Spending Rule

A spending rule is a strategic guideline that helps you figure out how much money you can safely withdraw from your investment portfolio each year without running out of cash too soon. Think of it as your personal financial speed limit for retirement. It's a crucial tool for anyone living off their accumulated wealth, whether from a retirement account, an endowment, or a trust fund. The central challenge it addresses is the tug-of-war between enjoying your money today and making sure it lasts for an unknown number of tomorrows. A good spending rule provides a disciplined framework that accounts for market ups and downs, inflation, and your own longevity, helping you navigate the tricky path of decumulation. It replaces guesswork and emotional decisions with a logical, repeatable process, giving you the confidence to spend while preserving your capital for the long haul.

So, why can't you just take out what you need, when you need it? The biggest party-crasher in retirement planning is a nasty concept called sequence of returns risk. This is the danger that the timing of market returns can wreck your plan. If you're hit with a major bear market in the first few years of retirement, withdrawing a fixed amount of cash can deal a devastating blow to your portfolio. You’re selling assets when they are cheap, permanently reducing the capital base that needs to grow to support you for the next 20 or 30 years. A spending rule is your shield against this risk. It imposes discipline, preventing you from overspending when the market is euphoric during a bull market and protecting your principal when the market is tanking. It’s a pre-commitment to a sensible strategy, made with a cool head before emotions take over.

There's no one-size-fits-all rule; think of them as different tools for different jobs. Here are a few of the most popular approaches.

This is the celebrity of spending rules, known for its elegant simplicity. Popularized by financial planner William Bengen in the 1990s, the 4% rule works like this:

1. In your first year of retirement, you withdraw 4% of your starting portfolio value.
2. In every subsequent year, you take out the same dollar amount, adjusted upwards for inflation.

Example: If you retire with a €1,000,000 portfolio, you’d withdraw €40,000 in year one. If inflation is 3% that year, your year-two withdrawal would be €40,000 x 1.03 = €41,200, regardless of what the market did.

• Pros: Simple to calculate and provides a predictable, inflation-protected income.
• Cons: It can be rigid. It was based on historical US market data and may not hold up in future low-return environments. It doesn't adapt to actual portfolio performance, meaning you might leave a huge amount of money on the table or, in a worst-case scenario, run out.

This method is highly responsive to the market. You simply withdraw a fixed percentage (say, 5%) of your portfolio's value at the end of each year. Example: With that same €1,000,000 portfolio and a 5% rule, you take €50,000. If your portfolio grows to €1,200,000 next year, your withdrawal becomes €60,000. But if it falls to €800,000, your withdrawal shrinks to €40,000.

• Pros: You'll never technically run out of money, as you're always taking a percentage of what's left. It automatically forces you to “buy low and sell high” with your lifestyle.
• Cons: Your income can be a rollercoaster! This volatility can be extremely stressful for budgeting and may lead to drastic lifestyle cuts just when you feel the most financial anxiety.

This is the sophisticated hybrid, attempting to get the best of both worlds. Often called dynamic spending or the “guardrails” method, it combines the stability of the 4% rule with the flexibility of the percentage method. The strategy sets a baseline spending target but establishes upper and lower bounds (the guardrails). You only adjust your spending if your withdrawal rate drifts outside these guardrails due to market movements. Example: You start with a 5% withdrawal rate. You set guardrails that say you won't let the rate fall below 4% or rise above 6%. If a great year causes your 5% withdrawal to represent only 3.8% of your now-larger portfolio, you cross the lower guardrail and give yourself a raise. Conversely, if a bad year means your withdrawal now represents 6.2% of your portfolio, you cross the upper guardrail and take a small, pre-planned cut.

• Pros: Provides a much smoother income ride than the pure percentage method while still being responsive to market conditions.
• Cons: More complex to track and requires you to stick to the plan even when it calls for a spending cut.

As a follower of the value investing philosophy, you're already equipped with the right mindset: you're patient, you understand that market price isn't the same as intrinsic value, and you don't panic. This is the perfect foundation for using a spending rule effectively. Here’s the bottom line:

• No Rule is Perfect: Think of any spending rule as a starting point, not a commandment set in stone. The best approach is one you can stick with.
• Be Flexible: The wisest retirees are prepared to adjust their spending. If you've just been through a terrible market year, maybe you postpone that expensive world cruise. A little flexibility can dramatically increase the longevity of your portfolio.
• Consider Your Whole Picture: Your spending rule should work in concert with your asset allocation, risk tolerance, and other income sources like a pension or an annuity. Also, be aware of legal mandates like required minimum distribution (RMD)s in the U.S., which can force withdrawals that override your personal rule.

Ultimately, a spending rule is a powerful tool for turning a pile of assets into a reliable income stream. It’s about creating a plan that lets you sleep at night, confident that you can enjoy your hard-earned wealth without the constant fear of it disappearing.