May 6, 2021 | Vanguard Perspective
Guide clients on retiring in uncertain markets
Clients don't always have the luxury of choosing to retire as financial markets are rising. Yet, the timing of clients' transition out of the working world can have a tremendous impact on their retirement savings longevity.
As Vanguard research has shown, sequence-of-return risk—the threat to a successful retirement posed by a concentrated run of poor market performance—can be substantial, especially if it happens early in retirement. This risk can mean lower-than-hoped-for retirement income, early exhaustion of retirement savings principal, or both.
Fortunately, you and your clients can leverage much more than lucky timing to boost their chances of a financially comfortable retirement. Small adjustments to retirement spending, guided by actual market conditions, can go a long way toward boosting the probability of long-term retirement success (that is, spending that's sustainable for life, while affording the client a satisfactory lifestyle). This article examines the dynamic spending strategy for sustaining retirement savings and provides resources to deepen your and your clients' understanding of this important concept.
Spending in a market decline—the issues
Ideally, no one wants to enter retirement during a prolonged and significant market decline. After all, a market shock reduces a client portfolio's value, diminishing the amount that can safely be withdrawn. But it's not entirely bad news: By lowering the valuations of securities, the shock can also raise expected returns, potentially offsetting some of this decline. A decline in stock market valuations has tended to be associated with higher future returns.1
In a series of Vanguard Capital Markets Model® (VCMM) simulations, this rise in expected returns meant that the decline in sustainable spending was shallower than the decline in the portfolio's value. At the end of December 2019, VCMM projections suggested that a $1 million portfolio could sustain $45,000 in annual spending, adjusted for inflation (dollar plus inflation rule), for 30 years. In 10,000 simulations, the portfolio met this target 85% of the time. After the market shock, the $1 million portfolio fell to $800,000, a 20% decline. However, as expected returns rose, sustainable spending dropped by less than 10%, to $40,800.2
In simple terms, a comparatively small reduction—by percentage—in annual spending can preserve a portfolio after it's been hit by a much larger market shock.
Figure 1. Sustainable spending in times of crisis
Further, Figure 1, above, shows that substantially higher annual spending is possible through a flexible approach, calibrated yearly to market conditions (dynamic spending rule).
To help clients in adopting such an approach, it's first helpful to summarize three of the most common spending strategies (Figure 2):
- Dollar plus inflation—The retiree determines a set amount to spend and adds the cost of inflation annually.
- Dynamic spending—The retiree adjusts spending each year to adapt to market conditions. They set a ceiling and floor for how much to take from their portfolio (for instance, 5% greater than the previous year’s spending in exceptional market conditions or 1.5% less than the previous year in a poor market).
- Percentage of portfolio—The retiree determines a set percentage to spend each year, no matter the size of their portfolio.
Figure 2. Comparing spending rules
Of the three, dynamic spending offers an appealing combination of overall versatility, flexibility, and stability—allowing retirees to spend more in bull markets while having to cut back only slightly in down markets.
Dynamic spending also increases the probability of success throughout a wide range of market conditions and at different target spending levels, as demonstrated in the VCMM simulation (Figures 3 and 4). For instance, with a $40,000 spending target, the base case success rate—after a crisis reduced the portfolio to $800,000—was 97.8% using a dynamic spending strategy, versus 88.6% using the dollar plus inflation spending strategy (assuming a time horizon of 30 years after March 2020).
Figure 3. Probability of success in times of crisis with $50,000 spending target
Figure 4. Probability of success in times of crisis with $40,000 spending target
A reduction in annual spending (even a small reduction), can significantly boost the chances of a clients' retirement portfolios lasting the rest of their lifetimes. Further, a dynamic spending strategy provides retirees the flexibility to spend more in good market conditions while they only have to cut back a little when markets retreat.
Note that the calculations here exclude Social Security and other possible income, such as pensions, rental property, or supplemental employment after retirement. Such income streams can enhance the chances of individuals successfully maintaining their portfolio through the end of retirement.
As a financial advisor, you're uniquely situated to help clients understand sequence-of-return risk, and how implementing a dynamic spending strategy can mitigate that risk. You can also remind them that bearish markets are inevitable. While it's impossible to accurately predict when downturns will appear, with your help, clients can take steps ahead of time to minimize the long-term impact on their retirement.
Consult the resources below to explore this topic in greater depth.
For a deeper analysis of sequence-of-return risk and how to mitigate it for your clients, download the original Vanguard research:
1 Khang, Kevin I., Andrew S. Clarke, 2020. Safeguarding retirement in a bear market. Valley Forge, Pa., The Vanguard Group.
2 David Pakula, 2020. Guiding your clients through stormy weather: Sustainable withdrawal rates in times of crisis. Valley Forge, Pa., The Vanguard Group.
- IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
- The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
- The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
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