An Investment Strategy That Offers the Best of Both Worlds

Interview with Colleen Jaconetti

Douglas Goldstein speaks with Coleen Jaconetti on the different ways that people can decide how much money to spend during retirement.

Douglas Goldstein: I am very excited to be talking to Colleen Jaconetti. She is not only a tax expert, she's also a certified financial planner just like I am. She is a senior investment strategist with Vanguard Investment Strategy Group, which is a team of global economists and investment and portfolio construction strategists who help clients financially.

Colleen, I speak a lot about the difference between strategy and tactics. I actually talk about it on the Chessboard, and I always try to use that as a metaphor for investing. When you talk about strategy for clients, what are you referring to?

Colleen Jaconetti: What we’re usually referring to is a high level plan. Most planning happens ahead of time, and then when we talk about tactics, it’s like implementation. Let’s put together a high level plan and then we’ll get into the details of the implementation as far as the tactics come.

Defining the Strategies: Dynamic Retirement Spending

Douglas Goldstein: A big part of what you do is you deal with retirement planning, which is the stage for people before retirement. Then there is the post-retirement period – what you do once you're retired. I don’t think we’re going to be able to cover all of that today because that is kind of managing your money for your whole life.

But let’s take a minute to talk about something that I know you deal with a lot – which is called “dynamic retirement spending.” Let’s start with the definition, and then we’ll go on to some of the details.

Colleen Jaconetti: The dynamic retirement spending strategy is really a hybrid of two traditional strategies. There's the percentage of portfolio strategy, where investors would spend a percentage of portfolio every year, which comes along with a bit of fluctuation in income, as a result of the market movements. Then there’s the dollar plus inflation strategy where people just spend a certain dollar amount every year and they increase that amount by inflation.

That’s really like the 4% rule, part of that strategy. What we’re saying is we think that the dynamic spending strategy will offer the best of both worlds. We have a strategy that is responsive to market changes, but it also has limits on it, so it doesn’t cause significant fluctuations in annual spending from the portfolio.

Douglas Goldstein: Let’s break these down because actually all of the strategies you mentioned are different ones that people use. The first one you spoke about was where you spend a percentage of your portfolio. So for example you're saying if someone retires and has a million dollars, he might say, “Okay, I will spend 4% of my portfolio ($40,000) a year, the first year. But then the next year, it could be more or less, depending on what happens to the portfolio. Is that the first model?

Colleen Jaconetti: Yes, exactly. That one hardly influences what happens to the markets because the end of year balance is dictated by what happens to the markets that year. So if the markets could be more volatile-

Douglas Goldstein: I always tell people that you don’t want your retirement spending to be determined by what’s going on in the markets. You might have a dream, in your retirement, to go on vacation, or to buy a house, or to help your kids. All of a sudden, the market goes down and you don’t want your dream to be shattered because of that.

So then that leads to the next model which you described as the 4% rule linked to inflation. Spell that out a little more.

Colleen Jaconetti: Basically, at the beginning of retirement, a retiree would set a certain dollar amount, say 40,000$ on a 40 million dollar portfolio. Then it would grow that amount every year by the inflation rate. Basically they’ll be having real $40,000 spending throughout retirement.

The big problem with that is it does not adjust to the market at all. It’s great for retirees to be able to budget. But if the market should go down maybe 10, 15, 20% a number of years in a row, and someone is continuing to take out that 4%, which now is probably something a lot higher than 4%, given their portfolio went down, they could actually be having a higher probability of running out of money before the end of their retirement.

Douglas Goldstein: I know there are lot of people who have a lot of money, and who can do what I am about to say, and maybe it’s not for everyone. But sometimes people – to answer your question – will say you should break up your portfolio into different buckets.

One of them should simply be a short-term investment portfolio, literally in cash, from money markets or short-term CDs that could cover you for not just three to six months, but possibly two, three years. Then the rest of the portfolio could be invested a little bit more dynamically, or invested for growth or for income. Would that solve the problem of a bear market for a couple of years?

Solving the Problem of a Bear Market

Colleen Jaconetti: Yes, depending on the length of the bear market, that’s certainly a prudent strategy. Some retirees quite frankly are just more comfortable with a lower return, and not having that portion of their portfolio in the stock or bear market. It helps them sleep at night, and is worth the trade off to them.

Douglas Goldstein: Thank you for taking the time to go through these definitions because it is important that people realize there really are a number of different strategies. Now let’s dive into the dynamic retirement spending strategy. What's this all about?

Colleen Jaconetti: Similar to the percentage of portfolio strategy, you would take a percent of the annual year-end balance, so that per year end balance, they would take 5% of that balance. Then we will calculate that number and say $50,000 as an example. Then we would compare that number to a ceiling and a floor. So you would say, “Okay, if the markets are up, how much would I want my spending to increase each year?”

Maybe we say we use a ceiling of 5%; so year over year, there’s a change in spending when you go up by more than 5%. We also select the floor for saying, “If the market goes down by 15%, how much can you actually handle in reducing your spending?” There we say maybe only two-and-half percent decrease in spending.

We calculate the annual spending - a ceiling and a floor - and then we look at the annual spending amount and say, if the amount we calculated is higher than the ceiling - if it is, that means your portfolio – the market return was higher than the amount that you had adjusted for your ceiling. Then you only spend the amount of this ceiling, right? So you do give yourself a raise, but you reinvest the difference in the portfolio.

If the amount you accumulated that year is below the floor, you limit the spending to the floor, so you don’t have a reduction all the way down to what it would have been if you spend a percentage of portfolio. You say, “Okay, I am going to stop here at the floor.” That’s the amount that you can spend.

Douglas Goldstein: So you're finding a middle ground right?

