Sustainable spending is an important retiree preference. For millions of current and future retirees, the bulk of their savings will be in self-directed accounts. These retirees need strategies to manage their assets and budget their drawdowns, indicates Jason S. Scott and John G. Watson, authors of “The Floor-Leverage Rule for Retirement” featured in the Financial Analysts Journal, September/October 2013.
There are several recommended strategies for investment portfolios in retirement: 50% stocks and 50% bonds; 4% strategy; the “bucket” approach or split-account approach; constant proportion insurance (CPPI); or an annuity. This discussion focuses on another strategy proposed by Scott and Watson: floor-leverage rule.
The floor-leverage rule combines a portfolio for sustainable spending with a growth portfolio. Let’s go through the three-step process:
- Step 1 is to build a floor portfolio with 85% of the money invested in bonds or an annuity that pays out a specific rate. This bond portfolio can be a ladder, a zero-coupon Treasury Inflation Protected Securities (TIPS) or an annuity that will guarantee a sustainable rate of spending throughout retirement.
- Step 2 is to invest the remaining 15% in a portfolio of stocks that are leveraged 3:1, also known as the surplus portfolio.
- Step 3 is to annually review the surplus portfolio, and if it exceeds 15% of the portfolio, add the excess to the floor portfolio in step 1.
The floor-leverage rule allows for a portion of the portfolio to be at risk while maintaining a sustained spending rate. Due to the borrowing that is in the leverage portfolio, this portion can lose significant amounts. A person who is averse to leverage or risk may dislike the portfolio; however with only 15% allocated to risk, the investor is limited to a 15% loss.
In 2008, investors would have lost roughly 13% of the portfolio value. Because the leverage portfolio incurs borrowing costs and volatility, there is a potential drag to the portfolio that does not allow for exactly three times the market performance.
Scott and Watson analyzed the historical returns. The worst returns came when stock valuations were the greatest in 1960 and then again in 2000. We do not yet have 20 years of returns from the peak in 2008. 1960 was the only starting period that fell short of a withdrawal rate of less than 7.17%.
What the authors did find was that the floor-leverage rule enables individuals to sustain spending with a potential for increases due to the leverage of the surplus portfolio.
The floor-leverage portfolio accomplishes two things. First, it provides a sustainable rate of spending in retirement. And second, it provides a level of growth with the stock market, although the investor is still at risk investing at a time when the market is overvalued as it was in 1960 or 2000. While the benefit is that the investor has a sustained level of spending, losing almost the entire surplus portfolio may be gut-wrenching and the emotional impact too great for an investor to continue with the planned strategy.