Retirement Income Complexity Is Here to Stay

Increasing life expectancy, disappearing sources of guaranteed income, and historically low yields on bonds make for some tough fixed-income investing conditions; a disciplined approach can help.

A new white paper from Vanguard researchers provides a helpful framework for investors to consider as they look to turn an equity investment portfolio into a sustainable and consistent source of income.

“For many retirement-oriented investors, developing and overseeing a retirement spending strategy can be a complex undertaking, further complicated by increasing life expectancies, disappearing sources of guaranteed income, and historically low yields on bonds,” Vanguard explains in the paper, “From assets to income: A goals-based approach to retirement spending.”

The basic tenants of the framework go as follows: For retirees who hold the majority of their assets in tax-deferred accounts, assets can fairly easily be turned into income by setting up an automatic withdrawal plan from their current holdings or purchasing an investment that is specifically designed to provide regular distributions. For other retirees, where taxable assets are a meaningful portion of their portfolio, working with an adviser to develop a unique goals-based strategy can add significant value.

Under both approaches, Vanguard researchers advocate for tailoring spending to a retiree’s unique goals using a “dynamic spending” rule under which annual spending is allowed to fluctuate based on market performance, but “smoothed” by applying an annual ceiling and floor to the amount. It goes without saying that maintaining a broadly diversified retirement portfolio will be a key part of this approach, researchers posit.

The Vanguard researchers recommend building a balanced, diversified investment portfolio that focuses on total return rather than income. This portfolio, as far as possible, must then be ramped down via a tax-efficient withdrawal strategy.

“With many investors holding taxable, tax-deferred, and tax-free accounts, Vanguard researchers suggest a withdrawal order strategy designed to minimize taxes, as well as to potentially increase the spending amount and a portfolio’s longevity,” the paper explains. “The stakes in retirement are high, and the impact of suboptimal decisions can be severe, particularly taking into account the unknowns, such as market returns, life span, and health issues.”

“Vanguard’s framework can help investors negotiate the inevitable trade-offs between spending sustainability and stability,” adds Colleen Jaconetti, senior investment strategist at Vanguard and co-author of the paper.

NEXT: More detail on dynamic withdrawals 

According to Jaconetti, the Vanguard framework is built around the idea that regardless of the means—a product offering an automated distribution feature or a goals based spending strategy developed with an adviser—the combination of complexity and consequences underscores the need for skillful guidance.

The first step down this road is “carefully mapping out sources of both income and expenses.”

“When accounting for income, retirees need to examine both the stability and the sustainability of each source,” Vanguard recommends. “For example, sources such as Social Security and pensions may be more stable and can reasonably be expected to persist throughout retirement, while others, such as income from trusts or part-time employment, may be less stable. In terms of expenses, the most important consideration is to separate discretionary spending (e.g., for travel and leisure) from nondiscretionary spending (e.g., for housing and food).”

Under this approach, the gap between a retiree’s income sources and expenses is understood to be the amount he or she needs to supplement from the investment portfolio, generally consisting of both taxable and tax-advantaged accounts.

“Obviously, if the amount needed from the portfolio is too high, the portfolio will be depleted regardless of the spending rule selected,” Vanguard notes. “That said, four primary levers affect how much a retiree can spend from his or her portfolio: the retiree’s time horizon or life expectancy; the portfolio’s asset allocation; the retiree’s annual spending flexibility; and the retiree’s degree of certainty that the portfolio won’t be depleted before the end of his or her time horizon.”

As expected, Vanguard finds the longer the retiree’s anticipated time horizon, the lower the initial spending rate. Conversely, the shorter the time horizon, the more spending the portfolio is likely to be able to sustain.

“For example, a 60-year-old investor with a 30-year time horizon can spend less than an 85-year-old investor with a 10-year horizon (as a percentage of the overall portfolio),” the white paper observes. “Similarly, the more conservative the asset allocation, the lower the expected return over the time horizon and, therefore, the lower the spending rate. On the other hand, the more aggressive the asset allocation, the higher the initial spending rate—with one caveat: As the equity percentage approaches 100%, the return volatility will likely increase, and over shorter time horizons may actually increase the chance of prematurely running out of money.”

NEXT: General guidance on withdrawals 

According to Vanguard, in general, the greater the proportion of expenses one can eliminate or minimize in any given year, the greater the level of spending flexibility.

“For example, if leisure and entertainment take up a large portion of each year’s expenses, a retiree may be better able to endure a reduction in his or her portfolio-based income,” Vanguard argues. “The higher the preferred degree of certainty, the lower the spending rate.”

As a general guideline, Vanguard defines a prudent initial withdrawal rate for retirees entering retirement as 3.5% to 5.5% of their portfolio balance, per year.

“Typically, the 3.5% would apply to more conservative portfolios, and the 4.5% to 5.5% to more moderate or aggressive portfolios,” Vanguard explains. “Clearly, these rules can be broadly applied, and each investor’s circumstances are unique, potentially allowing for more or less spending than this general guideline.”

For a retiree whose primary goal is spending stability, Vanguard recommends the “dollar plus inflation” rule, or “a dynamic spending rule with a 0% ceiling and 0% floor.”

“With this rule, upon retirement, a retiree selects the initial dollar amount he or she wants to spend from the portfolio and then increases that sum by the amount of inflation each year thereafter,” Vanguard concludes. “Although this rule allows for more stable spending from year to year than the other spending rules we discuss, it comes with the risk of either premature portfolio depletion or lifetime underconsumption. This is because the strategy is exposed to sequence of returns risk—that is, it is indifferent to the capital markets, given that the annual spending amount is automatically increased by inflation regardless of whether the portfolio’s market returns are positive or negative.”