Portfolio Design: A Modern Approach to Asset Allocation

SPENDING RULES FOR RETIREMENT

There is a key concept in retirement planning that most Americans have not even heard of. That is the concept of a spending rule, a rate of spending in retirement that can be sustained through time. As explained in the last chapter, foundations have spending rules that guide their activities through time. So must retirees, since they also must live off of their endowment---the wealth they have accumulated for retirement. If the retiree has a defined benefit retirement plan, spending can be tied to the income from that plan (plus Social Security). Most of us are not fortunate enough to have such a plan. For the many Americans with only defined contribution retirement plans, there is no guaranteed income from those plans, and retirement spending must depend on returns from accumulated wealth. So a spending plan is necessary.

Like foundations, some retirees base their spending in retirement on the income from their bonds and stocks. They choose their portfolios so as to maximize the coupons from their bond portfolios and dividends from their stock portfolios. This strategy may or may not be ideal as an investment strategy, but it should not be the basis of a spending rule. Retirees should be willing to use both income and principal from their portfolio if the spending can be sustained.

Like foundations, retirees have to worry about the volatility of their portfolio returns. We can measure that volatility using standard deviations, but somehow that doesn’t ...