On Retirement Income, Part 10: Flexible Spending, Can You DIG It!

“On Retirement Income” series:

Sometime back in the Dark Ages, when this article series began, our long-suffering fictional clients Bob and Fred first explored the investment advice of two fake firms, Rule of Thumb Investment Advisors (ROT IA) and Supremely Consistent Asset Management [acronym redacted]. The two advisors recommended rules drawn from opposite points on the same spectrum: the “4% Rule” and the “Fixed Percentage Rule.”

As illustrated and explained in detail, those methodologies result in stock/bond risk expressing itself very differently, but neither methodology can eliminate the reality that risk asset are risky and that the riskiness extends to someone’s income. Graphically, these opposite expressions of the same fundamental risk look like the charts on the left and right of the image below, and they lead naturally to two questions:

Is there a middle way? Can we reduce risk of income collapse (or runaway gains) of the 4% Rule while also reducing the income volatility of the Fixed Percentage Rule?
Or perhaps a completely different way? What are some tools to generate income that is not derived from a risk asset portfolio at all?

Is there a middle way for producing retirement income? Or perhaps a completely different way?

After a quick detour to discuss how goals-based investing (the approach we favor at Round Table) starts by determining the goals to target, we spent four articles explaining how to generate or optimize income using tools like Social Security claiming, annuities, pensions, and Treasury Inflation-Protected Securities.

Now, at last, we turn our attention back to the traditional stock/bond portfolio, and we move up to the question about a “middle way” to generate income therefrom.

Flexible Spending Rules[1]

When we split Bob and Fred’s annual budget into flexible and inflexible spending targets, we wanted to meet the inflexible spending goals with income sources designed to ensure an uninterrupted stream of cash flow. (Preferably inflation-protected and preferably longevity-hedged, though the combination of the two is hard to come by outside of Social Security.)

An advantage to flexible budgetary spending—i.e., annual budget line items that can be adjusted up and down as needed—is that we can take advantage of the available flexibility by investing the dollars designated to cover the target spending in assets whose riskiness is compensated by an expected return premium.

The ability to be flexible is important. At Round Table, we are not going to pretend (à la the 4% Rule) that safe income can be pulled from risky investments. But we do believe that the growth potential of a stock/bond portfolio can generate more lifetime income on average—with potential for significant legacy asset value—than can tools designed solely for income safety. That’s can, not will. The return in high-risk/high-return is real, but so too is the risk. And we believe some flexibility in the cash flow taken from a portfolio is required both to reduce the risk of ruin and to take advantage of market gains in the good times.

We call our model for doing so…

Dynamic Income & Growth (Can you DIG it?!)

Unlike “IPI” (“Inflation-Protected Income”), at least the silly acronym for Round Table’s stock/bond income model spells an actual word! Not an obviously meaningful word, but whatever… The DIG model is Layer 3 of Round Table’s Layer Cake system.

There are many possible flexible spending rules. Retirement researcher Wade Pfau has explained and analyzed an impressive list of them. The method we employ at Round Table is a variant of a “guardrails” system, which in our view is about the middlest of the “middle ways” Bob and Fred are seeking.

Our methodology derives from a strategy originally developed by researchers Jonathan Guyton and William Klinger, though we have made many modifications. We explain the basic idea to Bob and Fred in the following four steps:

Invest portfolio assets in a stock/bond combination.
When starting retirement income, pick a percentage of the portfolio to draw in year 1.
Each subsequent year, if portfolio value has increased OR if the prior year’s withdrawal amount is below the current year’s target percentage, adjust the prior year’s withdrawal amount by the prior year’s inflation rate.
Apply “guardrails”: If the income stemming from Step 2 is too high a percentage of the portfolio, reduce the income amount, taking a “pay cut” to protect the portfolio. If the income is too low a percentage, take a “pay increase” to reap the benefits of the investment growth.

