A Comparison of Variable Spending Strategies

This is part two of a two-part series. You can read part one here.

In part one of this series, I established a framework for evaluating variable spending strategies in the context of retirement planning. My framework used a “PAY” rule that integrated the probability (P) that the remaining portfolio balance falls below a threshold amount (A) of (in inflation-adjusted terms) by year (Y) of retirement (Probability, Amount, Year). I evaluated a constant real spending strategy (motivated by William Bengen’s original research on the 4% rule) using this framework and illustrated a number of drawbacks in this approach.

Let’s analyze the remaining strategies using this framework. Those strategies were in exhibit 1 in part one of this series, reproduced here:

Fixed-percentage rule

On the spectrum of spending strategies, the fixed-percentage rule shown second is the opposite of constant inflation-adjusted spending. It calls for retirees to spend a constant percentage of the remaining portfolio balance in each year of retirement. Occasionally the popular press will mistakenly define the 4% rule this way (a 4% fixed percentage strategy calls for withdrawing 4% of the remaining account balance each year), but the accepted definition of the 4% rule is the constant inflation-adjusted spending strategy described in part one. To be clear, with constant inflation-adjusted spending, the nominal withdrawal rate will change throughout retirement as the portfolio value and inflation rate change. The withdrawal rate adjusts, while spending stays the same. But with fixed percentages, the withdrawal rate stays the same, while spending adjusts.

An advantage of the fixed-percentage strategy is that, since it always spends a percentage of what remains, it never depletes the portfolio. Of course, spending could fall to uncomfortably low levels, but the concept of portfolio failure rates is inapplicable here. In addition, spending increases when market returns outpace the spending rate and the portfolio grows. As well, this strategy eliminates sequence-of-return risk, as the late and esteemed Dirk Cotton first pointed out in 2013 at his Retirement Café blog. The fixed-percentage approach provides a clear mechanism for reducing spending after a portfolio decline. As with investing a lump sum of assets, the specific order of returns makes no difference to the final outcomes realized with this strategy. As such, we can expect the sustainable spending rate to be higher than with constant inflation-adjusted withdrawals. With our PAY rule calibration, this strategy allows initial spending to begin at 8.54%, which is more than double the initial spending with the baseline strategy.