A few weeks ago, I gave you six ways to make your nest egg last. It’s an important topic, so here’s a seventh: Dynamic Spending. There’s a growing body of research that shows it can significantly extend the life of your portfolio. What is it and how does it work?
In retirement, like in your working years, your budget will include both fixed and discretionary expenses. Fixed expenses are things like food and your mortgage. Discretionary expenses include things like travel. In retirement, many of your fixed expenses are gone. Your house and cars are likely paid off. The kids are out of college. You’re no longer saving. Fixed expenses make up a smaller portion of your budget than ever. Your discretionary expenses are another story. Most retirees have a long list of travel, hobbies and other things they want to do.
That type of budget—low fixed, high discretionary—is ideal for dynamic spending rules. As the name implies, dynamic spending is simply adjusting your spending each year based on how your portfolio is doing. You establish rules that give you a raise when times are good and cut back a little when times are tough. The adjustments don’t need to be large to be effective and, as we saw earlier, spending adjustments are easier in retirement because a larger portion of your budget is discretionary.
How it works.
Vanguard did some research in this area and found evidence that dynamic spending rules can greatly improve success. What they tested was a hybrid distribution strategy that was basically a percentage withdrawal of the previous year’s portfolio value with adjustments based on certain rules. They would allow the spending to adjust each year based on year-end value, but would limit it to a ceiling and a floor. This allows your spending to rise as high as the ceiling when times are good and adjust downward as far as the floor when times are bad.
Let’s look at a quick example. Assume a $1 million portfolio and a 4% withdrawal rate, so the first-year distribution is $40,000. Now for next year, they would calculate a ceiling and a floor 5% above and 2.5% below that $40,000. So the ceiling is $42,000 and the floor is $39,000. Now let’s assume we have a big up market and the portfolio value is $1.1 million. 4% of that would now be $44,000. That’s above the ceiling, so you limit your withdrawals to $42,000. What if instead the portfolio had a bad year and it dropped to $900,000. 4% of that is $36,000. That’s below the floor, so you take the floor amount of $39,000. Basically, you’re giving yourself a raise during good times or taking a pay cut during bad times, but you are limiting each by predetermined amounts. This strategy had a 92% success rate vs. the 78% success rate of just taking a dollar amount grown by inflation. That’s a huge jump, all because you set a few simple rules that help ensure you don’t overspend (and risk running out of money) or underspend (and risk not living to the full).