Does a “Percentage of Remaining Portfolio” Retirement Withdrawal Strategy Work?

Even after writing my last ebook “How Much Money Do I Really Need to Retire & Achieve Financial Independence?” which talks a lot about retirement withdrawal strategies, I still like to actively comb through the Internet and see what sorts of other ideas are out there.

One of the least talked techniques that I’ve come across (but I see them mentioned in forums like the EarlyRetirement.org) is one where you simply take out a “Percentage of the Remaining Portfolio“.

Note that this is drastically different from the traditional 4 Percent Rule that most people follow.  With the 4 Percent Rule, you take out 4 percent of the “initial” portfolio balance, not the remaining portfolio balance each year.

What’s got me thinking about this lesser known safe withdrawal strategy?

It’s because of this paper I read by Vanguard that was published back in October 2013 entitled “A more dynamic approach to spending for investors in retirement“.  In it, the authors attempt to present a case for a retirement strategy that they believe is better than the others.

However, after reading it, I came to a different conclusion ….

Could there be some merit to a Percentage of Remaining Balance retirement withdrawal strategy?

Let’s find out and see if you agree with me!

The Vanguard Paper

The Premise:

The Vanguard paper presents a variation of yet another type of retirement withdrawal strategy called the “Floor & Ceiling” strategy.  (Ironically, throughout the paper, they call this the “Ceiling and Floor” strategy; probably to side-step any copyright laws.)

The Floor & Ceiling strategy is something that was first introduced by Mr Bill Bengen in 2001.  Yes, the same Bill Bengen who came up with the 4 Percent Rule.

Due to criticisms about the flexibility of the 4 Percent Rule, Bengen later suggested this new dynamic approach called the Floor & Ceiling approach where retirees would place reasonable upper and lower boundaries on how much they could take out each year (hence, the ceiling and floor).   This allowed them to enjoy more money during the good times and scale back withdrawals during tough times so that there was extra safety and security.

The Vanguard paper suggests a very similar approach but with a few changes.

The Challengers:

To make their case, the Vanguard paper compares 3 types of methods for making retirement withdrawals:

1. The traditional Bengen / Trinity Study “4 Percent Rule” strategy (termed here “Dollar amount grown by inflation” in this paper).  Just like the regular 4 Percent Rule, this strategy starts off with the retiree making an initial 4 percent withdrawal from their portfolio and then continuing to make the same inflation adjusted amount every year thereafter.
2. The “Percentage of portfolio” strategy. (This is the one that caught my attention, and we’ll talk more about in a minute.)  Again, with this one, you withdraw a fixed percentage of your remaining portfolio balance every year instead of a fixed amount.  To keep all things the same, the authors again use 4 percent for their annual withdrawal.
3. The Ceiling and Floor strategy. This one works just like Bengen’s strategy accept for two things: The floor and ceiling amounts are different (5 percent ceiling and a 2.5% floor) and decisions are based on the previous year’s real (i.e. inflation adjusted) spending amount (Bengen’s was based on the initial amount).

The Criteria:

The paper then goes on to quantify and evaluate each strategy based on:

• How responsive they are to the market
• The degree of spending fluctuation
• The survival rate of the portfolio

Conclusions:

As you can guess, the paper seems to suggest that their version of the Ceiling and Floor is the best compromise of each of these criteria.

In all areas, its pretty much straight down the middle.  It’s responsive to the market without being overly reactive, spending fluctuation is minimal, and the portfolio survives longer than it would with the traditional 4 Percent rule.

However, let me point out a few observations I made …

My Observations

When it comes to retirement, there are a few BIG priorities:

1. To provide a reliable amount of income (since we are no longer working).
2. My portfolio must never deplete.
3. If possible, I’d like to leave behind some wealth for my heirs.

In the grand scheme of things, I think priority 3 is arguably the least important for most people. But priorities 1 and 2 can be neck-and-neck with each other in terms of importance.

So for a brief minute, let’s skip over priority 1 and focus on priority 2.

