Trying to figure out how much of their savings to withdraw each year perplexes many retirees. A Vanguard research paper looked at the problem and recommended a hybrid approach that mixes two common methods of calculating spending.
The two traditional strategies rely on withdrawing a fixed percentage of a portfolio each year. Vanguard’s analysis found long-term problems with each method.
The paper first looked at the so-called 4 percent rule. A retiree using this strategy would withdraw that percentage of the amount in their retirement funds at the beginning of each year. Because a portfolio’s assets would rise and fall with the markets, this strategy makes it difficult to plan spending. The upside to this method is that assets would never be depleted.
The paper also looked at a method that uses the 4 percent rule, but adjusts the amount each year by the inflation rate. This strategy ensures retirees have a stable amount to spend each year, but is unresponsive to market ups and downs. The chances the fund will last 35 years are 78 percent, the lowest of the three methods, including the “dynamic” one that follows.
Finally, Vanguard analyzed a modified version of the two methods. This “dynamic” method still uses the 4 percent rule as its base, but adds a “ceiling” and “floor” that adjusts the amount withdrawn each year based on market performance.
Under this strategy, a retiree would increase withdrawals up to 5 percent over the previous year if assets grew by that amount or more. If assets decreased, the amount taken would decrease by as much as 2.5 percent.
In this way, Vanguard said, market fluctuations would be accounted for, at least in part. It calculated at 92 percent the chances that a portfolio managed in this way would last 35 years.
The paper’s take-home message for retirees is that “flexibility is the one word that best describes a prudent spending strategy. Rigid spending rules cannot eliminate investment volatility; they simply push its consequences into the future…. The more investors can tolerate some short-term fluctuations in spending, the more likely they are to achieve their longer-term goals.”