What’s the best way to plan your retirement spending?
As any experienced mountaineer will tell you, there’s more to climbing a mountain than getting to the top. Statistically, there are in fact more accidents on the descent.
It’s a similar story with wealth management. Most of what we read about it focuses on the so-called accumulation phase — in other words, building a sufficiently large pot of money over the course of your working life to enable you to retire. But just as important, and in many ways, more problematic, is the decumulation phase, or ensuring that you make the most of your wealth in retirement, without running out of money and having to rely on your family for financial support in your old age.
In recent years, we’ve seen a huge growth in interest in what is sometimes called the science of retirement, and it’s a subject which we at RockWealth pay very close attention to.
Last week, RockWealth’s Head of Investor Education ROBIN POWELL met one of the financial industry’s leading authorities on retirement planning — GARRETT HARBRON, an investment strategist with Vanguard Asset Management. Garrett has recently relocated from Arizona to London, where he heads a team of strategists developing Vanguard’s retirement methodology in the UK.
In this interview, Garrett explains the latest developments in retirement strategy and the different options open to retirees.
RP: Garrett, why has there been so much interest in retirement strategy in recent years?
GH: For a long time, we didn’t give a whole lot of thought to what retirement spending looked like because we didn’t really have to. Most people had a defined-benefit plan. State pensions and social security were a little bit more generous than they are today. People weren’t expected to provide for their own retirement to the extent that they’re expected to now. This has been compounded by the fact that the Baby Boomers are retiring, so we have more people retiring each year, and also people are living longer. The concept of a 40-year retirement 30 years ago was completely foreign. Today it’s very much a reality.
How you fund your retirement is an incredibly important question, because it determines your lifestyle. It’s really exciting to see the financial planning profession embracing these questions and trying to figure out the best answer.
RP: Of course, it’s vital that advisers and their clients get the accumulation phase right — that they invest for their retirement as efficiently as possible. But, in many ways, sound financial planning post-retirement is just as important, isn’t it?
GH: If you had to make me choose — What is more important, as far as advice goes, the accumulation phase or the decumulation phase? — I would say unequivocally it’s the latter. Think about all the things that go into a successful decumulation through retirement — How much can I spend? When do I take it? How do I take it? Which buckets do I take it out of? How do I manage the tax impact? Those things are much more complicated than the accumulation phase.
RP: Indeed, things can go badly wrong financially in retirement, even for those who start with a large pension pot, can’t they?
GH: Absolutely they can. All things being equal, having a large pension pot makes that less likely, but it all depends on what spending decisions you make, how your portfolio is invested, what equity exposure you have, and how you define failure. For me, failure may mean not being able to pay the utilities bills or the mortgage. For someone else, it may mean not being able to take a golf vacation every year. We all have different goals for retirement, and we all define failure differently.
RP: OK, let’s look specifically at retirement spending strategy. Traditionally, financial advisers have often used what’s known as the 4% Rule. Explain what that is.
GH: The 4% Rule says that you should take a pre-set amount of money out of your portfolio account each year, adjusted for inflation, and the amount never changes, except for those inflationary adjustments. The reason it’s called the 4% Rule is that, a few decades ago, there was some research done that said the sustainable withdrawal rate was 4% of the initial value of the portfolio.
There’s been a lot of talk lately about whether the 4% Rule is dead, and based on our research, at least in the UK, we don’t feel that it is. When we ran our numbers and did our simulations for the 4% Rule and measured it against an 85% portfolio success rate — that is, over 10,000 simulations the portfolio has money left after 30 years 85% of the time — we found that the maximum sustainable spending rate is actually 4.17%.
RP: All right, so it’s still a valid approach to retirement spending. But there’s another strategy called the Percentage of Portfolio Rule. Explain how that works.
GH: Yes, the Percentage of Portfolio Rule is kind of the opposite of the 4% Rule. It means that you take a pre-set percentage of your portfolio value every year, regardless of what happens. So if the market goes up 10% one year, you have a 10% pay rise, and if the market goes down 20%, you take a 20% pay cut. Whatever the market does, your income mimics it.
RP: Without wanting to get too technical here, you and your colleagues at Vanguard have come up with a third option for retirement spending, haven’t you?
GH: Yes, you’re making different trade-offs with the two rules we’ve mentioned, and those are the two extremes of the retirement spending spectrum. On the one hand, with the 4% Rule, you have extremely stable spending, but if you look at portfolio success rates, there’s a good chance that you’ll run out of money before the end of your retirement period. With the Percentage of Portfolio Rule, you never run out of money, but your spending can be very volatile. Neither of those solutions makes a great trade-off for clients.
So what we’ve done is to develop what we call the Dynamic Spending Rule, which takes a little bit of the 4% Rule and a little bit of the Percentage of Portfolio Rule. We allow spending to vary in line with market conditions from year to year, but within a present corridor that the client can set according to their needs and objectives. So we get some market responsiveness, which helps us increase the probability of success for the portfolio, but it’s within constraints that the client can tolerate.
RP: You’ve got a paper on this, haven’t you, and another one coming out later this year?
GH: We introduced a paper called From assets to income: A goals-based approach to retirement spending in the US a year and a half ago, and that’s where a lot of this research comes from. What we’re doing now is taking that analysis and re-casting it for the UK market. The technique remains the same but the numbers are a little bit different, and well be launching our UK paper in the next few months.
If you are either in retirement or approaching retirement and would like to discuss the optimal strategy for you, why not get in touch with us? One of our financial planners will be happy to help you.