Every element of this four-step process is parameterizable and can be individually tailored. (What is the “target” percentage. Should it increase as you age? How much is “too much”? How large a “pay raise/cut”? Etc.) We do have standard settings for each, though, and when Bob and Fred’s eyes glazed over before we got to “-izable,” it was clear we should start there.[2]

DIGging into the Details

If you hold a “total return” risk asset (i.e., stocks and bonds) portfolio for part of your retirement income, you cannot eliminate the riskiness. But as the chart above illustrates, how the risk manifests will depend on how you take cash flow from the portfolio. The primary goal of the DIG model’s withdrawal rules is to strike a balance between the “cliff risk” of the 4% Rule and the annual income volatility of the Fixed Percentage Rule.

Of Bob’s $1,000,000 in available assets, $173,000 has been allocated to a TIPS ladder and a deferred income annuity to cover “inflexible” spending not already covered by Social Security. When Bob filled out his retirement budget in Part 5 of this series, his annual “flexible” spending goal came to $21,300.

Bob's inflexible and flexible annual spending goals. — Bob’s inflexible and flexible annual spending goals.

Using a 4% initial withdrawal rate (our “standard” at age 65, but not a necessity…we’ll talk more about this in the next article), we model a 60/40 DIG portfolio with $532,500 of Bob’s remaining $827,000 in assets.

We have several different charts to illustrate the potential outcomes. One shows the range of total real (i.e., inflation-adjusted) income over time, including Social Security and Bob’s TIPS/DIA solution:

Bob Real Income Range — **Source: Round Table calculations**

The green/blue/red lines on that chart represent modeled incomes at the 75^th/50^th/10^th percentiles in a Monte Carlo simulation of potential futures, using the modeled DIG rules. By design, Layers 1 and 2 of the Layer Cake are immune to market fluctuations, so the divergence in the “good”/“normal”/“bad” outcomes thus illustrated are driven entirely by the guardrails in the DIG model.

As indicated by the blue line, Round Table’s default parameters are designed to keep the annual withdrawal approximately steady in real dollar (i.e., inflation-adjusted) terms in a “normal” market backdrop. Importantly, this means total income is rising in nominal dollar terms (i.e., the actual dollar figures Bob will spend each year):

Bob Nominal Income Range — **Source: Round Table calculations**

To see how the different layers each contribute to overall income, we can show, for example, this breakout of the median (blue) line in the real income chart above:

Bob median real income — **Source: Round Table calculations**

An important caveat to these charts is that the smooth evolution of, in this example, the 50^th percentile for each year, masks the reality that a real-world DIG model will almost inevitably hit a guardrail and propose a jump in income, up and down, every so often. A “real world” median-ish[3] income path might look something like this…

Bob sample median real income 1 — **Source: Round Table calculations**

…or this…

Bob sample median real income 2 — **Source: Round Table calculations**

…or this…

Bob sample median real income 3 — **Source: Round Table calculations**

…or endless other possible patterns.

Nonetheless, the typical year-to-year volatility of the DIG model is significantly less than what you get with the Fixed Percentage Rule. And in the majority of years, DIG model income is the same (either nominal or real) as it was the year before.

Keen-eyed Bob notices that the orange bar in year 40 (when Bob would be 105 years old!) in the second example is entirely missing. This illustrates that while the DIG model is designed to significantly reduce the risk of total portfolio depletion relative to the 4% Rule, it does not eliminate that risk entirely. We can tweak model parameters to balance between the risk of overly conservative cash flow and the risk of portfolio collapse, but our standard model generates something like a 10% chance of running out of money at about 103-105 years old—a distinctly conservative model outcome.[4]

DIG Portfolio Values

Relatedly, whereas “IPI model” TIPS ladder assets are, by design, consumed to $0 on a fixed schedule, “DIG model” stock/bond portfolio asset levels are more volatile—a volatility driven by the riskiness of the underlying investments, dampened by the reactive flexibility of the DIG model distribution rules.

