Navigating Variable Income Strategies in Retirement
Retirement income planning involves careful consideration of how to fund your lifestyle and future goals. Variable income strategies provide a flexible approach to withdrawing from a retirement portfolio by adjusting the amount withdrawn based on various factors like market performance, life expectancy, and portfolio sustainability. Unlike reliable income strategies, where income is drawn from sources like social security, pensions, or annuities, variable strategies seek to adapt over time to create a balance between spending and optimizing portfolio longevity.
Nearly every retirement planner uses some variation of the strategies discussed here. However, there are many strategies out there, so I’ll just be focusing on the most commonly seen.
See Retirement Income Strategies – Gilbert Wealth for a high-level review of Reliable versus Variable.
On Assumptions
All retirement projections are based on assumptions and which assumptions are used will heavily dictate which strategies shine and which fail. It’s important to be comfortable with your retirement assumptions as you’ll be working with your chosen strategies for the rest of your retirement. All of these strategies have been developed on either historic returns or estimated future returns.
See Understanding the Types of Retirement Projections – Gilbert Wealth
Components of Variable Income Strategies
Variable Income Strategies across the board have three main components to them:
- How the Initial Income is Set
- If the Income Maintains Spending Power
- If the Income is Adjusted for Performance
How the Initial Income Is Set
The beginning of any variable income strategy is the method by which the initial income is determined. Setting the initial income level is critical, as it establishes a baseline from which future adjustments will be made. There are several approaches to setting this starting point:
- Percentage-Based Withdrawal: A common method is using a percentage of the portfolio each year. This method seeks to determine how much you could spend. For example, the 4% Rule states that your initial income is 4% of your Starting Portfolio Value. The initial percentage depends on the strategy tradeoffs and the assumptions used.
- What is the Right Rate? The 4% rule was developed in the 1990’s using historic returns up to that point. Arguments have been made that the 4% Rule should be lower, and arguments have been made that it should be higher. Arguments for lowering the number typically focus on the original rule, lower estimated future returns, and longer life expectancies. Arguments for increasing the rate generally have variations to the original rule as discussed below.
- Choosing a Lower Rate: In general, choosing a lower rate will create a more predictable lifetime income as fewer adjustments may be necessary. However, you may be underspending in your retirement.
- Choosing a Higher Rate: Choosing a higher rate means you’ll be spending more up front but have a higher likelihood of spending adjustments in the future or having a lower legacy.
- Life Expectancy: Some strategies calculate initial income based on life expectancy and expected future spending needs. Actuarial tables, Present Value calculations, and Payment Functions all live in this bucket. These are often converted into tables of percentages and applied in a similar fashion as the Percentage Based Withdrawals.
- Spending Needs or Goals: The final method of setting withdrawals is to base it on what you are spending or want to spend. Crazy right? Of course, there should be a discussion around if that amount is too much or too little, but this method just takes current spending patterns and projects that into the future.
If the Income Maintains Spending Power
Once income has been set, the second component is whether your income maintains purchasing power over time. Inflation is a significant factor in retirement planning, as it erodes the value of money year after year. To combat this, it’s important to determine whether and how income will be adjusted to keep pace with inflation.
There are a few ways this can be handled:
- Fixed Cost-of-Living Adjustments (COLA): Choose a rate like 3% and that is the fixed adjustment every year. Actual inflation and costs could be higher or lower than this.
- Full COLA: One approach is to automatically increase income by a certain percentage each year to account for actual inflation. Whatever the inflation is for that year, you increase (or decrease) your spending to match that.
- Fun Fact: The Original 4% rule was developed using data from 1926 to 1992 covering The Great Depression, World War II, and more. What year was the 4% Rule generated? 1966. Why not The Great Depression? Deflation which lowered assumed spending during that time.
- Modified COLA: Finally, the income could be adjusted based on a modified COLA formula. Typically, these formulas are expressed in the following:
- Capped Inflation: Inflation adjustments but only up to a certain limit per year.
- Floored Inflation: Spending cannot be decreased below a certain level.
- Triggered Adjustments: Inflation adjustments can be eliminated entirely if certain triggers are tripped. For example, if the portfolio value is down in the prior year, do not take inflation.
If the Income is Adjusted for Performance
A distinguishing feature of variable income strategies is the ability to adjust income. While some strategies are rigid, offering consistent incomes regardless of how the portfolio performs, variable strategies can allow for adjustments depending on the growth or contraction of the investment portfolio.
- Upside Adjustments: If a portfolio performs better than expected, it may be possible to increase the income to enjoy a higher standard of living or to cover additional expenses. For instance, if stock markets see substantial gains, a retiree could choose to take out more without jeopardizing long-term sustainability.
- Downside Adjustments: Conversely, if the portfolio underperforms or market downturns occur, income may need to be reduced to avoid depleting the principal too quickly. By scaling back withdrawals during these times, retirees can preserve their investments and reduce the likelihood of running out of funds.
The upside and downside adjustments can be triggered by a number of factors depending on the strategy:
- Portfolio Performance: If your portfolio has returned more or less than expected, income can be adjusted up or down.
- Portfolio Balance: If your portfolio balance which encompasses both performance and spending/saving reaches certain levels, your income could be adjusted up or down.
- Withdrawal Rate: If the amount of money you are drawing as a percentage of your portfolio exceeds or is below certain levels, your income could be adjusted up or down.
- Funded Ratio: Funded ratio is a present value calculation of all assets, income, and expenses. If your funded ratio increases above or decreases below certain levels, your income could be adjusted.
Which Strategy is For You?
There is no one right answer to this question. Rather you should decide based what your retirement will look like under that strategy and if you are comfortable with that. What does that mean exactly?
Here are a few things to consider when choosing a strategy:
- What is the likelihood a given strategy will last a lifetime of spending?
- How does my income get calculated over time and how variable is my spending?
- Does it generally increase? If so, by how much and how often?
- Does my income ever decrease? If so, how frequently and by how much?
- What spending flexibility will I have if an unexpected expense arises or my goals change?