Matching portfolio volatility to budgetary flexibility in retirement

CIO Global Blog

21 Feb 2019

An important concept to think about when you move from the accumulation stage of life to retirement is that your portfolio's volatility is related to the volatility of your future spending. That's one possible reason many investors, and in particular retirees, felt very uncomfortable during the market decline at the end of last year.

What does this mean exactly? Quite simply, if a portfolio declines in value by 20%, the future spending potential of that portfolio has also declined by 20%. For instance, a fair estimate of the max spending potential of a USD 1mn portfolio today (for an investor with a 30-year horizon) is 4.8%, or USD 48,000 per year. How do we get that number? Using a discount rate of 2.75% (the current average on the Treasury curve), the net present value of USD 48,000 for 30 years is USD 1mn. The net present value of a retiree's future spending has to be equal to or less than the value of the assets at retirement.

If an investor is spending at that rate and the portfolio declines by 25%, a perfectly normal equity market drawdown during a mild recession, the now- USD 750,000 portfolio can still safely generate 4.8%, but the dollar amount has also declined by 25%, to USD 37,000 per year.

There are a couple of important takeaways from understanding the linkage between portfolio volatility and spending volatility. First, it’s important to understand how comfortable an investor is with fluctuations in their spending or whether they have a buffer. Some families have lots of flexibility in their budgets or are conservative in regards to their spending relative to their overall assets. Others are unwilling to adjust their spending over time or want to spend as much as possible. Those with spending flexibility or low spending rates can afford to take more risk in their portfolios, but investors without flexibility or with high spending rates need to hold correspondingly low-volatility portfolios to match their spending needs.

How does the 4% rule fit into this analysis? Basically, the 4% rule is a spending floor that disconnects spending entirely from the portfolio. The rule says you can spend 4% of your portfolio in the first year of retirement and then increase the spend amount with inflation for 30 years and not have to worry about running out of money. Of course the 4% is based on historical data, and the 4% rule is actually closer to 3.5% for current retirees based on UBS's capital market assumptions.

Going back to the earlier point, 4.8% is a fair estimate of how much someone can spend today if they have a 30-year horizon, but it assumes the retiree is willing to reduce spending when needed. The now-3.5% rule targets a lower initial spend (27% lower), which creates the buffer necessary to never have to reduce spending even if the market declines. Whether or not such a constrained strategy is ideal depends on the family, but in my experience a lot of retirees would prefer to spend higher amounts earlier in retirement in exchange for reducing spending later on if necessary.

A final note: I've only addressed investment assets in this blog post. Public and private pensions, which should be included in this analysis for a particular family, provide a low- or no-risk hedge for some portion of the family's spending.

Author: Michael Crook, Head Americas Investment Strategy, UBS Financial Services Inc. (UBS FS)