All investments are subject to risk, including the possible loss of the money you invest. The information presented in this podcast is intended for educational purposes only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions.

You may access and download this podcast only for your personal and noncommercial use. You may not use it in any other manner or for any other purpose without Vanguard’s written permission

© 2016 The Vanguard Group, Inc.All rights reserved.


Jason Method: Hello, and welcome to Vanguard’s Investment Commentary Podcast series. I’m Jason Method. In this month’s episode, which we’re taping on July 21, 2016, we’re going to discuss how to manage retirement portfolios in the drawdown stage.

Michael DiJoseph of Vanguard Investment Strategy Group is here to explain how advisors can help their clients withdraw potentially more from their portfolios through a dynamic spending rule and how to manage the funds carefully and efficiently so they can last through retirement.

Michael is coauthor of a new white paper, From assets to income: A goals-based approach to retirement spending. Hello, Michael, and thanks for joining us.

Michael DiJoseph: Great to be here.

Jason Method: We’re now at the point where many workers who have saved throughout their career in a private plan are at retirement age. If a late middle-aged couple walked into an advisor’s office and asked how they can turn those assets into retirement income, how should an advisor approach that conversation? What factors does an advisor need to take into account?

Michael DiJoseph: We’ve come a long way on the accumulation side of retirement. But when it comes to actually converting those assets into a stream of income, things aren’t quite so simple.

When we talk about how much can you spend from a portfolio, we look at a series of four levers, first of which being the time horizon. So the longer the time horizon that the portfolio has to support an income stream, the lower the amount of money that they’re going to be able to spend over the life of that portfolio.

Secondly would be the asset allocation. We would say that the more aggressive the portfolio, the higher the level of spending it can sustain. But aggressive portfolios can tend to be more volatile over periods of time, so that effect might not be as pronounced as generally thought.

Third would be the level of flexibility that a client is willing to sustain in their spending plan. The more flexibility that a client is able to build into their plan—and we’ll get into this in a little more detail later—generally speaking, again, the more money they’re able to spend, especially at the beginning.

And then, finally, is the degree of certainty required. Or simply put, how certain do they want to be that they’re not going to run out of money? So if they want to be really certain that they’re never going to run out of money, they’re probably going to spend a little bit less.

Jason Method: When it comes to retirement drawdowns, the 4% rule has been the rule of thumb for many years. What does Vanguard think about that?

Michael DiJoseph: There’s nothing inherently wrong with it, and it’s a good starting point, but the 4% rule of thumb is based on a strategy called “dollar plus inflation,” which simply means that you pick a percentage of the portfolio in the first year, so 4% in this case, and then you take that amount of money and you just increase it by inflation each year.

It gives you pretty steady spending from year to year—not a lot of spending volatility. But it’s also completely separate from the markets. It’s not sensitive to the ups and downs of the markets at all.

On the other end of the spectrum would be what’s called the “percent of portfolio” method. So let’s take that same 4%. You’d spend 4% every single year regardless of what the portfolio has done that year based on the markets.

On the plus side there, it’s very sensitive to the markets, but opposite to the dollar plus inflation, it can provide extremely volatile spending year to year.

Jason Method: In your paper, you’ve built a new mousetrap, as it were. Please tell us about it.

Michael DiJoseph: Yeah, so, first, we should say there’s nothing inherently wrong with either one of the strategies that we talked about just now, but we do think that the vast majority of investors probably fall somewhere between those extremes. And so we’ve created a hybrid strategy called Vanguard’s “dynamic spending” with a ceiling and floor, which basically, in a nutshell, allows the portfolio to adjust a little bit each year based on the markets, while also building in kind of a corridor to prevent the spending volatility from getting too far out of control in any given year.

Jason Method: That sounds a little more complicated. Would you explain step by step how this would work?

Michael DiJoseph: It is a little more complicated but, first, we would say [to] select the initial withdrawal rate based on those four levers that we had discussed earlier. And then once you have that, you need to select a ceiling and floor percentage as well, which are basically: How much do you want the withdrawal to go up in good years, and more importantly, how much can you afford for the withdrawal to go down in the poor years? So what level of flexibility do you have?

[You] would take that percent of portfolio that you’ve chosen and you’d calculate that number every year based on inflation-adjusted spending, and then you would calculate the percentage increase. So we recommend a 5% ceiling, so a 5% increase each year, and a 2.5% floor, so a decrease of 2.5% each year, as a good starting point for most investors.

And you would calculate where that number falls. If it falls above the ceiling, you would bring your spending down to the ceiling. If it falls below the floor, you would bring your spending up to the floor. If it’s somewhere in between, that’s the amount that you would spend.

Jason Method: How would an advisor present this to a client?

Michael DiJoseph: I think this is one of those areas that an advisor can add significant value. The stuff’s pretty complicated, and it’s hard for the average investor to figure out on their own. But I think that the way to describe it to a client would be to simplify it. Just say, “Hey, for example, your salary is going to go up probably a good amount in years when the economy is doing really well, when your company is doing really well. But in years when it’s not, it’s probably not going to go up quite as much.” So I think you can put it in terms that clients can easily understand.

Jason Method: Let’s move to the second major part of your paper, which is to discuss why it’s important for retirees to hold a broadly diversified portfolio. That seems to go against conventional retirement-planning wisdom. Tell us why that may be of particular importance right now.

