Vanguard Tests Approach to Decumulation: The ‘Dynamic Spending Rule’

In a new report, “Guiding Your Clients Through Stormy Weather: Sustainable Withdrawal Rates in Times of Crisis,” Vanguard explores options retirees have at their disposal to preserve their savings and make their money last when there are sharp market downturns. Vanguard said it decided to conduct the research and issue the report after the coronavirus caused U.S. equity markets to tumble 35% in just 33 days between mid-February and mid-March.

Vanguard says the amount an investor can safely withdraw from a portfolio depends on the size of their portfolio and its expected returns. While a market shock reduces a portfolio’s value, Vanguard says, securities with values that have been lowered are inevitably going to rebound, potentially offsetting some of the decline. “A decline in stock market valuations has tended to be associated with higher future returns,” Vanguard says in the report.

“Vanguard models this dynamic in the Vanguard Capital Markets Model (VCMM), a proprietary forecasting tool that provides investors with a range of possible future expected returns for a wide range of asset classes,” Vanguard continues. “In December 2019, the VCMM projected a range of 30-year returns for U.S. equities with a median projection of 6.1%. In March, following the market shock, the VCMM projected a higher range of future returns, with a median forecast of 8.3%. … In the VCMM simulations, the 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. 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.”

Vanguard has come up with a dynamic spending rule that balances the objectives of two popular theories about how to drawn down an account in retirement. The first is the “dollar plus inflation” rule, whereby person sets a dollar amount they want to live on each year and increases it along with inflation as time goes by. Another strategy is the “percentage of portfolio” rule, whereby people spend a fixed percentage of their account. However, if the portfolio declines by 30%, spending must also decline by this much.

To implement the dynamic spending rule, a retiree would calculate each year’s spending by setting a collar—say, a 5% ceiling and a negative 1.5% floor—that gets applied to the ending balance of the portfolio the previous year. If the new spending amount exceeds the ceiling, then spending will be limited to the ceiling amount. If it falls below the floor, spending will be maintained at the floor amount. Vanguard says this makes spending relatively consistent while taking financial market performance into account to help preserve the remaining portfolio.

Vanguard applied this principle to a $1 million portfolio prior to the crisis and found that annual spending would range between $45,000 and $52,000. Applying several scenarios to the portfolio post-crisis, spending would range between $39,200 and $47,200. “After the shock, spending declines, but it remains consistently higher for dynamic spending,” Vanguard says. “By trimming spending when returns are poor, dynamic spending preserves more of the portfolio to compound when returns are strong.”

In conclusion, Vanguard says, “Market shocks are unsettling, but their impact on retirement spending can be managed. On average, a decline in market valuations has been associated with a rise in expected returns. A dynamic spending strategy can position a portfolio to benefit from these potentially higher returns and protect a portfolio’s long-term spending power.”