Here are some good/normal/bad-market curves for the portfolio value of just these DIG model assets, starting one year from today:

Bob DIG real and nominal portfolio range — **Source: Round Table calculations**

Again, actual experience will involve more volatility than the percentile-per-year charts would indicate. Here’s one illustrative example pulled from an infinite universe of possible futures:

Bob sample median DIG portfolio over time — **Source: Round Table calculations**

Notably, our standard DIG approach is designed to be reasonably income efficient, which implies that the real-dollar value of the portfolio should be expected to decline over time, though not typically to $0. In other words, if an income-producing portfolio performs well, we want our clients to enjoy additional income more than we want them to die with a bigger income-producing portfolio. However, we can set DIG model parameters to emphasize the “G” (growth) a little more and the “I” (income) a little less, and there are circumstances under which we might choose to do so.

But lest this feature look too much like a bug, we can’t resist jumping ahead to Layer 4, showing Bob what his total portfolio asset evolution—real and nominal—might look like in good/normal/bad long-run markets, if we build an “unencumbered growth” portfolio using dollars not allocated to more specific goals:[5]

Bob all portfolios real and nominal range — **Source: Round Table calculations**

Again, year 40 is 105 years old, but if, for example, Bob and Barbi have both passed away in year 30—age 95 for Bob and/or 96 for Barbi—they could be passing on nearly $4 million (perhaps $1.5 million+ in today’s buying power) to their kids!

A side question to ponder: This looks impressive, but is it really a good outcome for a retiree to pass away with more than they had initially? The answer will be highly personal. For some, leaving a solid legacy is an important goal. For others, the idea of “self-insuring” (technically not insuring at all, just setting aside for) potential long-term care (LTC) expenses is important. In either of those cases—which in our experience collectively describe most clients—this type of “LTC if needed, legacy otherwise” growth portfolio can be quite attractive. But for those with little or no legacy motive (i.e., no heirs and/or minimal desire to leave money behind), a better plan may be finding a way to insure against LTC risk, so that more money can be spent on desired purchases and experiences,[6] with retirees aiming to (approximately!) “die with zero.”[7] But this concept takes us very far outside the scope of this article!

More DIGging when We Resume

Meanwhile, with Layers 1-3 of Bob’s Layer Cake, we’ve now satisfied both his inflexible and his flexible annual budgetary targets, with $304,500 of investable assets still available to allocate towards other goals (Layer 4).

For Fred, however, things are a bit trickier. Tricky enough that the solution to cover Fred’s flexible expenses will have to wait until the next article. You, however, need not wait until the next article to find out how Round Table can target your flexible and inflexible spending needs in retirement. Contact us here!

[1] Not to be confused with Flexible Spending Accounts, which are tools to fund annual medical expenses with tax-free dollars. The field of personal finance has so much jargon, even two-word phrases get recycled!

[2] Fictional account based on real-life events.

[3] Once we start looking at “real-world” volatile income streams, the meaning of “median” becomes a bit complicated. Median on one particular year? Median averaged across all 40 modeled years? Across some subset of modeled years? The specific method employed to generate the charts shown here is to grab a sample path that produces an average real income over the full 40-years that closely matches the median of all such 40-year averages. (Ain’t that a mouthful!) Each time simulation is run, the year-by-year income on the specific Monte Carlo trial that meets this criterion changes significantly.

[4] Even keener-eyed readers may have noticed that the graph in question was a 50^th percentile sample chart, not a 10^th percentile sample. This again is where statistical sampling can get quite complex. For example, a chart with ~50^th percentile average 40-year real income can still have 10^th percentile or worse year-40 real income. This is a good example of why we find it so helpful to show multiple simulations at each of the chosen percentile levels.

[5] More to come on what this all means!

[6] To use a powerful phrase from retirement researcher and American College of Financial Services professor Michael Finke, dying with that much money may mean “leaving joy on the table” in copious quantities.

[7] A funnier—if less ethical—version of this phrase is, “Have the last check bounce on your way out.”

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