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The Floor-Leverage Rule for Retirement

Jason S. Scott

Financial Engines, Inc.

John G. Watson

Financial Engines, Inc.; Stanford Graduate School of Business

November 18, 2011

Financial planners assume that retirees have a strong preference for consistent, predictable spending. Their widely used rule of thumb, the 4% rule, was developed to identify the maximum spending level that could be maintained throughout retirement. In stark contrast, the standard advice from financial economist may result in large fluctuations in spending. We reconcile these disparate views by augmenting the utility maximization framework of financial economists with the strong preference for consistent spending identified by financial planners. The resulting optimal strategies allocate a significant portion of retirement wealth to a floor portfolio invested in high-grade bonds to guarantee the current level of spending. All remaining wealth, the surplus portfolio, is invested in a leveraged equity position. If equities perform well, spending increases and money is transferred from the surplus portfolio to the floor portfolio. Surprisingly, we find that an 85% floor allocation and a 3x leveraged surplus portfolio is near-optimal across a wide range of retirement case studies. We refer to this general strategy as the Floor-Leverage rule for retirement.

Number of Pages in PDF File: 26

Keywords: Retirement, spending, investing, ratchet, consumption, floor, leverage

JEL Classification: D11, D91, G11, H31, J26

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Date posted: November 20, 2011  

Suggested Citation

Scott, Jason S. and Watson, John G., The Floor-Leverage Rule for Retirement (November 18, 2011). Available at SSRN: https://ssrn.com/abstract=1961791 or http://dx.doi.org/10.2139/ssrn.1961791

Contact Information

Jason S. Scott (Contact Author)
Financial Engines, Inc. ( email )
1050 Enterprise Way, 3rd Floor
Sunnyvale, CA 94089
United States
John G. Watson
Financial Engines, Inc. ( email )
1050 Enterprise Way
Sunnyvale, CA 94089
United States
Stanford Graduate School of Business ( email )
655 Knight Way
Stanford, CA 94305
United States

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