Risk-Based Guardrails: A Flexible Approach to Spending in Retirement

Last week’s blog focussed on the challenges facing retirees, moving from a period of work and wealth accumulation to one of drawing down on their life’s savings to fund retirement.?

This transition often raises a difficult question: How do you strike a balance between the fear of running out of money (FORO) and the fear of missing out on life experiences or helping loved ones (FOMO)??

I shared some strategies to address these challenges, including:

• Using cashflow modelling to forecast your financial future and gauge whether your savings are likely to last, even under unexpected costs like long-term care.
• Considering home equity as a safety net for future expenses and how moving to a retirement apartment might bring added benefits.
• Purchasing guaranteed annuity income with some pension savings to secure at least a minimum baseline income, sufficient to meet essential spending needs for life.

You can read the full blog here: Retirement Spending - When FOMO meets FORO

I also introduced the concept of Risk-Based Guardrails as a more flexible approach to retirement spending, one that takes into account investment performance and adjusts the spending threshold accordingly.?

I explore this concept in more detail in this week’s blog.

A Risk-Based Guardrails Approach to Retirement Spending

Many people are familiar with the concept of the 4% “Safe Withdrawal Rate.”

This idea, introduced by US Financial Planner Bill Bengen, suggests that you can withdraw 4% of your pension in the first year of retirement, increase that amount annually with inflation, and have a 95% chance of not running out of money over 30 years. This calculation assumes a portfolio made up of 50% stocks and 50% bonds and is based on historical returns from 1926 to 1976.

While the 4% rule is a handy guide, it has some major limitations:

1. Changing spending habits: Retirees often spend more in the early, active years of retirement and less in later, quieter years.
2. State Pension timing: State Pensions often start partway through retirement, reducing the need to withdraw as much from savings.
3. Market performance: The rule doesn’t account for market ups and downs. Strong early returns might allow higher spending, while poor returns might require cutting back to avoid running out of money. This is known as Sequencing Risk.

To address these shortcomings, modern financial planners are now using more flexible strategies, like the Risk-Based Guardrails approach outlined below.

How It Works

Step 1: Stochastic Cashflow Modelling

• We combine your current financial position with some key personal assumptions, like when you plan to retire, the income you expect to receive (from pensions, rental properties, etc.) and anticipated spending, including the ability to vary this through different stages of retirement.
• Meanwhile, for inflation and investment returns, we use actual historical data since 1915.?
• The result is a “fan chart” that shows hundreds of possible outcomes based on real market conditions over the past 110 years. For example, one scenario might show how your plan would have performed if it started in 1915 and ended in 1945, another if it started in 1916 and ended in 1946, and so on, right up to the present day.

This approach differs from the more traditional "deterministic" cashflow modelling, which uses fixed, straight-line assumptions for inflation and investment returns.??

Step 2: Calculate Sustainability Score

• The stochastic model will generate a ‘Sustainability Score’, which shows the percentage of scenarios in which you’d have had enough to meet retirement spending needs throughout. For example, a score of 90% implies that your plan would have succeeded in 9 out of 10 historical simulations run.?

Step 3: Set Initial Spending Level

• We then set an initial spending level that gives an 80% chance of success.?
• The rationale for 80% rather than 100% is that this strikes a balance between FORO and FOMO. That is, it implies a low probability of running out of liquid assets due to poor investment performance or higher inflation - just 20%. But it’s not ‘zero risk’ which could otherwise result in ‘underspending’ in retirement and missing out on aspirational spending.
• It's important to understand that the risk of running out of money in retirement, known as 'longevity risk,' isn’t just caused by factors like inflation or investment performance. It can also happen if you spend more than planned. Cashflow modelling helps in this regard by setting a clear and realistic spending goal, striking a balance between spending too much and too little. This is a key part of planning for a secure and comfortable retirement.

Step 4: Ongoing Reviews and Adjustments

• With a Risk-Based Guardrails approach, ongoing review is crucial.?
• Each year, or after significant market changes, we revisit the stochastic cashflow model.?
• If your sustainability score rises above 100%, you can increase spending (i.e. give yourself a pay rise) to the extent this brings the score back to 80%.
• If the score drops below 60% after poor market performance, spending is reduced (a pay cut), to push the score back up to 80%.

This dynamic approach adjusts to real-world investment performance, making it far more flexible than a fixed withdrawal rule like the 4% model. It ensures retirees can adapt to changing circumstances, including the volatility and vagaries of financial markets, allowing for a more confident retirement.

Worked Example

Consider the following example:

Michael and Ana, both 62 years old, have recently retired. They want advice on how much they can safely spend during retirement, including potential regular gifts to their children.

Their current financial situation is as follows:

• Income: They will receive full State Pensions at age 66.
• Savings:
• Home: They own a house worth ￡750,000 and currently have no plans to downsize

In terms of their retirement goals, Michael and Ana estimate they need around ￡60,000 a year for a comfortable retirement. They expect their spending to gradually decrease (we assume by about 1% a year after inflation) as they transition into a quieter lifestyle. However, they’d like to spend more if possible—for travel aspirations or to fund additional gifts to their children and/or future grandchildren.

Cashflow Modelling

The chart below illustrates their projected savings and investments over time using stochastic cashflow modelling. As noted earlier, this method runs hundreds of scenarios (840 in this case) based on real historical inflation and asset return data over the past 110 years.

• The blue line shows the middle (median) outcome.
• The dark grey area shows the range of more likely outcomes (between the 30th and 70th percentiles).
• The light grey area shows less likely outcomes (between the 10th and 90th percentiles).

Key Results:

• In 100% of the scenarios, Michael and Ana had enough money to meet their spending needs throughout their lives.
• Even in the worst-case scenario (a period covering both World Wars), they would still have ￡350,000 left (in today’s money) by age 100.
• In the best-case scenario (which occurred between 1980 and August 2019), they would have ended up with ￡15 million. Of course, this is extremely unlikely, just like the above worst case.?

With a 100% Sustainability Score, we can be confident that Michael and Ana are comfortably on track to meet their retirement spending needs. However, this ‘perfect score’ implies that there might be a risk of under-spending and potentially missing out on some of their aspirational goals (FOMO).

As a side note here, the large difference in outcomes (ranging from ￡350,000 to ￡15 million) shows how the order in which good and bad market returns happen—known as sequencing risk—can significantly impact your finances. We’ll be covering this in more detail in an upcoming blog.

A More Flexible Spending Strategy (Guardrails)

We now consider what level of spending would be consistent with an 80% Sustainability Score. As noted previously, this offers a good balance between FOMO and FORO.

In this case, we calculate that they could increase their spending from ￡60,000 to ￡86,300 a year (from ￡5,000 to just over ￡7,000 a month). This extra budget could be used for dream holidays, family gifts, or some other need entirely.

This strategy would then be reviewed regularly, at least once a year or whenever there’s a significant change in circumstances or market conditions. If markets perform well, they could increase their spending; if markets underperform, they could reduce their spending to ensure long-term stability.

This dynamic approach ensures that Michael and Ana can enjoy their retirement to the fullest while remaining financially secure.

As always, if you’d like any more information or wish to review your own retirement plans, please let us know.

Happy Thursday!

Please note this blog is for general information and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and does not contain all the information that an investor may require to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is correct as of the date it is received or will continue to be correct. We cannot accept responsibility for any loss due to acts or omissions made for any articles.