A key component of retirement planning is figuring out how to draw an income from all that money you’ve invested. “Create your own paycheck.” The trick is figuring out how to take a stable amount out every year without running out of money.
This has led to a debate about “safe withdrawal rates”. The 4% number has been thrown around a lot, where for example if you retired with $1,000,000 in a balanced portfolio of stocks and bonds you might take out $40,000 a year (increasing with inflation) for 30 years with confidence. The problem is that if you simply take out 4% of your starting balance and then keep taking that number out every year robotically then your outcome depends a lot on sequence of returns. If you hit a prolonged bear market just a couple years into retirement (i.e. value drops to $700,000), your nest egg is much less likely to survive. On the other hand, if you hit a bull market for the first 10-15 years and only experience the bear market afterward, then you may die with more money than you started with.
This is why many experts encourage a more flexible “dynamic” withdrawal strategy that adjusts withdrawals based on portfolio performance. There are an infinite number of ways to implement this, so I looked for an industry example and found it in the Vanguard Managed Payout Fund (VPGDX)*. This all-in-one fund uses a 4% target distribution rate and with regular, monthly distributions that you can indeed treat like a (somewhat variable) paycheck. The fund is actively managed for total return, although a majority of its components are passive index funds.
How does the Vanguard Managed Payout fund calculate how much you can spend each year? Reading through the prospectus, we find that the monthly payout is calculated on January 1st every year, then kept constant for the next 12 months, and then reset again the next January 1st. If you started January 1st, 2014 with a $1,000,000 in this fund you would get a payout every month of 2014 for $2,995 ($35,940 a year). Why isn’t it 4% or $40,000?
The fund’s dynamic spending approach uses a “smoothing” method that keeps the monthly payout from changing too dramatically from year to year. Specifically, the 4% withdrawal rate is based on a 3-year rolling average of hypothetical past account value (assumes you spend the monthly distributions, but reinvest any year-end capital gains and dividends). Screenshot from prospectus:
So since the average of the past 3 years is lower than the current value, you’re getting 4% of a smaller number. As you can see, with smoothing your annual income from this fund can vary significantly over time. A starting portfolio size of $1,000,000 might get you an annual distribution varying from less than $36,000 or more than $44,000. Other smoothing methods include setting a maximum ceiling or minimum floor value, but this fund does not do that. Ideally, you would use the income from this fund to supplement other income from more reliable sources like Social Security, pensions, or guaranteed income annuities. That way your overall income will vary even less, and you’ll only have to cut back a little during down years.
(* Previously, Vanguard had three different Managed Payout funds with three different target spending rates of 3%, 5%, and 7%. I think this was confusing for many investors who didn’t really understand that the 7% fund would most likely experience a significant loss of principal over time. This is only speculation on my part, but the 7% payout fund did gather 8 times the assets as the 3% payout fund, even though 3% is a more realistic number for most folks. Vanguard now says that 4% is best for the “typical retirement period of 20–30 years”.)
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They make it more complicated than it has to be. For me it is very simple. My house is paid for. My car is paid for. For all of the daily spending needs I use my MasterCard (2.5% cash back on every purchase!!!). Let’s say my billing period goes from 1st to 31st of the month. For example, I got my statement on the 1st of April, say it is $2300, and it is due on the 20th of April. Comes mid-April, I sell $2300 worth of mutual funds and get my distribution in my bank account and then pay my MasterCard. Rinse and repeat month after month. It is that simple!
@Nick, How are you getting 2.5% back on EVERY purchase?
That’s the same strategy that I always intuitively knew made the most sense. Vanguard just takes all the thinking out with this managed fund. I guess more savvy investors could implement the same withdrawal strategy with their vanguard portfolio of etfs or mutual funds.
While this seems like an easy “set it an forget it” fund, I think taking a monthly check of an equal amount of money may not work for many retirees. In retirement I would think that you’d have fewer large monthly bills (house/car/student loans all paid off) and your large expenditures may be more random/variable (medical care, vacations, etc.).
So do you think it might better if the whole 3-4% was paid out beginning of the year instead of monthly installments? I could see that working but then the total money would have less capital to grow with.
I would have liked to hear more about this payout fund and what sort of allocations it has.
I think I need to reread the prospectus but if it’s doing the 4% withdrawal approach ( or a smoothing of it), wouldn’t the expectation be that this fund closes down in 30-40 years? I thought the “endowment fund” like withdrawal (in perpetuity cash flow) was more like 2% (and a 40 year withdrawal rate was 3%).
Fidelity’s approach on these income replacement funds is to place a defined end date to the fund. It will be interesting to see how each of these works over time.