Portfolio Survival:

When I look at the data presented in the Vanguard paper Figure 2, I see that portfolio survival rates stack up like this:

1. Dollar amount grown by inflation: Survives 78% of the time.
2. Floor and ceiling strategy: Survives 92% of the time.
3. Fixed percentage of portfolio: Survives 100% of the time!

(Technical note: In case you’re wondering why the traditional 4 percent rule method only survived 78% of the time when the Trinity Study says it works 95% of the time, I should point out that Vanguard conducted their study with quite a few differences from the usual 4 percent rule statistics: The asset allocation was different, the number of years was 35 instead of 30, and the simulations were done Monte Carlo style instead of using actual past market data.)

Wait a second … why does “fixed percentage of portfolio” work all the time?

Think of it this way: If you have a pie and you’re always cutting a fraction of that pie, then it can never truly go away.  Your slices will get smaller and smaller, and so will the pie.  But by definition, it can never be completely gone.

Lowering Withdrawals in Bad Market Times:

Fixed percentage of portfolio has got you covered here too.  Because you’re already tied into the value of the reminding portfolio, it automatically builds in the necessary adjustments that the floor and ceiling strategy seeks to do.  It just does it to a higher degree.

Wealth to Leave to Heirs:

If wanting to leave behind a nice chunk of change to your heirs is important to you, then (again) the “Fixed percentage of portfolio” method yields the greatest result.

According to the Vanguard paper, Figure 2, the median real (inflation-adjusted) ending asset balances is:

• Dollar amount grown by inflation: $1,068,600
• Floor and ceiling strategy: $1,153,700
• Fixed percentage of portfolio: $1,226,200 – the greatest amount!

Again, “Fixed percentage of portfolio” comes out on top.

But What About Providing a Reliable Stream of Income?

Okay, you got me.  This is the one place where things get “iffy” …

Often, in Excel, it’s easy to model a portfolio that compounds at some steady percentage year over year. Therefore, to withdraw only 4 percent from this magic portfolio means a constant steady stream of income that naturally grows over time.

But this is not the case … Portfolios don’t grow in this way due to market fluctuations. In reality, they go up and they go down. Therefore, if you rely on this strategy, then there is a very, very real certainty that in some years your income will be less than the previous years.

How often?

That’s the interesting part to me …

According to the Vanguard paper, using a “Fixed percentage of portfolio” strategy, 48% of the time you’d have income that is below the real spending amount you had initially set.

BUT using Vanguard’s suggested floor and ceiling strategy, you’d also experience real spending levels that are below your initial amount 45% of the time.

Hmmmm …. A 3% difference … is this very significant?

I think not; especially when I can also see in Figure 2 that the “median” spending for all three strategies is again the highest with the Percentage of Portfolio strategy.

Conclusions:

So, if I go back to my three main priorities and see that

1. I’ll never run out of money, and
2. I have the potential to leave more money to my heirs,

Then is it really worth the trouble to use the ceiling and floor strategy?  Can I stomach the fluctuations in annual spending?

You might ask yourself: Why not just simply increase the limits of the floor and ceiling to be more responsive?  The Vanguard authors actually did this and presented their results in Figure 3.  What’s very interesting, however, is that when you compare the conclusions to Figure 2 to a strategy where you use a generous 10% ceiling and 10% floor, the results are nearly the same as using a percentage of remaining portfolio balance!  Coincidence?

My Twist: 

Though I have not yet ran any simulations myself, I believe it may be reasonable to think that in a Percentage of Remaining portfolio scheme that the retiree doesn’t have to necessarily spend all the money they withdraw.  If there’s a surplus above what they would normally spend, then why couldn’t they defer some of that money into a safe emergency fund for later use during the poor market years?  That’s an experiment I’ll have to try another time.

Readers – What do you think about the Percentage of Remaining Balance strategy?  Is there any merit there, and are you more sold on one of the two other strategies?

Featured image courtesy of Flickr – sharyn morrow