The Floor-Leverage Rule for Retirement

Abstract

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.

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

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