Colleen Jaconetti: Yes. Really the thought is, if you're trying to preserve some of the upsides, so we have found in talking to many retirees over the years, is that when the markets go up, people don’t necessarily need to increase their spending by 20 or 15% per year, right?

They could spend a little bit more. But it’s better if they spend some and then reinvest the difference so that if the markets go down by 10 or 15 or 20%, they could actually know how to reduce their spending. So just creating a little bit for a rainy day spending there. It’s a little more in line with what investors do; like if the markets are up, maybe they would buy a new car. If they're down, maybe they’ll cancel a vacation, right? So it’s kind of a little more in line with how people think about their own money.

How to Apply the Dynamic Retirement Spending Strategy

Douglas Goldstein: Yes, I think that’s true. People do – regardless of how we want them to be robots and have no emotions when investing – the fact is, when people feel richer, they're more likely to spend.

Colleen, let’s get down to nuts and bolts. Let’s say someone retires and wants to actually apply this strategy. What's the first step?

Colleen Jaconetti: The first step is to get their portfolio balanced. I guess really the first step would be, how much do they want to spend? They need to do a little bit of a budgeting or financial planning exercise of how much they need to take out of the portfolio.

If they come up with my income sources, which is social security, pension, part-time income, rental income, it’s a certain dollar amount. Then they say all my recurrent expenses, whether it’s healthcare expenses, or food, travel, home is another number. The difference between those two kind of gives them a rough amount of how much they need to take out of the portfolio.

If they say they want to take 4% or 5% from the portfolio, we first calculate that number. So we do 5% of the priority balance and we get a number. We would then compare that number to a ceiling and a floor. If that number, that they had calculated, is higher than the ceiling, we limit spending to the ceiling. If that number is lower than the floor, we limit the decrease in spending to the floor amount. This helps keep their annual spending within a range of their initial spending.

Douglas Goldstein: What is the range? How does a person figure that out?

Colleen Jaconetti: Really there’s a lot of flexibility and planning that comes into place. What we would do is show people a range of possibilities. You could say it’s a percent of the prior year’s spending. What we’re trying to do is we’re trying to control year over year change in real spending. It really is an exercise you could go through as a financial planning exercise. If the market is up by 5%, 10%, 15%, and I increase my spending by 1, 3, 5%, what does that do to my outcomes? What does that do to how long my money lasts, and how much do I have at the end?

Then also it’s an exercise of people looking through their expenses to see what are their “must haves” (food, clothing, shelter) vs. “nice to have” (vacations, new cars, things like that), and figuring out how much could they realistically cut their spending if they need to? That really helps decide what that floor amount is.

So it’s kind of going through the exercise of figuring out if the market should drop, how much can I – if I have $50,000 of “must haves” and “nice to haves” - how much of that is really “must have”? If it’s really only $20,000, then that would be great because that means that the “nice to haves” could be cut if the markets should go down.

Douglas Goldstein: It could be a little bit scary for some people realizing that they are living at a certain level, and they're used to it, then all of a sudden, things change. For example, now, we’re in a low return world in terms of fixed incomes. For someone who is conservative in his investment approach and wants to have money in CDs or high quality bonds and he’s getting very low yields, this could actually kind of shake him and he would say, “Well, I am not even able to make the money that I would want to make in order to live the lifestyle that I’d like to lead. How do you sustain this kind of retirement income if interest rates are low and stay low, like they’ve been doing for so many years?

Sustaining Retirement Income When Interest Rates are Low

Colleen Jaconetti: I think part of the key here is having a balanced portfolio on retirement, right? So if you have 1) a portfolio that’s going to last say, 30 or 40 years, there will most likely need to be some allocation of equities, right? We would actually recommend that investors maintain a balanced portfolio between stocks and bonds, and don’t try to overweight high dividend paying stocks, or high yield bonds and things like that.

Really focus on spending from the principal, in years when they need to, then living off the income in the years when the income exceeds the amount that they need to spend from. We try, say , tohave a more balanced approach, and then implement that when spending. That’s as far as asset allocation. Dynamic spending means having a little bit of flexibility in your annual spending needs. Having that flexibility actually helps people to be able to make sure they get their “must haves” as far as expenses go. Then be also able to have something “nice to have”, and be able to continue that for an indefinite period of their lifetime.

Douglas Goldstein: So it actually gives them a way to look at the amount that they're going to be spending within a realistic framework. Because the fact is, you can want all you want, but if what the market’s going to do is simply not producing the returns that you would like, you may not be able to spend the money.

But it sounds to me, Colleen, what you're also pointing out is that people shouldn’t be afraid of having money in the stock market, to try to grow their portfolio, but just to do it within a measured amount. You said a balanced portfolio; were you saying a 50-50 or were you just referring to some sort of planned asset allocation?

Colleen Jaconetti: It’s really just some sort of planned asset allocation. Just generally speaking, if you have a 30 or 40-year horizon for spending a certain amount at retirement, you should have at least some allocation to equities to really help the portfolio growth in retirement or at least to keep expenses in line with inflation.

How to Follow Colleen Jaconetti

Douglas Goldstein: Colleen, I see we’re just running out of time here. This has been really interesting, and I know that you actually have a lot more information on it. In the last few seconds, can you just tell people, how can they learn more?

Colleen Jaconetti: Sure. They could go to www.vanguard.com, and if they go under “Personal Investment” under “Blogs”, I have a series of blogs written on the dynamic spending strategy and on sustaining retirement income levels all over the world.

Douglas Goldstein: Okay, what we’ll do, we’ll put links to that at the show notes of today’s show at goldsteinongelt.com. Colleen Jaconetti, thank you so much for taking the time.

Colleen Jaconetti: Happy to. Thank you for having me.