Spending in retirement can be just as important as saving for retirement, especially in the current low-return environment. With that in mind, Vanguard, the giant mutual fund company with more than $3 trillion in assets, has developed a goals-based approach to retirement spending designed to turn an investment portfolio into a “sustainable and relatively consistent” source of income for retirees.

Traditionally, many retirees followed the 4% rule, withdrawing that percentage from their portfolio annually, but that approach has been losing currency lately given the relatively low yields that portfolios collect in the current market and probably for years to come. A 50/50 stock/bond portfolio as well as a portfolio comprised solely of bonds yield only 2% today, according to Vanguard.

(Related: Finke: Keys to Retirement Planning in a Low-Yield World)

Investors can try to make up the difference, reaching for yield by either lowering the credit quality or increasing the duration of their bond portfolio, which increases its credit or interest rate risk, respectively, or they can add more dividend-paying stocks to the portfolio, which can reduce diversification. In either case, they still may not earn enough in their portfolio to justify a 4% withdrawal rate.

A better strategy, said Vanguard, is to adopt a “goals-based approach to retirement spending.” This approach “can help investors negotiate the inevitable trade-offs between spending sustainability and stability,” said Colleen Jaconetti, a senior investment strategist at Vanguard, in a statement.

Jaconetti is a co-author of a report, “From Assets to Income: A Goals-Based Approach to Retirement Spending.”

“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,” said Jaconetti.

The approach has three primary components:

  1. A prudent spending rule that tailors spending to a retiree’s unique goals. It uses a “dynamic spending” rule that allows annual spending to fluctuate, based on market performance, but “smooths” the variability by applying a ceiling and floor to the amount. 
  2. A broadly diversified retirement portfolio that focuses on total return rather than income.
  3. Tax-efficient withdrawal strategies designed to minimize taxes and potentially increase spending amounts and  portfolio longevity.

Each component is complex and comes with tradeoffs, according to Vanguard, which suggests using a knowledgeable financial advisor.

The strategy incorporates two basic approaches to withdrawals in retirement: an income (spending) target, which increases annually, adjusted for inflation, and a portfolio percentage target, which varies based on the performance of the capital markets.

Withdrawals are kept within a range between a maximum percentage increase (the ceiling) and minimum percentage decrease (floor). Investors should not withdraw more than the maximum or less than the minimum.

In a strong market, where portfolio gains exceed the ceiling set, an investor would leave the excess gains in the portfolio, providing a cushion for those times when the market suffers losses. In a weak market, the investors would at minimum withdraw the amount of the floor, which could be higher than the percentage set originally.

“The strategy is a buffer, limiting the upside and downside in spending,” said Jaconetti. “The key is what you set for the floor and ceiling. More flexibility on the floor leaves more money in the portfolio.” In its recent paper Vanguard set the ceiling at 5% and floors at -2.5%. An example of how it works is included report’s appendix.

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