Once someone settles on a variable withdrawal scheme during retirement, such as PMT, it is natural to notice the withdrawals they suggest can be quite large.
For instance, imagine you simply withdraw 5% of your portfolio every year. You start out with a $1,000,000 portfolio and figure that $50,000 is fine for your lifestyle. If it goes up or down a little bit, you can cope. But a lot of the time your portfolio will increase…and increase substantially. One day you’ll wake up with a $2,000,000 portfolio and that “withdraw 5%” strategy will be telling you to withdraw $100,000.
But you were happy on $50,000. Why should you withdraw $100,000? And if you don’t withdraw that extra $50,000, if you “leave it in the bank”, maybe it will help cushion any possible future spending cuts?
I’ll use PMT as my variable withdrawal strategy in the examples below but I have a feeling that almost any variable withdrawal strategy would have similar results.
At first glance, the strategy seems to have some merit. If we compare the standard deviation of incomes under the two strategies, the “bank” strategy seems to have less volatility:
- “Plain VPW” has a standard deviation of 24,330
- “Banked VPW” has a standard deviation of 5,636
Plain VPW has a volatility that is substantially higher! Less volatility is better, right? Well, not exactly. Remember that volatility on the upside (how much extra income I might get) isn’t a bad thing.
If we check semideviation of real income (well, really semideviation with a target of $41,000) we find that
- “Plain VPW” has a semideviation of 8,521
- “Banked VPW” has a semideviation of 5,636
(edit: Originally I showed a result here that strongly favored plain VPW when looking at semideviation. I realised I had made a mistake in my calculations; the above is the revised calculation for both standard deviation and semideviation.)
“Banked VPW” has a lower semideviation, which is what we hoped to see, but the results don’t look as impressive as when we look at standard deviation. And when you look into the details, the picture becomes even cloudier.
What follows isn’t an exhaustive, totally convincing analysis but what I’ve seen so far leaves me unconvinced it is likely to work out quite like we hope it might. The basic problem is:
- Most of the time the market goes up, so “leaving it in the bank” means forgoing substantial improvements in your lifestyle. It means not taking those European vacations. It means not helping your grandchildren with a downpayment. It means not flying the family out for Christmas when they can’t afford it themselves.
- A lot of time when the market does go down, that paltry $50,000 or $60,000 you skipped won’t make a huge different. I mean…the market just crashed 50% and you lost $400,000…
Here’s an example of the first case, when you end up with so much money you’re wondering what exactly you’re “banking” for.
And here’s an example of the second case where things are so bad that there’s never anything to “bank”.
Even when there are some inbetween cases — things aren’t great but neither are they “the absolute worst” it is hard to say that “banking” makes an appreciable real-world difference.
In 1969, it just meant that after two decades of belt-tightening you put a limit on your spending when the market recovers. But at that point you’re 90 years old…so it isn’t clear what you’re banking for.
1955 is the closest to our “ideal” scenario that we’ve seen yet. We forgo all that crazy spending for the first 20 years of retirement and it means we don’t have to cut spending in the last decade of retirement. That’s a good outcome, right?
Well, it probably isn’t a good outcome if you’re among the 50% of people who die in their first 20 years of retirement. And it probably isn’t a good outcome if your expenses go down as you get older. You might be sitting there thinking, “Hmm…I really wish I had taken that Antarctic cruise before I became wheelchair bound.”
But I have a suspicion that 1930 is probably how it works out most of the time. Sure, in the 7th year instead of pulling out an extra $15,000 and flying the grandkids to Disney World, you kept your cool. And again, in the 9th and 10th years, instead of taking an extra trip to Civil War battlefields, you kept a lid on things.
And so when the market went down and everyone else had to cut spending…you also cut spending?!? I mean, sure you get an extra, what?, $500 a year? That hardly feels like just desserts for your prior thriftiness.
And then when there’s that brief spike around year 16…you don’t spend that extra $8,000 on downpayment for a new car…you kept your cool. And so when the market went back down again right after that…you had to cut spending almost as much as your spendthrift neighbors?!?
The problem is that most of the time when we are banking large amounts of money, the market is doing so well that we’re unlikely to ever need the bank. And the rest of time we’re banking small amounts of money (a few thousand here and there) which isn’t enough to offset the $10,000 or $15,000 drop we suffer through.
So what do we make of that?
Should we not bank? To some extent, I think that is the lesson. With good savings and a good retirement plan, at some point you’re building in too many overly-conservative safety guards. You already have a low withdrawal rate. You have tons of bonds. You have Social Security to fall back on. You have a reverse mortgage as a last option. And now you’re trying this funky “banking” strategy to squeeze out a few more percentage points of risk.
Maybe when PMT tells you to withdraw $150,000…you do it. And go on that crazy expensive round-the-world trip you always dreamed about but never thought you would.
Think about PMT as encouraging you to loosen up the purse strings a little bit because it will still be all right.
That said, there’s nothing that says you have to spend money this year just because some spreadsheet said you could. Maybe you’re sick of traveling, you never drive anymore, and the roof on your house is just fine. There’s no reason to manufacture spending like a misguided retirement version of Brewster’s Millions.
It isn’t like “banking” hurts any. It just doesn’t seem likely to help much.