Michael DiJoseph: And I don’t think it’s necessarily important [only] just right now. We think that the Vanguard principles of investing success—knowing your goals; understanding why you’re investing; putting together a low-cost, broadly diversified portfolio; and having the discipline or seeking help to have the discipline to stick with it—are the drivers of investment success that are actually in your control. So we think you should always focus on those things.

Jason Method: Well, many people would like to live off their interest and dividend payments in retirement and then preserve their portfolio, perhaps for their heirs or for an emergency. What do you think about that?

Michael DiJoseph: Traditionally, the conventional wisdom is that an investor could have saved up a certain amount for retirement and then use the dividends or interest to support their spending needs without ever having to spend from their principal.

Over the past decade or so, the yields on portfolios have been in decline to the point where this isn’t really viable anymore, which leaves investors with a choice: spend less, spend from principal, or reallocate their portfolio toward higher-yielding investments. And this last one, reallocating the portfolio, is what we’ve seen many investors do. And it’s something we’ve written quite a bit about over the past few years, because it can really change the fundamental risk profile of a portfolio in unforeseen ways.

For example, reallocating the bond portfolio toward higher-yielding instruments by either investing in longer-term bonds—extending duration—or [investing in] riskier bonds—overweighting credit—can make that part of the portfolio more sensitive to interest rates or equity-like risk, respectively, all of which could reduce the diversification effects of bonds when they’re needed the most.

So we advocate that retirees spending from a portfolio embrace what we call a total return approach, meaning they view the capital or price returns equal to the income returns and spend accordingly. Ironically, investors may be putting their portfolios at greater risk by not spending from their principal.

Jason Method: And taking some capital gains may be a tax-efficient way of approaching it too, correct?

Michael DiJoseph: That’s correct.

Jason Method: Okay. What about the idea of asset location? That is, the importance of a strategy to use taxable, tax-deferred, and tax-free Roth accounts?

Michael DiJoseph: That’s a great segue. As we just talked about the income investing approach, it’s often done not only in ways that alter the risk profile of the portfolio, but in ways that alter the tax efficiency of the portfolio as well. So we’ve written about asset location, which simply put is understanding the tax efficiency of your different types of investments and figuring out where to place them between tax-advantaged accounts or taxable accounts.

So, for example, you may have taxable bond funds in your portfolio—which tend to kick off income that’s taxable at the marginal tax rate—compared to, say, index equity funds—which to the extent that they do kick off income, tend to be qualified dividends or long-term capital gains—which are often taxed at a lower long-term capital gains rate.

So we would say [to] take those taxable bonds and shelter them in the tax-advantaged accounts to mitigate some of the effects of that tax inefficiency.

Jason Method: Your paper discusses how to spend those assets, located in the various buckets, in a tax-efficient way. Help us understand that.

Michael DiJoseph: Right. So the story goes like this. You spend your whole life saving for retirement where?

Jason Method: In retirement accounts.

Michael DiJoseph: Right, retirement accounts. So now you’re retired and you’re ready to spend your money. Where are you going to spend it from?

Jason Method: From those accounts.

Michael DiJoseph: Exactly. That’s the conventional wisdom, but we actually think there might be a better way to look at this. We would say [to] start with required minimum distributions, RMDs, since they’re required by law anyway, and then spend your portfolio’s taxable cash flows—so the dividends and interest that the portfolio are kicking off. They’re already being taxed. If you reinvest them and spend them later, they’re going to be double taxed.

And then, next—and this is where we deviate a little bit and it gets a little bit counterintuitive—we would say, actually, take a look at the taxable portfolio. Instead of spending those retirement accounts right away, look at that portfolio and spend from there. Keep your eyes on tax-loss harvesting or, at the very least, gain minimization when you’re selling assets to generate that income.

And then, finally, once that portfolio is depleted, we would then turn our eyes to the tax-advantaged accounts, so the 401(k)s, IRAs, Roth IRAs, etc., and deplete those last.

Now, of course, this is a really complicated strategy, and it may not be right for each and every individual. Retirement spending is something that’s really dependent on each individual or each family’s unique goals.

Jason Method: Isn’t this all very client-specific? Doesn’t this require an advisor to spend a lot of time with the client discussing how this may interact with Social Security, how to do Roth conversions, plan out the different buckets, worry about taxes, and think about lifestyle choices?

Michael DiJoseph: It is, and it really does. So, again, we go back to this is another area where an advisor can add significant value to the relationship with the client that doesn’t involve managing the actual money. So it’s the other stuff that they’re doing, and we know that clients really value that face-to-face relationship—sitting down, understanding what their goals are, and helping them navigate the complex landscape that is retirement.

Jason Method: Excellent. That is a great point for us to end on, Michael. Thanks for being with us here today. We appreciate your time and insights.

Michael DiJoseph: Thanks so much for having me.

Jason Method: And thank you for joining us for this Vanguard Investment Commentary podcast. To learn more about Vanguard’s approach to retirement portfolios, check out our website and look for the new white paper, From assets to income: A goals-based approach to retirement spending.

And be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on Twitter and LinkedIn. Thanks for listening.


  • All investments are subject to risk, including the possible loss of the money you invest. The information presented in this podcast is intended for educational purposes only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions.
  • You may access and download this podcast only for your personal and noncommercial use. You may not use it in any other manner or for any other purpose without Vanguard’s written permission.

© 2016 The Vanguard Group, Inc. All rights reserved.