The Floor-Leverage Rule for Retirement

The floor-leverage rule is a spending and investment strategy designed for retirees who can tolerate investment risk but insist on sustainable spending. The rule calls for purchasing a spending guarantee with 85% of wealth and investing the remaining 15% in equities with 3× leverage. Surprisingly, this leverage is a tool for managing risk. The authors compare the rule with some popular strategies, illustrate it for a variety of retiree preferences, and evaluate its historical performance. The floor-leverage rule is a spending and investment strategy designed for retirees who can tolerate investment risk but insist on sustainable spending. The rule calls for purchasing a spending guarantee, or floor, with 85% of wealth and investing the remaining 15% in an exchange-traded fund (ETF) or mutual fund that maintains a daily 3× leveraged exposure to equities. The equity or surplus account is reviewed annually, and if it exceeds 15% of total wealth, additional floor spending is purchased with the excess. Although the strategy uses a leveraged surplus account, the total portfolio is not leveraged; leverage is used as a tool to manage risk. Similar to the dynamics of constant proportion portfolio insurance, this strategy sells equities and reduces risk when markets decline. The authors found that using leveraged ETFs or mutual funds is a cost-effective, limited-liability approach to implementing this dynamic strategy. Floor investments and spending rates depend on a retiree’s preferences. A retiree with a preference for sustainable real spending should invest in Treasury Inflation-Protected Securities and expect an initial withdrawal rate near 3%. A retiree with a preference for sustainable nominal spending should invest in government bonds and initially withdraw about 4%. But if this retiree will consider purchasing a late-life annuity with some of her assets, a 5% withdrawal rate is feasible. The authors compared the floor-leverage rule with some popular strategies found in the literature on financial planning, private wealth management, and economics. They found that most of these rules are either quantitatively vague or unduly complex. But the floor-leverage rule, which approximates an optimal investment and spending strategy from the economics literature, strikes a balance between precision and simplicity. Although not optimal, the floor-leverage rule is a very good approximation to the optimal solution; it has at least a 98% efficiency compared with the theoretical optimal solution. Finally, the authors analyzed the floor-leverage rule by using historical equity returns. They found that although spending was always sustained, spending upside varied widely with equity returns. In fact, after 20 years of retirement, spending for retirees when equities performed well was nearly three times higher than when equities performed poorly. Spending tends to ratchet upward nicely until a traumatic market event. Although spending is preserved after the event, there is a lengthy stagnation in the spending rate. For example, the 1970 retiree took a substantial hit to the portfolio during the 1973–74 bear market and then had to wait until 1981 for a spending increase.