This fund doesn’t have a target date like Fidelity’s target income funds do, so any investor could ideally invest and just make sure to monitor their preferred AA in their overall portfolio. There’s no “glide path” winding down the funds total assets. I like how Vanguard uses their Total US Stock and Total Int Stock indexes for most of the equity in the MPF and the same for bonds. Vanguard uses simplicity at it’s best. Plus the ER just came down to .34%! It’s very affordable for an actively managed mutual fund.
Nick R. what card gives your 2.5% back on all purchases??
PayPal debit MasterCard (1.5%) backed up by Ebay MasterCard credit card (1%). Actually, Ebay MasterCard currently gives me 2% (special promotion). So, currently I am getting 3.5% on all purchases. That’s why when I file my federal tax return next week, I am going to pay the amount I owe with the card (using a third party payment website). They charge 2.5% fee but I am getting 3.5% back. So, basically I am getting back 1% of the amount I owe to IRS. And it defers the time when I really have to pay the money since my credit card bill is not due til the end of May.
Interesting. It was my understanding that this “loophole” was closed a while back and that you can no longer double-dip the two rewards on both debit and credit cards.
Well, they are issued by two different companies. PayPal debit card is issued by PayPal and I get cash back in my PayPal account (then transfer it to my checking account). Ebay MasterCard credit card is issued by GE Money Bank and I get cash back (points) for charging against your credit. So, not really a loophole. I have been taking advantage of this for many years. And like I said, having 3.5% cash back for the first 6 months of this year is great, I can pay my federal tax return with it, then my property taxes at the end of June, etc.
They use monthly disbursements because most people pay bills on a monthly basis. If they went with an annual lump sum, some people would have trouble making sure not to overspend early in the year.
Furthermore, the monthly payout schedule reduces risk by spreading out highs and lows over 12 months. You smooth out price changes as you essentially dollar cost average out of the fund.
Example: if you sold 4% of your portfolio last month, you would have significantly more money than if you sold at today’s close.
Finally, by taking money out monthly, they provide the investor with the opportunity to collect more dividend/interest due to leaving the money in the fund longer. In an era with low (zero) rates for short term savings, that is probably a huge advantage.
This is what I think about the “dollar cost average”, when you invest, you spend fixed amount to purchase every month. When the share price is low, you buy more share. When the share price is high, you buy less share. It’s like buy more when it’s low. That’s why it’s good. But it’s on the contrary when you sell. Use the same principle for buying, you sell fixed amount of share not dollar. When the share value is high, you get more money back. When the share value is low, you get less money back.
So just wondering, does this resemble what most people reading this blog expect their retirement to look like. Or will yours be 1.5 – 2 million instead of 1 million? Or will yours be 40 -50 years long? (lets assume die at 90).
Interestingly, most University endowments use a similar “smoothing” algorithm to determine how much they can give to the University each year. They tend to be weighted averages over the last 10 years or so. (Not 3)
It’s pretty fascinating. Nice to see a mutual fund take the same approach…
Wonderfully written blog post and I appreciate the effort put into itr in calculating the amount that we can utilize every year. However, I have a point to make. Why should we at all take out money from the appreciating value of the balanced fund when we are accumulating it for the sake of retirement? If the annual withdrawal, whatever be the percentage, is done every year the corpus shrinks, which is not desirable, irrespective of the fact how less the withdrawal is. I believe that investments are made to accumulate capital and increase that corpus so that our retirement life, when we don’t earn or earn very little, remains smooth and hassle free. Therefore, I question the basis of withdrawal of yearly sum from the investment (no matter for which purpose it is used, until and unless the requirement is an Emergency). Correct me if I’m wrong.
in situations where withdrawals are not mandatory, the decision to take money out of the corpus involves your lifestyle and desire to pass money to heirs.
Let’s say you have $1M saved.
– If you only take out earnings each year, it could last forever and you could pass the entire $1M to heirs.
– If you gradually reduce the corpus, your retirement “lifestyle” can be maximized as you live on both the earnings and the principle. If you time things perfectly, you leave $0 to heirs.
Does Vanguard’s equation seem backwards to anyone else? When the market is going up, the formula returns less than 4%. When the market is going down, it returns more than 4%. Should you take more when the market is up and less when it’s down?
BEWARE !!!
VPGDX fund after years of paying
Dividends and reinvesting into shares
@ EOY….has FAILED MISERABLY this past
Year with a booming stock market….
The promised 4% was not achieved
Despite earlier years being accomplished!
Requiring further investigation
This fund does NOT promise to pay 4% each year. It only promises to pay 4% of the average hypothetical portfolio over the previous 3 years. Therefore, in up years, it will pay less than 4% and in down years it may pay more, depending on the 3-year average. It’s doing exactly what it’s supposed to do by smoothing out the gains and losses so that your income is not whipped around too much by the market swings. And generally, yes, it will pay out less than 4% (as the market trends upward) but I think that’s a good thing because it preserves more of your principal in the process.