Academic research on retirement spending strategies usually focuses on what is optimal or sustainable.
The problem for financial advisors is that each client has specific needs, considerations and preferences, says Luke Delorme, research fellow with the Barrington, Mass.-based American Institute for Economic Research, in a recent Journal of Financial Planning study entitled “A Blueprint for Retirement Spending.”
His analysis specifically looked at systematic spending strategies – those that employ a predefined method of spending – while ignoring other factors that potentially could increase retirement income, such as liquidating a home, working longer or drastically changing asset allocation.
For retirees lacking significant pensions who want to engineer a structured spending strategy, Delorme suggests advisors take a two-pronged approach.
Would these clients prefer safe spending – whereby the portfolio has a minimal likelihood of running out during a predetermined period of time – or optimized spending, in which there may be a higher likelihood of exhausting the portfolio, but more latitude in available income year over year?
At the same time, do your clients wish to have a steady and constant income over the course of retirement, or are they comfortable with an income that fluctuates?
From there, Delorme groups retiree clients into four basic spending strategies:
– safe and constant. These retirees want to maximize a safe, constant dollar spending rate that will ensure the portfolio lasts for at least a certain length of time. This does not reflect the reality that the average retiree’s spending steadily declines as retirement progresses.
– optimal and constant. This group seeks optimal constant dollar spending so that they have the same spending amount every year, but also the ability to spend more from time to time based on mathematical probabilities.
– optimal and flexible. These retirees want optimal flexible spending that allows them to consume in proportion to survival probabilities, as opposed to withdrawing constant income automatically for life.
– safe and flexible. Retirees in this group want to maximize safe, flexible spending that allows for higher potential spending than constant dollar strategies do, with the caveat that spending may fall below what a safe constant dollar pattern might allow.
Looking at a 65-year-old married couple, for example, Delorme outlines a variety of potential results for each category.
The maximum safe spending rate for a 34-year planning horizon is 3.8% of retirement assets, rising to 4.6% for a shorter horizon of 25 years.
As the retirement age is delayed, starting at a higher level of initial spending is optimal. The optimal and constant spending percentage, therefore, increases from 5.4% at age 65 to 6% for those retiring at age 70.
The optimal and flexible strategy is an inflation-adjusted percentage starting at 5.6% at age 65, increasing to 6.6% at age 70.
Whatever the numbers say, Delorme believes, client preferences should drive the spending strategy. After these have been revealed, he says, there are systematic ways to adjust the spending amount based on the retirement horizon, amount of pension, return assumptions, equities exposure, bequest motive and expected asset-management fees.
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