Last week I made my first stab at designing a retirement income strategy that adapts to portfolio performance. By allowing monthly income to vary we can overcome serious problems with the “4% rule” and rules of thumb about the percentage of bonds in your portfolio. Unfortunately, the monthly changes in income were too erratic. I now have a fix for this problem.
I won’t repeat too much from the original post. I did experiments based on a 60-year old retiring at the start of the year 2000 with $1 million in today’s dollars. I designed a spending plan based on keeping 5 years’ worth of monthly spending in a high-interest savings account (HISA). I used a target life expectancy of 95 and assumed that all savings not in the HISA would be invested in the Canadian stock ETF XIU. (I don’t recommend such a concentration in Canadian stocks for a real portfolio.)
Stocks were extremely volatile from 2000 to 2013 and the goal of this experiment was to design a retirement spending plan that doesn’t have the monthly spending amount vary too much while controlling the risk of overspending and draining savings too early.
The latest feature I’ve added is some filtering on the changes in spending. When the strategy calls for spending to increase from one month to the next, I actually only increase it by 1/40 of the called-for amount. One way to think of this is that it takes roughly 40 months for spending to rise to meet an outperforming portfolio. When the strategy calls for spending to decrease, I only apply 1/20 of the decrease. So, it takes roughly 20 months for spending to drop to reflect an underperforming portfolio. This adds some risk of spending too much while stocks drop sharply, but 20 months’ worth of spending is only one-third of the 5 years’ worth of HISA savings.
So how well does this new filtering smooth out monthly spending? The following chart shows the performance of XIU with reinvested dividends, the unfiltered spending from the previous experiment, and the new filtered spending. All are inflation-adjusted.
Without any filtering, monthly spending reacted immediately to changes in XIU leading to a very bumpy ride. With the filtering, changes are much more gradual but still show good reaction to XIU returns. For example, if XIU had stayed down from 2002 onward instead of roaring up, the filtered spending would have reacted to the new reality in a couple of years.
Overall the addition of the filtering seems to have given us a good compromise between reacting to permanent changes in a portfolio without causing monthly spending to jump around wildly. I’m definitely interested in feedback on this retirement spending strategy. Are there flaws? Are there market events that it would react to badly?
Disclaimer: It would be crazy for anyone to blindly follow my recipe for retirement spending at this point. It needs much more analysis.