Wednesday, October 23, 2013

A Retirement Income Strategy

I find most rule-of-thumb strategies for drawing retirement income from savings very unsatisfying. We have things like the “4% rule” and using your age as a percentage for your bond allocation, but such one-size-fits-all rules can’t possibly fit everyone. Here I introduce my own candidate strategy for generating retirement income.

Troubles with the 4% Rule

The 4% rule says that when you start retirement you can calculate 4% of your initial savings and spend this much each year rising with inflation. So, if you have $1 million saved, you spend $40,000 in the first year and increase this amount by inflation every year.

Of course, the main problem with this rule is the possibility of running out of money. If your investments perform poorly in the first few years, you just keep spending based on your initial savings even though your savings will start to dwindle quickly.

A second problem is that everyone uses the same percentage regardless of how they invest their money. Suppose two investors, April and Ben, have exactly the same asset allocation. But April is a do-it-yourself investor who pays 0.2% in ETF fees each year, and Ben pay 3% fees each year on his mutual funds. Obviously, Ben’s spending has to be 2.8% lower than April’s. If April can only spend 4%, then Ben can only spend 1.2%.

Yet another problem is the inconsistency of treating two investors differently when they have exactly the same portfolio size. Suppose that Cheryl and Dan are both 70 years old, have been retired for 5 years, and both have $1 million in savings. However, Cheryl’s portfolio began 5 years ago with $1.1 million and Dan’s has stayed steady at $1 million. The 4% rule will have Cheryl spending 10% more than Dan because she started with the larger portfolio. But this makes no sense given that they are in the same position now. You could even argue that Cheryl should spend less than Dan because her portfolio returns are weaker than Dan’s and, being a woman, she is likely to live longer.

Troubles with using your age as a bond percentage

People have different risk tolerances. Some of these differences are rational and some irrational. A tenured professor might reasonably have more appetite for stock risk than a middle manager in a high-tech company. A retired 55-year old might reasonably have less appetite for risk than a 55-year old who plans to work for another 10 years. On the irrational side, some people simply can’t sleep at night with any of their money in risky investments no matter what a rational analysis might conclude. Given these differences, how can we have a one-size-fits-all bond allocation rule make sense?

Income variability

Any strategy that keeps income completely stable (like the 4% rule) is going to either have a risk of running out of money or have such a big margin of safety that income will be very low. So, we need a strategy that adapts monthly spending based on portfolio performance. The goal is to find a way to keep spending as steady as possible without undue risk of running out of money.

I’m sure that financial advisors will tell me that many of their clients simply could not tolerate a reduction in their monthly spending. While this may be true, I would rather slowly reduce my spending than just run off the edge of a cliff when the money runs out. So, even if many people can’t adjust their lifestyles until all the money is gone, I’m more interested in a strategy that makes sense. That said, I still think controlling the volatility of cash flow is an important goal.

My proposed retirement income strategy

So here’s the idea. After retirement, we maintain 5 years of spending in a high-interest savings account (HISA). The rest gets invested the same way it was before retiring. In my case, that’s 100% low-cost stock index ETFs. The tricky bit is calculating the appropriate monthly spending amount. And because this amount will vary somewhat, the 5 years’ worth of savings in the HISA will vary somewhat. This means that there will be rebalancing between the HISA and the investment portfolio.

To calculate monthly spending, we need to make a series of assumptions. We choose a spending level so that if our return assumptions are exactly correct, we will run out of money at a chosen life expectancy. If returns are higher than expected then spending will go up the next month, and if returns are lower than expected then spending drops. As we will see in an experiment, monthly spending based on this rule turns out to be more stable than portfolio returns.

Here are some of the assumptions that I used in an experiment:

Portfolio return: inflation + 3%

This may seem conservative for an all-stock portfolio, but if we choose this to be too high then retirement spending will drop over time. I think it makes sense to choose this percentage to be lower than historical returns, but how much lower depends on how accepting you would be of reduced monthly income. Another thing to consider is that this percentage should be lower for investors who choose to include investments in bonds, real estate, or any other asset classes that historically have had lower returns than stocks.

HISA return: inflation +0%

I’m assuming here that the high-interest savings account interest will just match inflation.

Years of spending money to keep in the HISA: 5

I don’t have any particular justification for using 5 years other than it seems like long enough to stay sheltered from some wild swings in the stock market.

