Being flexible with investment portfolio spending can make a big difference in the lives of many retirees by helping to mitigate sequence of returns risk. This flexibility allows synergies to develop, making it possible for them to potentially spend at a higher average level than with a constant inflation-adjusted strategy.
In fact, as discussed by retirement researcher Wade Pfau in a recent webinar hosted by his educational platform Retirement Researcher, the development of better variable spending strategies represents one of the most compelling approaches to improving retirement outcomes today. The big obstacle, Pfau explains, is finding a risk-baseline framework that allows for the clear comparison of different variable spending approaches.
Simply put, some variable spending approaches require investors to stomach more risk, though these are also generally the approaches that will result in the greatest lifetime spending potential. Alternatively, some variable approaches involve less risk, but the anticipated income stability generally comes with a lower lifetime spending potential.
"We can achieve the best outcomes from a financial and experiential standpoint by pairing people with the right variable spending framework," Pfau says. "However, it has been difficult to calibrate the downside risk across income strategies in order to match them for a level of risk the retiree is comfortable taking."
To tackle the problem, Pfau has developed what he calls the "PAY" framework, based on his own prior work and in reference to the extensive academic literature about retirement spending strategies developed over the past several decades.
"By reviewing existing research on variable spending, we can identify and describe key representative variable spending strategies from the countless possibilities," Pfau says. "We can, in turn, classify them into a general taxonomy that facilities clearer investor choices."
The PAY Framework
As Pfau explains, the traditional approach to comparing spending strategies — generally based on extensive Monte Carlo modeling — involves analyzing their respective failure rates and using this as a proxy for overall riskiness. This is a useful exercise, Pfau says, but it doesn't provide great insight into how the user experiences of each approach will actually compare.
As an alternative to failure rates, Pfau suggests "calibrating the downside risk across strategies in order to match them for a level of risk the retiree is comfortable taking." This calibration can be done with a customized "PAY rule," which Pfau has previously described as the XYZ Formula in an article in the Journal of Financial Planning.
The original XYZ Formula as stated in that article was: "Retiree accepts an X% probability that spending falls below a threshold of $Y (in inflation-adjusted terms) by year Z of retirement."
As opposed to using a failure rate, which might simply say retirees accept a 10% chance of failure within the first 30 years of retirement, an XYZ formula would instead say that the retiree accepts a 10% chance that their spending level will fall below a specific inflation-adjusted dollar amount by the 30th year of retirement.
As Pfau explains, this may sound like a subtle difference, but having a specific income figure in hand, rather than a simple failure rate, can help savers incorporate such factors as Social Security and other income sources into their overall risk-taking framework.
In other words, it provides a way to compare strategies while also dealing with the reality that higher initial spending rates can be justified if spending is subsequently allowed to drop more steeply.
Pfau says the PAY approach is a meaningful improvement on this original design.
"Since publishing the first article, I have come to realize that calibrating the third variable to wealth, instead of spending, will work better," Pfau says. "Attempting to calibrate downside spending can easily create a situation in which no spending rule works, which was an issue in my published article.
