The Retirement Spending Conundrum

Many people spend years saving for retirement. Then, when the time comes to begin spending their savings, they have no strategy in place.

There’s plenty of evidence showing that retired investors often don't spend much of their retirement savings. They often pass on more to their heirs than they started out with when they retired.

In other words, good accumulators don’t necessarily succeed in making the switch to being good decumulators.

There are reasons to save and invest other than to meet your retirement income needs.

Nevertheless, some investors succumb to fear of the unknown and fail to use what they thought of as their retirement savings as intended once they retire.

The key reason many people are overly frugal in retirement is because they're not sure how much they can "safely" spend.

It's crucial to have a strategy for accumulating retirement assets. Equally important is a strategy to withdraw from your retirement savings. A withdrawal strategy should give you confidence in knowing how much you can safely spend each year for the rest of your life without flirting too closely with running out of money.

Your withdrawal strategy should accomplish two often-competing goals:

1. Having enough money to support your desired lifestyle.
2. Ensuring there's enough left for the future, including any money you plan to leave to heirs

‍Levers Affecting Withdrawal Rates

There are four key factors that should influence your withdrawal rate:

• Time horizon - how long do you need the portfolio to last
• Asset allocation - the mix of assets you hold in your portfolio (e.g. 60% shares / 40% bonds and cash)
• Spending flexibility - the degree of wiggle room you have in your spending
• Degree of certainty required - how important it is to know the likely outcome of your withdrawal strategy

Here are several alternative ways to structure retirement savings withdrawals over the long term.

‍Dollar plus inflation strategy

Under this strategy you spend a percentage of your portfolio the first year and adjust that amount in subsequent years based on inflation.

The "4% rule" is a popular example of the dollar-plus-inflation strategy. You withdraw 4% of your portfolio in your first year of retirement. Then, in each subsequent year, the amount you withdraw increases with the rate of inflation. If you don't expect your expenses to change much throughout retirement, this strategy can help ensure you'll be able to cover your yearly costs for as long as the portfolio lasts.

This strategy ignores market conditions, so you could end up running out of money (in down markets) or spending much less than you can afford (in up markets). It could be best for you if you plan to maintain a steady level of spending from year to year.

‍Percentage of portfolio strategy

You spend a fixed percentage of your portfolio every year. For example, in Year 1 you might calculate 5% of the portfolio balance at the start of the year and set up monthly withdrawals of 1/12 of the annual withdrawal you’ve calculated. In Year 2, you repeat the 5% calculation based on the portfolio balance at the start of the year and adjust your monthly withdrawals. Rinse and repeat in subsequent years.

This strategy:

• Gives you confidence of achieving goal 2 - not running out of money.
• Results in yearly spending amounts that are completely market-driven and could fall short of what you need to live. In this way it tends to result in larger variations in your retirement withdrawals;
• Could make sense for you if your main concern is ensuring you don't deplete your portfolio and you can adapt your budget to a wide range of spending levels.

‍Dynamic withdrawal strategy

Many people equally prioritise spending levels and portfolio preservation. The dynamic spending retirement strategy helps achieve both important goals: covering current spending while aiming to preserve enough money for the future.

Dynamic spending is a hybrid of the dollar-plus-inflation and percentage-of-portfolio strategies. It builds on people's natural tendency to spend more when markets are up and less when markets are down, but moderates the wild swings you get when giving market performance free rein over your spending.

In other words, it achieves a happy medium. Your spending is more flexible than with a dollar-plus-inflation approach but also more stable than with the percentage-of-portfolio approach. It's also very adaptable, so in addition to deciding how much to withdraw in Year 1, you decide how much you're willing (and able) to raise or lower your spending in response to market movements.

To apply a dynamic spending approach, you calculate the upcoming year's spending by adjusting the amount of this year's spending based on your portfolio return for the year. But you don't go any higher than the "ceiling" or any lower than the "floor" you set as part of your strategy.

You might have a ceiling of 10% and a floor of minus 5%. After a strong year of portfolio returns, you would have the flexibility to increase your withdrawals by up to 10%. Likewise, you might reduce your withdrawals by up to 5% following a particularly poor year.