There is a lot of debate, particularly in the FIRE (financial independence, retire early) community, about what the best, sustainable draw down strategy is when it comes to living off your investments. There are a number of strategies out there but, like most things in finance, there appears to be no ‘one-size-fits-all’ approach that suits all investors during all market conditions. However, Vanguard have done some research and believe they have a fix.
Vanguard has introduced what they call the dynamic spending strategy which is a total return approach to wealth drawdown, adjusting your level of income annually based on investment performance. Before we jump into the details of this fancy new strategy, let’s quickly touch on some of the more traditional strategies that have been adopted to date.
The first, and probably the most obvious strategy, is the income-orientated strategy where you simply live off the passive income generated by your investments. This makes a lot of sense right because you eat what you earn and leave the capital to produce more delicious treats. However, there are a couple of issues.
By focusing all your investments on income generating assets you are missing out on some great asset classes, such as international stocks, which produce very little income (in comparison to Australian equities) but have excellent growth potential. Also, in times like we are experiencing now, with interest rates at record lows and many big companies slashing dividends (like the banks), your income can drop substantially. Suddenly you might not be generating enough cash to meet your basic living costs.
This is where the total-return approach comes in. Instead of focusing solely on income producing assets, the total-return approach focuses for on income and capital growth – they don’t really care where the return comes from! This opens a wide array of investments which have the potential to meet your target.
Under the total-return approach many investors determine their drawdown one of two ways; the “dollar plus inflation” rule or the “percentage of portfolio” rule.
Under the dollar plus inflation rule you determine a specific drawdown of your portfolio from the start and increase that amount by inflation every year to ensure your standard of living remains the same. The very common and very well-researched 4% rule is an example of this method.
The great feature of the dollar plus inflation rule is that you have certainty of drawings each year. You will always draw-down what you did last year plus inflation so your spending habits can remain the same. However, this certainty comes at a cost to your portfolio. The dollar plus inflation rule completely ignores investment return and will continue to draw down capital in a bear market.
Under the percentage of portfolio rule your drawdown amount is recalculated as a percentage of your portfolio every single year. Therefore, if your portfolio is up for the year, your drawings will go up, if your portfolio is down, your drawings will go down. This is highly responsive to market changes and will be better for your portfolio in a bear market but doesn’t give you much security around your ability to fund living costs.
Now I could spend hours on each of these rules and argue the pros and cons about each one in detail BUT that is not the primary topic of today. Today we want to consider Vanguard’s new approach under the dynamic spending strategy.
The dynamic spending strategy is a total-return approach to investing, as opposed to income focused, which is great as we open ourselves up to a broader universe of assets. Where it varies from the other total return approaches is in the drawdown of your funds.
This strategy is essentially a hybrid between the dollar plus inflation rule and the percentage of portfolio rule, trying to get the best of both worlds. It attempts to keep fund drawings stable, to assist with cash flow management, while protecting your portfolio in negative periods.
Under this strategy you first determine what you believe a sustainable spending rate is for your portfolio. This is basically the drawdown rate which you think can be supported in perpetuity and will vary from portfolio to portfolio depending on the risk you take. If you aren’t able to deduce a number for yourself then go back to the old 4% rule.
Every year you then adjust your annual withdrawal limit within a bandwidth. The bandwidth is determined by setting a minimum drawdown known as the floor and a maximum drawdown known as the ceiling.
The research suggests that the ceiling is capped at your previous year’s income plus 5%. The floor is capped at the previous year’s income less 2.5%. So each year you calculate your drawdown based on your sustainable spending rate and limit it to the floor and ceiling each year. Let me give you an example.
The diagram below summarises how the dynamic spending strategy would be applied to a $1 million dollar portfolio with a sustainable spending rate of 4%, a ceiling of 5% and a floor of 2.5%. This scenario assumes investment returns are 10% in year 1 and 5% in year’s 2 and 3.
So as you can see, you make three calculations each year – the ceiling, the floor and the amount based on a sustainable spending rate. The sustainable spending rate is your default drawdown unless it exceeds the floor or ceiling.
As a result of this strategy you get stability of income, as the withdrawal amount doesn’t fluctuate too much year-to-year, but also capital protection in a down market.
Considering a safe drawdown level is very important for anyone who is living off their investments. We are all living longer and therefore the chance of outliving our capital is increasing.
While I do see the merits of running the dynamic spending strategy, probably more so than the other strategies, I don’t think the demands of life can be met with a set formula. This is something you are going to need to review every year, taking into consider your unique goals, portfolio returns, income demands, health and wealth.
Whatever strategy you decide to run with (if any) just keep this thought in mind – when markets are good your portfolio will look after you, when markets are bad you need to do your bit to look after your portfolio.