Life expectancy: 95

This is conservative, but hey, who wants to run out of money early. It probably would make sense to increase this life expectancy age is we get closer to it. Perhaps the remaining life expectancy should never go below 15 years.

Using these assumptions, I did an experiment based on a 60-year old retiring at the start of the year 2000 with $1 million in today’s dollars. (All of the dollar amounts in the experiment are adjusted for inflation.) The portfolio holdings other than the money in the HISA are invested 100% in the Canadian stock ETF XIU. I don’t recommend such a high concentration in Canadian stocks, but the goal here is to see how portfolio volatility affects monthly retirement income.

A few other details were that I assumed stock trades cost a $10 commission, a one-cent per share loss due to spreads on each XIU trade, and we only make stock trades when the amount of cash in the HISA is more than 5% from its target value.

Here are the steps that get performed at the start of each month.

1. Take the total portfolio value and calculate the monthly spending amount (rising with inflation) so that we would run out of money exactly at age 95. Transfer this amount to a chequing account from the HISA or form the investment account if there is cash there, possibly from dividends. (If any readers are interested the details on how to calculate the monthly spending amount, I’ll answer questions about it in the comments section for this post.)

2. Calculate the amount that needs to be in the HISA to support 5 years of this monthly spending.

3. If the actual HISA balance is low by more than 5% of its target value then sell enough stock (or other investments) to bring the HISA up to target. Selling stock periodically is inevitable as we spend down our savings.

4. If the actual HISA balance is high by more than 5% of its target value then transfer the excess from the HISA and buy stock (or other investments). This can happen when stocks drop sharply.

Experimental results

The following chart shows how monthly spending, adjusted for inflation, varied from the year 2000 to the present. Also shown on the chart is the value of XIU with reinvested dividends adjusted for inflation. The starting dollar amount of XIU was chosen to best contrast XIU price with monthly retirement spending in the chart.

While the XIU investment value varied over a range of 98% of its starting level, monthly spending varied over a range of 56% of its starting level. So, monthly retirement spending is less volatile than stock prices, but perhaps still too volatile.

At this point you may ask why monthly spending has to be so volatile. After all, if the stock market drops, it will probably come back eventually. This may or may not be true, but the model I used always assumes that whatever the current stock market level, this is the base from which steady 3% above inflation gains will be made. So, in this sense, we assume any big drop in stock prices is permanent and spending must go down. Factoring in some amount of stock price reversion of the mean in the model may be a path to improving my strategy, or it may just increase the risk of running out of money.

To try to reduce monthly spending volatility, I did a second experiment where we hold 10 years’ worth of spending in the HISA. Here are the results:

This time the monthly spending is steadier; it varies over a range of only 45% of its starting value. The trade-off is that monthly spending is generally about 10% lower in this case because more of the retiree’s portfolio is locked up in the low-return HISA instead of in XIU. Despite XIU’s volatility, it did give a positive return above inflation from the year 2000 to the present.

Limitations of this analysis

I haven’t dealt with taxes or the complication of a portfolio split across a number of different types of accounts, like RRSPs, RRIFs, TFSAs, and taxable accounts. I haven’t factored in CPP benefits or old age security. As well, I’ve only experimented with one time period for stocks. However, I did choose a very volatile period that included two significant bear markets for stocks, so at last we have a test of severe conditions.

Overall I consider this to be just a starting point for my thinking on how I’ll handle my own portfolio when I choose to retire. To be clear, I think it would be crazy for anyone to blindly follow my recipe for retirement spending. I’m very interested in ideas for improving it.


  1. Hi Michael:

    I had to decide on whether to read your post or click your advertisement about "the 3 ?'s you need to ask her" but since I am married I took the safe route and read your post :)

    Glad I did. All I hear people say is, the retirement rule of thumbs are wrong. Yet no one provides an alternative. I commend you on your attempt. I only had time to do a quick read, but will read in more detail again later. Good work in providing an alternative; whether I decide I agree or disagree in the end.

    1. @Mark: I'm still trying to figure out whether I need to adjust some of the parameters such as return expectation, etc., or whether I need to add a new component such as an annuity or some reversion-to-the-mean assumptions in stock prices to smooth out monthly income. I'll be interested to get your feedback.

