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Traditional methods of man­aging clients’ retirement income needs can fall short. There’s a better way—an adaptable approach that combines such methods with spending limits so withdrawals remain between a ceiling and a floor.

Advisors have typically chosen one of two budgeting techniques. The first method, called “percentage of portfolio,” is for clients to spend part of their portfolios (typically 4%) every year. The second, known as “dollar amount grown by inflation,” is to choose sums that support clients’ lifestyles, and increase that amount annually by the inflation rate. However, each has drawbacks. The “percentage of portfolio” strategy can force painful austerity during times of market turmoil, and, if clients follow the “dollar amount grown by inflation” process, there’s a greater chance they’ll run out of money later in life.

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To address these pitfalls, investors should consider applying a minimum and a maximum to percentage-based withdrawals. In essence, this strategy is a hybrid. Called “percentage of portfolio with ceiling and floor,” our analysis shows it can result in higher retirement income while helping ensure the portfolio lasts as long as expected. It can also help your clients maintain income for basic expenses while allowing them more discretionary income if market returns are favourable. It’s a three-step process:

  1. Calculate spending based on a set portfolio percentage (e.g., 4%).
  2. Adjust the prior year’s spending for inflation.
  3. Apply the ceiling and floor test to determine an appropriate withdrawal rate.
    The ceiling and floor test

The ceiling and floor test

The advisor calculates a ceiling and a floor by applying chosen percentages (such as a 5% ceiling and a 2.5% floor) to the prior year’s real spending. Then she compares the two results. If the newly calculated spending exceeds the ceiling, the client limits spending to the ceiling; if the calculated spending is below the floor, the client can increase spending to the floor amount.

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You can adjust the percentages as you see fit, but keep in mind the narrower the spread between them, the more similar this strategy is to the dollar amount grown by inflation strategy, and the more likely that the portfolio could reach a crisis point at some time in the future.

The wider the difference between the ceiling and floor percentages, the more similar this strategy is to the percentage of portfolio strategy. That is because calculated spending reaches the ceiling or floor infrequently, leaving the withdrawal percentage as the primary factor in annual spending fluctuations.

Although spending will vary annually based on the markets, it shouldn’t exceed the range so long as assets remain in the portfolio. This certainty can assist with short-term financial planning. The strategy allows investors to benefit from good markets by spending a portion of the gains. During bad markets, they’ll have cash available while their withdrawals decrease to preserve their portfolios.

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Flexibility is the most prudent spending strategy in retirement. No formula should be applied without taking into account significant events in the markets or clients’ lives. So, periodically evaluate clients’ income strategies, assess their portfolios and consider clients’ life situations before deciding whether alterations are needed. If clients can tolerate some short-term fluctuations in spending, they’re more likely to achieve long-term goals.

COMPARE THREE SPENDING STRATEGIES

Strategy Method Key characteristics
Percentage of portfolio Withdraw a specific percentage of the portfolio each year.
  • Highly responsive to market performance
  • Spending may fluctuate significantly in the short term
  • The portfolio is never depleted; however, long-term spending levels depend on market performance and investment strategy
Dollar amount grown by inflation Calculate a dollar amount in the first year; adjust it for inflation yearly.
  • Ignores market performance
  • Provides short-term spending stability
  • Long-term effect on the portfolio can be unpredictable
Percentage of portfolio with ceiling and floor Percentage of portfolio with ceiling and floor
  • Somewhat responsive to market performance
  • Spending may fluctuate in the short term but is held within limits
  • If the markets decline significantly, the portfolio’s principal could fall far enough to require reductions in future spending beyond the floor

Source: Vanguard

By Atul Tiwari, managing director, Vanguard Investments Canada.

Originally published in Advisor's Edge Report

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