Maximizing Retirement Success: Vanguard's Dynamic Approach to Spending in a Challenging Market

High inflation and low expected market returns are every retiree's worst nightmare. Inflation eats away at purchasing power, and low returns ensure their portfolios deplete faster due to higher spending requirements. So what are retirees supposed to do to safeguard the longevity of their investments in the current market conditions?

In 2017 as if peering into the future, Vanguard came out with a paper titled "A Rule For All Seasons: Vanguard's dynamic approach to retirement spending". This paper proposes a fantastic alternative to the highly static approach of the "dollar plus inflation" spending rule and the alternative approach of the "portfolio percentage" withdrawal strategy. Vanguard's proposed strategy increased the success rates of retirees by 23% from the traditional withdrawal strategy of the dollar plus inflation approach in Vanguard's proprietary simulation software, VCMM.

First, I will break down the traditional retirement spending rules mentioned above to understand Vanguard's proposed alternative.

You may have heard of the dollar-plus inflation approach. This is the trendy 4% rule. The 4% rule was created by William Bengen in 1994 to find a safe withdrawal rate for retirees based on a balanced portfolio. The 4% rule proposes that you spend 4% of your beginning portfolio balance ($40,000 per year if your portfolio is $1,000,000) and adjust in future years based on inflation. There is risk to this, aside from the 4% rule being no longer generally accepted as a safe withdrawal rate according to some academic studies. (although most papers on the rebuttal were published in low-interest rate environments and cited continued low-interest rates as a reason for the 4% rule being inadequate). The risk is that the rule is highly static and agnostic to investment returns. If your portfolio sees negative returns in the beginning (2022, for example), you spend more than 4% of your portfolio to meet continued retirement spending needs. This will cause your portfolio to deplete faster, and you risk running out of money in retirement. This is called sequence of return risk.

The portfolio percentage strategy takes the opposite approach and is highly sensitive to changes in investment returns. This approach ensures you will always have money because you will only ever take a percentage of your portfolio balance, whether it grows or shrinks, based on market returns. In this strategy, the risk that retirees face is their portfolio needing to yield more to meet continued fixed retirement withdrawal needs. For example, if you need $40,000 per year to live on and start with a $1,000,000 portfolio, in year 1, you will take $40,000. If, in year 1, the portfolio loses 10%, as we saw in 2022 balanced portfolios, you will only have $860,000 left. Now you are faced with the hard decision of taking only 4% of $860,000. That means in year 2, you can only withdraw $34,400. This no longer meets your lifestyle requirement of $40,000, not to mention inflationary increases in lifestyle spending. This is a big problem as investors may have to increase their allocation to stocks to increase expected returns and face volatility.

Vanguard suggests a hybrid of the two approaches. The dynamic spending approach. A dynamic strategy sets a floor and a ceiling to portfolio withdrawals.

The floor is the max a retiree will allow spending to decrease, and the ceiling is the max a retiree will allow spending to increase, both tied to investment performance. IE: 5% ceiling increase, -2.5% floor decrease. In year 1, if your plan required a 4% spending rate of a $1,000,000 portfolio, the spending would be $40k. However, if the investments had a return of 10%, the balance at the end of the year would be $1,060,000. ?

For year 2, instead of just taking another 4% of $1,060,000, which would be $42,400, we had set a ceiling for increases, remember? It was 5% of the prior year's spending. What is 5% of 40,000? It's $2,000. So, instead of $42,400, you would spend $42,000 in year 2.

If in year 1 you had a negative return of greater than -2.5% in your portfolio, you would adjust spending down by a max of 2.5% of your initial withdrawal.

In summary, this spending strategy would help put rules-based constraints on a portfolio and help retirees spend more based on market conditions and less during down markets. ?

According to Vanguards Capital Markets Model, they ran a distribution of return analysis on 10,000 simulations for each modelled asset class. ?

Based on their analysis, the dynamic withdrawal strategy increases portfolio success rates from the dollar plus inflation method (4% rule) by 23%.

The research can be found here: https://www.vanguard.ca/documents/literature/dynamic-ret-spending-paper.pdf

Note: all illustrations provided do not take the registered nature of accounts into consideration. The numbers will change based on your tax rates, registered vs non-registered accounts and individual risk tolerance.

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Disclaimer: The information provided in this article is for informational purposes only and does not constitute financial advice. Investment returns are subject to market conditions and can vary significantly. Past performance is not indicative of future results. Readers should consult with a licensed financial advisor. Sam is a licensed financial advisor and CFP professional. All investment products are provided through Portfolio Strategies Corporation.