  2. Your approach looks good, and I'm interested to see how it develops. My only concern would be your ability to continue with the monthly calculation as you age. I think you might need to plan a strategy for objectively assessing your mental acuity and a recognizable trigger point that will tell you when it's time to move to some kind of automated strategy, or pass the calculation along to a power of attorney.

    The other concern with a strategy like this for a couple is how transferable it is and how comfortable a surviving spouse might be with the system. Again - solveable, just another piece to put into place well before it's necessary.

    As usual, precise and logical reasoning, Michael. I always enjoy reading your independent/iconoclastic take on things.

    1. @Sandi: We can certainly bake the calculations into a spreadsheet, but it's not clear how far we can go in automating the whole process. I could certainly make it simple enough for a spouse uninterested in math or finances to follow. However, it would be even better to be able to have the financial institution holding your assets to handle it all automatically.

      Thanks for the kind words.

  3. This entire post highlights to me another drawback of this major shift to defined contribution pension plans: Many people just aren't going to be able to handle this type of analysis and math.

    When my parents and older relatives retired, budgetting in retirement was fairly easy: you added up your monthly cheques from CPP, OAS and your defined benefit pension. You subtracted your fixed living expenses. What was left was your discretionary spending money for food, clothing, etc. If you were lucky and had private savings, you could choose to use them for travel or luxuries. If you didn't, well you knew what you didn't have. You didn't have to wonder how to cover your basic living expenses, provided the sum of your three monthly payments could cover your fixed expenses. If the sum was too low, you had to go back to work or get assistance from friends, family or charity.

    I'm not looking forward to watching this upcoming generation try to figure out this new way of paying the bills in retirement. And the opportunities for someone who is trusting and not financially astute to get taken in by schemes promising a high pension in return for signing over their assets seems dangerously high.

    1. @Bet Crooks: I agree that many people will have problems handling their money in retirement. However, I suspect that the main problem will be impulse control rather than the inability to do the calculations required. It's true that most poeple can't do this math, but it could all be baked into a spreadsheet, an online calculator, or handled automatically by an advisor.

      In the end, though, most poeple wold be better served by an increase in CPP.

  4. More of a question than a comment. I'm wondering if you have thought about the possibility of a long-term recession and how you would protect your investments now for that possibility. My daughter has about $250,000 invested (mostly RRSP money) plus own 4 rental units (with mortgages) which she rents out (and lives in one). I don't think she's untypical of a 40 year old today. Her money is currently invested in funds managed by a major bank. Would you have any recommendations on how to recession proof her investments?

    1. @Miriam: I have no useful insight into whether we are in for a recession or strong growth. It sounds like your daughter is exposed to significant real estate risk and likely stock and bond risk in mutual funds. There are certainly ways to hedge that risk with various types of derivatives. However, the problem is that she would lose out on upside if she hedges.

      I can't say what another person should do with their investments. The approach I take for myself is to choose a risk level I can live with, and I don't try to predict the future. I stick with low-cost investments which eliminates most products offered by big banks.

  5. I am more worried about my lack of impulse control than my math skills... I am leaning towards a flat 4% withdrawal of the remaining portfolio each year and make do with whatever that amount is, plus maintaining a good-sized emergency fund that can keep me afloat for 3 years with no withdrawals in the event of a stock market swoon.

    1. @Tara: Your strategy is actually broadly similar to the one I described. The main difference is that I allow for a draw down of capital as you get closer to your life expectancy.

  6. With 1 mln $ you can easily setup portfolio that returns 3% dividends (100% in equities). I believe I can live on 30000 per year, assuming I'll get CPP and OAS. You never touch principal and assume that principal could grow up with inflation. In case of recession you will have less money to spend these years, but assuming markets rebound, you will always have principal recovered. Is there anything wrong with my retirement plan?

  7. @Anonymous: Assuming that your portfolio would consist of a broad range of stocks that cover many industries and markets around the world, I'd say that your strategy is a little more conservative than the one I described. There is no guarantee that your dividends and principal will keep pace with inflation. So, if you're willing to cut back in the event that markets go through a rough period, I can't poke any holes in your strategy. I'm just looking for ways to spend more while still keeping income fairly stable.

