The Smarter Way to Spend Your Portfolio in Retirement

The ‘4% rule’ is one of the more widely quoted guidelines for investors approaching or during retirement. It was originally developed by financial planner William Bengen using historical market simulations which suggested retirees could withdraw 4% p.a. from their portfolios without exhausting their savings over a thirty-year retirement.

However, a growing number of voices are suggesting the 4% rule may be too rigid and inefficient for modern portfolios with optimisation in mind. In short, it can force investors to underspend in good markets and still risk painful reductions during downturns.

So what’s a better approach to this financial planning dilemma that all of us face at some stage?

Time to Update an Old Idea

Recent research offers an updated alternative to this old idea. Stefan Sharkansky proposes a much simpler but more flexible framework for turning investment portfolios into retirement income.

Stefan’s central hypothesis is that instead of complex asset allocation models or rigid withdrawal rules, investors could construct a retirement portfolio using just two components:

1. A ladder of inflation-linked bond exposure that provides predictable real income.

2. A diversified stock market index fund that provides long-term growth and variable spending power.

The argument is that together they can create a more efficient and realistic retirement income system.

Why the Traditional Rule Falls Short

Retirees must generally balance two risks pulling them in opposite directions:

• Spend too aggressively and their portfolio may be depleted before the end of their life.

• Spend too cautiously and retirees may live below their means while sacrificing quality of life.

Sharkansky argues that traditional strategies focus too heavily on avoiding depletion while ignoring the equally important problem of chronic underspending. So investors often end up ‘living below their means and dying with excessive unused wealth’.

The 4% rule is core to this dilemma. It assumes a constant inflation adjusted withdrawal rate regardless of market performance. The issue is that markets aren’t constant, and neither are retirees’ spending patterns.

Moreover, research shows that retirement spending typically declines over time, while market returns fluctuate significantly. So fixed withdrawal rules often struggle to adapt to the reality most retirees experience.

The alternative solution proposed is a dynamic approach known as the Annually Recalculated Virtual Annuity, or ARVA.

ARVA Explained

Under the ARVA framework, a retirement portfolio is treated each year as if it were converted into an annuity based on its current value and the investor’s remaining life expectancy.

In practical terms, this means annual withdrawals are recalculated every year rather than fixed in advance.

According to the same research, this dynamic approach allows retirees to spend more over their lifetime while reducing the probability of running out of money.

To that end, historical simulations show that ARVA does indeed produce higher lifetime income than many conventional strategies. On average, the simulated outcomes below (top charts) are better than the outcomes of traditional strategies such as the 4% rule (bottom charts).

Beyond higher total income, one of the primary advantages of ARVA is the simplicity of the portfolio structure required to implement it.

Two Building Blocks for a Resilient Portfolio

An ARVA portfolio can be constructed using just two asset classes:

1. A ladder of inflation-protected bond ETFs / funds.

Inflation-linked bonds provide the real, predictable income retirees need to depend upon. When markets fall, withdrawals temporarily decline but the bond ladder ensures essential spending needs are still met.

For example, Betashares Infl-Protd US Trs Bd CcyH ETF (ASX: UTIP) provides exposure to a portfolio of US Treasury Inflation-Protected Securities (‘TIPS’), hedged into AUD. TIPS are a type of government bond issued by the US Treasury, whose face value and interest payments are adjusted for inflation, as measured by US CPI.

And for a domestic equivalent, the iShares Government Inflation ETF (ASX: ILB) provides exposure to the Bloomberg AusBond Inflation Government Index, which comprises inflation-linked fixed income securities.

2. Exposure to diversified global and Australian ETFs that capture long term economic growth.

The ETF allocation provides investors with growth and flexible spending capacity in addition to the essential bond portfolio income. So when equity markets perform well, withdrawals can increase, and vice versa.

For example, Global X Australia 300 ETF (ASX: A300) provides exposure to the largest 300 Australian companies listed on the ASX.

And iShares Global 100 ETF (ASX: IOO) provides investors with exposure to 100 multi-national, blue chip companies of major importance in global equity markets.

The reason this simple two-asset portfolio works so well for many retirees is that the bond ladder creates a secure, inflation-proof income floor that covers most worst-case scenarios, while the ETF portfolio acts as a variable annuity that adjusts to market conditions and covers the nice-to-haves as well as the need-to-haves.

So the ARVA strategy translates into a simple portfolio structure: global and Australian ETFs combined with inflation-protected fixed income funds or ETFs designed to preserve capital and provide reliable income.

This structure is a simple version of the core / satellite approach that’s becoming more popular with investors in recent years. The defensive core stabilises the portfolio, while growth assets drive long term returns.

An Important Takeaway

Retirement planning is all about ensuring your income needs are covered in both bull and bear markets. It’s the sustainability of income that allows retirees to sleep well at night.

As with many aspects of investing, simplicity is where the best results tend to be found. A carefully structured combination of Australian and global ETFs and inflation-protected bond funds, combined with a flexible spending rule, may deliver better outcomes than rigid rules or complicated asset allocation frameworks.

This simple portfolio is surely worthy of consideration as a smarter way to manage your retirement portfolio than many traditional strategies.

Funds Mentioned

Disclaimer: This article is prepared by Simon Turner. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.