There is a lot of debate, particularly in the FIRE community (financial independence, retire early), about what the best, sustainable draw down strategy is when it comes to living off your investments. Like most things in finance, there appears to be no ‘one-size-fits-all’ approach that suits every investor, especially considering the everchanging market conditions. However, Vanguard have done some research and believe they have a fix!
Vanguard have created the ‘Dynamic Spending Strategy’ which is a total return approach to wealth drawdown. The level of income is adjusted annually based on investment performance, making it dynamic to investment volatility. Before we jump into the details of this strategy, let’s quickly touch on some of the more traditional strategies that have been adopted to date.
The income-oriented approach
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 because you “eat” what you earn and leave the capital to produce more future income. However, there are a couple of issues.
By focusing all your investments on income generating assets, you are pigeonholing your investment strategy, potentially missing out on great investment opportunities. Take international shares for example. International equities typically produce very little income (in comparison to Australian equities) but have excellent growth potential. Also, dividends can be correlated to interest rates. In times where interest rates are low, and many big companies slash dividends (like the banks), your income can drop substantially, along with the yield you generate on your defensive assets. 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 – the strategy doesn’t care where the return comes from! This opens a wide array of investments which have the potential to meet your target.
The total-return approach
Under the total-return approach, 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 returns 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.
We could spend hours on each of these rules, arguing the pros and cons about each one in detail, however let’s turn our attention to the Dynamic Spending Strategy. A hybrid approach to income drawdown.
The Dynamic Spending Strategy
The dynamic spending strategy is a total-return approach to investing (as opposed to the income-orientated approach). It is essentially a hybrid between the dollar plus inflation rule and the percentage of portfolio rule.
By taking a hybrid of both approaches, the Dynamic Spending Strategy attempts to keep fund drawings stable while also protecting your portfolio in negative periods. This offers both predictable income while reducing sequencing risk.
How it works
Under this strategy, you first determine what you believe the sustainable spending rate is for your portfolio. This is the drawdown rate which 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, revert 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 (the ‘floor’) and a maximum drawdown (the ‘ceiling’).
The strategy 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%. Given these parameters, each year you calculate your drawdown based on your sustainable spending rate and limit it to the floor and ceiling. Let me give you an example.
Example of the Dynamic Spending Strategy
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.
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.
The result of this strategy is 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.
If you would like to learn more about the Dynamic Spending Strategy, please refer to Vanguard’s article From assets to income: A goals based approach to retirement spending.
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.