  8. For mean revision, one thing I've been playing around with has been allowing the buckets to change: I start with 5 years of spending needs in cash/GICs and the rest in equities. Then if equities underperform, instead of taking a full year of cash out to replace the one just spent, I scale it back so only say a half year of equities get sold to cash. The portfolio gets more aggressive until equities recover, or the cash buffer is drained, and then the budget is forced to change. For minor bumps in the road that revert it allows the portfolio to recover. But if the return assumptions were wrong, it's way too slow in changing the budget. Haven't played with it enough to say how stupid it is yet.

    Anyway, this is a seriously unpolished comment, I can't even remember if I started with a point in mind. Feel free to take the shifting aggressiveness idea and do a post proving dangerous my thinking is ;)

    1. @Potato: It sounds like your approach would respond more slowly to changes in portfolio value. This would smooth out changes in spending, but as you say it might respond too slowly. We'd need to define precisely how it works and try some simulations to get a better idea.

  9. Good post.

    In retirement, 5 years of spending in cash is a bunch. Not sure I'd have that personally, seems like a major opportunity cost.

    I'd probably ensure my income covers expenses by a buffer of 15-20% in the early years of retirement, where I expect to spend more (when younger) and as long as the capital stays largely intact, then I wouldn't have to worry so much about spending in the latter years.

    The return of inflation + 3% is probably safe and good, but nobody can accurately predict either.

    Life expectancy of 95 is a pretty great life. Might as well aim high :)

    Have you attempted to calculate your estimated expenses in retirement?


    1. @Mark: Yep, it's a trade-off between opportunity cost and the possibility of sickening sales of stocks when they are way down in price. I'm not sure what you mean by income here; your only income is whatever you draw from your portfolio.

      I have tried to estimate expenses in retirement but I come up with a wide range depending on how much traveling I do.

  10. I am planning my retirement with my partner in a year or two. I worked up a cashflow spreadsheet which includes all sources of income (investment returns, pension, cpp, oas, misc) several of which occur at very different times (largely because there's a significant age difference between us). Assuming (for now) a goal of maintaining a constant annual income, this tells me how much I need to withdraw from my portfolio each year, and this amount (which for safety I consider a maximum) varies quite a bit over the years.

    Then I use Larry Swedroe's guideline (you covered this 2008-03-06) to work out the amount that "should" be invested in bonds for each 20 year period. I can use that to work out a bond allocation (actually, I take 3/4 of this, since it seems quite conservative--eg, comparedd to your own 3-5 year rule of thumb--and we're flexible and not particularly risk-averse). The bond allocation of course changes over the years, so I'd occasionally adjust it. We'd make our withdrawals from the overall portfolio to rebalance it (so not setting up any separate funds).

    That's the plan! whaddayathink?

    (ps, thanks for all the awesome posts!)


    1. @L.S.: You can't go too far wrong following Larry Swedroe's advice on bond allocation. What I couldn't tell from your plan was how large the withdrawals from your nest egg will be. I understand that they will change over time. If that means they will bounce between 1% and 3% of your portfolio each year, then you have a large margin of safety. If they bounce between 6% and 10%, then you'll likely run out of money. No matter what percentages you choose, you'll need to stay on top of whether you're draining your portfolio too fast. If you're destined to have to cut spending, it's better to do a small cut early on than to do it catastrophically later in life.

      Thanks for the kind words. I try.

    2. Using an after-tax income of 71k (shelter costs need to come out of this), a die-broke strategy @ last age 95, and 3% real return, withdrawals average 4.6% (range 4.2% - 5%, median 4.5%) in the first 20 years.

      I've noticed this may be a bit high, so we would need to consider withdrawals as an absolute maximum, and be prepared to be flexible (cut spending, earn income, etc.) if the plan ever starts to look shakey. Or lower the annual spend, or work a year or two longer.

      I guess it's obvious I've thought about this quite a bit. This is good catharsis!

    3. I assume your strategy is essentially an annuity calculation based on the remaining years to 95 with a possible minimum 15 with the amount of money you have at the time of recaliberation of the monthly spending amount and a CPI + 3% as a return. My problem is that over the years my portfolio has become so messy (all mutual funds; CAD & US too, for having lived there for a while) and probably expensive. I have to sort this out but am afraid to start while life goes by.

    4. @Sumar: I'm sorry for the very long delay in posting your thoughtful comment and replying. For some reason Google flagged it as spam, and I just rescued it.

