In Part 1 of the Retirement Planning Series I wrote about the two critically important questions that are answered with the planning process and how the planning process is freeing as opposed to limiting.

In this installment I describe my approach for determining sustainable spending for clients.

You will notice I speak in terms of “probabilities of success” because portfolio returns are anything but linear and static. Returns are variable so we’re always managing probabilities.

Therefore, when running the financial projections each scenario within the projection is actually modeling 1,000 different scenarios with random annual returns. The probability of success, then, is the percentage of those 1,000 hypothetical scenarios where we don’t run out of money prematurely.

Baseline

The first thing I do is run a baseline scenario. This baseline scenario tests the probability of success for the client’s desired or anticipated level of spending (along with other financial goals) given the financial resources at their disposal to fund those goals such as: cash, investment portfolio, social security, pension, annuity, other retirement benefits, inheritance, rental income, etc…

We run the baseline to see where things stand without any adjustments. If it looks great with a comfortable probability of success we move on to the next step of optimization.

If, however, the probability of success is below our comfort zone then I run more scenarios to back into a sustainable level of spending or, perhaps, identify financial goals that need to be scaled back or eliminated.

This is a spending breakeven analysis. I target an 85% probability of success for most retirees.

Probability of Success

85% probability of success doesn’t necessarily mean a 15% chance of failure. It means that of the 1,000 hypothetical scenarios, a spending adjustment would have been needed in 15%, or 150, of those in order to avoid running out of money prematurely.

Now, if your advisor makes a plan and then never revisits it with you then yes that could mean a 15% chance of failure because there are no updates, reviews or proactive adjustments occurring.

Another way to look at probability of success is the probability you’re under-spending relative to what you can afford. So, an 85% probability of success implies an 85% chance you’re under-spending and a 15% chance you’re over-spending.

Once we’ve arrived at a reasonable estimate for a sustainable level of spending we need to optimize our portfolio. That’s beyond the scope of this commentary, but, in short, we’re reviewing a multitude of scenarios with different investment strategies to identify the strategy that provides the greatest probability of success across a variety of market environments.

Spending Guardrails

By this point we’ve identified a reasonable spending target and an optimized investment strategy. But our work is not over.

Planning is not a one-and-done exercise. It must be updated and reviewed each year so that we can proactively identify adjustments if/as needed. After all, the markets and economy as well as our own personal lives are not static.

Sometimes things go better than we expect, sometimes they go worse and sometimes they go just as expected. In the case of retirement planning, if things go at least as well as expected then we find probabilities of success actually creep up over time. And if things go better than expected we find probabilities of success can shoot up pretty dramatically. In both cases, there may come a point where we can increase withdrawals from our portfolio.

Conversely, if things go worse than expected there may come a point where we need to reduce anticipated withdrawals from the portfolio.

In order to make informed decisions about adjustments we need an objective process in place. This is where my spending guardrail analysis comes in.

I set up a lower guardrail at 75% probability of success and an upper guardrail at a 95% probability of success with a long-term target of 85% probability of success.

In other words, if probability of success drops below 75% for too long I get concerned about the strain we’re putting on the portfolio and will make recommendations accordingly (e.g. reduce spending / withdrawals). The reductions are not random but based on updated financial projections that improve the probability of success back to our long-term target of 85%.

If the probability of success remains above 95% for too long I worry we’re sacrificing too much unnecessarily and will encourage clients to do more (travel, “toys”, gifting, etc…) if they so choose. After all, we can’t take it with us can we?

Conclusion

As you can tell, the entire exercise is an informed yet imprecise, ongoing process to find the balance between leaving a cushion for unforeseen circumstances (health, bad markets, living longer than expected, etc…) and not sacrificing too much lifestyle unnecessarily during our healthy years so that we can get max enjoyment and utility from our wealth.

 

In Part 3 I discuss optimizing the investment strategy.

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