Sustainable withdrawal rate with cap and collar inflation adjustment

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The assumption under Bengen’s rule is that withdrawals are adjusted for inflation throughout retirement. This includes periods of double-digit inflation, for instance between 1915-1920 and most of the 1970s.

This also means that during deflationary periods, retirees have to reduce spending, in line with falling cost of living. While the real spending power of each year’s withdrawal remains the same, it could be a challenge explaining this to the client.

A simple way to deal with these extremes is to apply a rule-based approach that sets an upper and lower limit for each year’s inflation adjustments. This way, retirees can avoid extreme changes to their income withdrawal, at least in a nominal sense.

A cap-and-collar approach improves the sustainability of the portfolio and aligns better with the typical spending pattern for most retirees. Income increases but at a slower pace than inflation.

In this video, I’ve applied a cap of 5% to inflation and a collar of 0%. (Advisers can model any combination of cap and collar using the Timeline web app.)

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