strategy using a more dynamic approach around spending to test how that may help investors balance the competing goals of maintaining a desired level of spending while preserving sufficient capital for the future.
The simulation work done by Colleen Jaconetti and Francis Kininiry modelled 10,000 potential portfolio outcomes for an investor that had an opening balance of $1 million dollars and had a time horizon of 35 years in retirement.
The initial spending target was set at 4.75% of the portfolio or $47,500 in the first year.
The portfolio allocation was a broad diversified balanced portfolio of US shares (35%), international shares (15%) and 50% in US bonds with allocations rebalanced annually. While the work was done in the US given it was based on a balanced portfolio – 50% growth assets and 50% fixed interest – not unlike most super funds default portfolio the broad findings should be just as instructive for Australian investors.
The simulations were done using a computer model that estimates future returns for broad asset classes and the researchers found that using the dollar amount plus inflation adjustment approach the portfolios survived only 71% of the time – meaning that in 2900 of the 10,000 possible return scenarios the investor would have run out of money within 35 years.
The second approach that bases the drawdown on the portfolio value at the previous year’s end is clearly linked to market performance and as a result the portfolio was never depleted.
However, the investor’s income stream fluctuated significantly and 53% of the time it fell below the initial target income level. In the worst case scenario the amount available for real annual spending fell to a lowly $2850.
Clearly that sort of fluctuation in the amount of money available for spending makes lifestyle planning very difficult.
To look at ways of addressing the pitfalls a third spending strategy was tested by applying a ceiling and a floor to percentage based withdrawals.
Essentially this approach is a hybrid of the other two. In the simulation a ceiling of 5% and a floor of 2.5% was tested. So although spending will vary from year to year based on what markets do it is not allowed to go beyond the set limits – the strategy allows investors to benefit from the good markets by increasing spending but prompts them to reduce spending during market downturns.
The result of the simulation was that 89% of the paths resulted in a positive ending portfolio balance after 35 years – a value between the portfolio survival rates of the other two approaches.
For people running their own self-managed super fund this is an interesting framework to consider for their drawdown strategy albeit with a weather eye on the minimum drawdown limits set for pensions. The Federal Government has in effect been providing a real-world example of this strategy by halving the minimum drawdown that account-based pensions were required to make since the global financial crisis on pension portfolios. That relief has been extended to the end of the 2010-2011 financial year.
These conceptual spending frameworks are interesting but life sometimes does not work out like that and spending cannot be planned in a blind or rigid way.
The researchers Jaconetti and Kinniry suggest the best word to describe a prudent spending strategy in retirement is flexibility. Rigid spending rules cannot eliminate investment market volatility – they simply push the consequences off into the future.
So having the flexibility to adjust spending and tolerate short-term fluctuations will make it more likely you will achieve your longer-term income goals.
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Robin Bowerman, Vanguard Investments Australia's Head of Retail, has more than two decades of experience in the finance industry as a writer, commentator and editor.
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