      Your assumption is essentially correct, except that the CPI + 3% return doesn't apply to savings in the HISA. I adjust the spending level periodically based on how actual market returns have affected portfolio value.

      Your problem of a messy portfolio of expensive products is all to common. It took me a long time, but my portfolio now consists entirely of a cash buffer and 4 index ETFs.

  11. A great post once again. Well done. It makes a lot of sense to have x years of living expenses in fixed income to smooth out income and provide protection against poor stock returns, where x changes depending on your risk tolerance.

    Another way to look at asset allocation in retirement would be to think about your fixed costs (e.g. food, clothing, shelter) separately from discretionary spending (e.g eating out, travel), where the asset allocation for fixed costs is safer than an asset allocation for discretionary spending. Have you considered this approach?


    1. @Blitzer68: I haven't considered your approach of splitting expenses into fixed costs and discretionary spending in any detail. I was thinking it might make sense to buy an annutity to set a floor on income which I think is similar to what you're talking about. The problem right now is that interest rates are so low relative to inflation that annuities are quite expensive. Whether this will change much in the future I don't know.

  12. The following comment from S.P. seems to have disappeared. Perhaps the commenter deleted it. In any case, I'll answer.

    "I assume your strategy is essentially an annuity calculation based on the remaining years to 95 with a possible minimum 15 with the amount of money you have at the time of recaliberation of the monthly spending amount and a CPI + 3% as a return. My problem is that over the years my portfolio has become so messy (all mutual funds; CAD & US too, for having lived there for a while) and probably expensive. I have to sort this out but am afraid to start while life goes by."

    You're right that I'm doing an annuity calculation. It gets a little complicated by the fact that I'm only assuming that the stocks grow at inflation + 3% (the HISA grows at inflation + 0%). So the stocks will run out early and then the HISA will run out. I need to find the monthly payment that keeps payments constant for both phases.

    Sorting out your portfolio can be daunting. It makes sense to take your time and think things through. There is nothing wrong with choosing a desired portfolio mix and then taking your time getting there. I made a decision to change my own portfolio several years ago. I changed the worst parts of it first, and I'm not completely done changing it yet -- I still have one individual stock.

  13. I think purchasing an annuity can be a good idea, particularly later in life when one is looking put one's retirement funding on auto pilot. Deferring CPP payments until age 70 would be one way to do this, at least in part.

  14. Why not go 100% CDN, US & Int'l low beta, blue chip dividend growth stocks that increase their payouts regularly (and exceed inflation) and count your pension, OAS & CPP as the fixed income portion of your portfolio.

    1. @Bernie: Who's to say that the current crop of stocks that meet your criteria will continue to deliver in the future?

    2. There's no guarantee in any investment strategy but living solely off the distributions of solid companies that have long track records of increasing their payouts far beyond inflation is extremely safe in my view. Of course, this is a hands on style that requires periodic monitoring and adjustments should any companies freeze or trim their dividends.

  15. Hi Michael;

    I just don't see how the CRA will permit a 4% withdrawal rate unless someone has a lot of their funds in non-registered accounts. The CRA wants their taxes back and mandates the minimum withdrawal rates as of 71 years of wisdom. At 65, if you convert to a RIF, you will get the 4%

    So the 4% rule may be applicable to the USA (I do not know their tax laws) but the CRA has other ideas for us.


    1. @Richard: What I'm talking about in this post is trying to determine a safe spending rate in retirement. There isn't necessarily the same thing as the minimum forced withdrawal from a RRIF. I can certainly imagine a case where a retiree might determine that it is safe to spend $30,000 per year from his or her portfolio, but is forced to withdraw $40,000 from a RRIF. This just means that the retiree should save some of the RRIF withdrawal to spend in a future year. Just because CRA forces you to withdraw money from a RRIF doesn't make it safe to spend it all.

  16. I really enjoy your posts. Thanks! With regard to your choice of 5 years of cash reserve, I seem to remember a post (I think it was you), where you said that there had not been a period of more than 5 years and 6 months when the market had not regained it's previous high. I realize your approach here does not require previous highs to be reached in a particular time, but could you refer me to this particular post as I can't find it. I read many different numbers from 16 to 25 years in other articles for a full recovery, but don't know if they include reinvested dividends and are real or nominal numbers. Thanks.

    1. @Grant: The post you want is my review of Stocks for the Long Run (3rd paragraph):