Accumulating wealth is a challenge. But "decumulating" it can be trickier still.
The problem is that you don't know many of the key elements that would enable you to come up with a perfect plan for tapping your money in retirement. How long will you live? What will market returns be like? And in what sequence will those returns appear? The answers to all those questions are unknowable.
Hence the growing fascination with so-called decumulation strategies for consuming retirement nest eggs. The strategies include the simple and much-quoted 4-per-cent rule, as well as much more complicated sets of guidelines and formulas. Each approach has enthusiastic fans.
To help bring some order to this jumble, it would help to put all the leading strategies side by side. And that's exactly what Wade Pfau, a professor of retirement income at American College in Bryn Mawr, Penn., has done.
His new paper, Making Sense Out of Variable Spending Strategies for Retirees, compares 10 systems for drawing down your savings in retirement. His research demonstrates that even experts have widely different opinions on the issue.
It also helps explain why arguments about retirement strategies often resemble a shouting match among people who don't speak a common language. The essential problem, and the reason for all that shouting, is that you can evaluate any given approach on many different criteria.
The 4-per-cent rule, for instance, says that if you start retirement by withdrawing 4 per cent of your initial portfolio, and every year bump up that starting amount in line with inflation, you will not run out of money over a 30-year retirement. Based upon market history in the United States and Canada, this is nearly always true.
So judged on one criteria – will it ensure you don't outlive your money? – the 4-per-cent rule works out pretty well. It also scores well on another criterion: It keeps your spending at a constant level, in after-inflation terms.
However, it's not so good if you're interested in being able to live as well as possible in retirement.
People who use the 4-per-cent rule can end their lives with large amounts of unspent cash. This is because the 4-per-cent guideline is designed to allow your portfolio to soldier through even a Great Depression. If you're among the many retirees who don't run into such a disaster, your portfolio grows and grows while you keep restricting yourself to modest annual withdrawals.
The 4-per-cent rule is probably unrealistic in other ways as well. If you're unfortunate enough to be smacked by a market calamity in the first few years of retirement, and your portfolio falls by half, you will probably not keep blindly spending at a constant level.
And that's a good thing. By cutting back when hard times hit, you give your portfolio a chance to heal.
But how much should you cut back? And when? That's where things get interesting.
Among the variable-spending strategies that Prof. Pfau compares are various approaches that adjust withdrawals depending on how your portfolio performs. He calls them "decision rule methods" because they lay down explicit guidelines for how to tap your savings.
He contrasts them to what he calls actuarial methods. These recalculate your sustainable spending every year based on your portfolio balance, expected longevity and expected returns. (For a closer look at one actuarial approach, check out an earlier Long View column)
One interesting strategy makes use of annuities to cover your basic expenses. It lets you tap your remaining portfolio quite aggressively, but also requires you to slash those withdrawals if markets turn against you.
So which approach works out best? Prof. Pfau sidesteps that question because no one number can sum up all the characteristics of a strategy. Some strategies, for instance, offer temptingly high initial spending rates, but also have more potential to disappoint later. Some can be more easily tripped up by sequence-of-returns risk – a run of bad market outcomes – than others.
As a rule, the decision-rule strategies are less efficient than actuarial strategies, meaning they have more potential to leave you with large amounts of unspent money at the end of 30 years. But that may not matter to you if you like the idea of possibly leaving a large legacy.
Prof. Pfau's paper can help you figure out which approach best fits your own needs. The simplest takeaway, though, is that it pays to build a bit of wiggle room into your planning, no matter which system you choose.
"Flexibility, such as the option to cut your spending if results disappoint, can go a long way toward ameliorating the risk of running into a sequence of bad market returns," he said in an interview.
Ian McGugan