“Consumption smoothing” means going out of your way to have the same standard of living throughout your life–as opposed to, for instance, a standard of living that climbs throughout your working years and declines throughout your retirement years.
Economists love consumption smoothing.
But for most people, real life doesn’t work out that way. For most people, there are some higher-earning years and some lower-earning years, and spending is generally allowed to fluctuate (to some degree) along with income.
And, for the most part, that’s OK, despite not being ideal from an economic textbook standpoint.
Consumption Smoothing and Retirement Spending
When it comes to retirement planning, the most commonly-discussed spending plan is one based on the idea of consumption smoothing: Withdraw a given percentage of the initial portfolio value (usually around 4%), and adjust the withdrawal upward each year in keeping with inflation.
Of course, in real life, that 4% withdrawal plan isn’t perfect. If you never stray from that original plan, you face two undesirable possibilities:
- Running out of money completely (at which point spending drops rather precipitously), or
- Accumulating a huge pile of money without ever increasing your standard of living.
What if, instead of using such a rigid plan, we did the same thing in retirement that most of us do throughout our working lives? That is, what if we incorporated a bit of flexibility into our level of spending from year to year?
Same Portfolio, Flexible Spending
One alternative approach would be to keep the same type of portfolio we usually discuss here on the blog (that is, a diversified portfolio of low-cost index funds) but change the way in which you go about liquidating it. For example, Vanguard published a paper last year proposing a strategy in which the investor:
- Starts with a certain withdrawal rate, and
- Tentatively adjusts the spending upward each year in keeping with inflation, but
- Limits that spending using both a ceiling and a floor (for example, annual spending cannot drop below 2.5% of the current portfolio value or exceed 5% of the current portfolio value).
Without being able to see the inputs they used for their simulations, it’s difficult to know how much confidence to have in the specific quantitative results of their study, but I don’t think that changes the fact that the proposed strategy is worthy of further consideration. Just from a common sense standpoint, it seems like it could do a good job of minimizing the probability of either of the two undesirable outcomes discussed above for the typical consumption smoothing strategy.
Safe Income for Basic Needs
Another alternative approach (one that, at this point, I anticipate using myself) is to ensure that your most basic spending needs are satisfied with very safe, inflation-adjusted sources of income–Social Security, TIPS, and inflation-adjusted lifetime annuities.
After that, because your most basic needs are covered, you’re left with a great deal of flexibility with the remainder of your portfolio. (Though admittedly, this remainder may not be very large.)
- You can invest the remainder conservatively or aggressively,
- You can use whatever starting withdrawal rate you feel comfortable with–the less you mind the possibility of living exclusively on the safe income stream, the higher withdrawal rate you can use–and
- You can adjust that withdrawal rate freely over time based on the performance of this part of your portfolio.