Before the Great Recession and Great Bear Market of 2007 to 2009, it was considered to be eminently reasonable and prudent for people to take a withdrawal rate of 4% from their portfolios after they retired. But after the market collapse, some have suggested that those withdrawals should be closer to 3% if the money is going to last throughout a person’s lifetime. But I suggest that the sustainable withdrawal rate is closer to 5%, and also that those investors in the withdrawal phase are likely underallocating to stocks because of their misguided reliance on risk-tolerance questionnaires.
One of the more common ways of finding a suitable withdrawal rate starts with a forecast of the future rates of return and the level of inflation. But such an approach means the analyst will be making predictions about the future. I make no attempt here to forecast the future returns of stocks, bonds or inflation.
Instead, my analysis relies on historical data, specifically the monthly total returns provided by Global Financial Data (a San Juan Capistrano, Calif., firm) from September 30, 1875, through June 1, 2013. A look at robust data from the last 138 years allows us ways to think about the future (it contained, for instance, three different depressions).
By using past returns, I am implicitly assuming that future returns will be similar to past ones, though the way we get there may be different. (The stocks in my analysis are represented by the S&P 500, while for bonds I use 10-year U.S. Treasurys and for inflation the All Urban Consumer Price Index.)
Let’s assume we have a couple who have just retired with $1 million of investable liquid assets (Figure 1). They want to invest it in some combination of stocks and bonds.
In this example, the withdrawal period of 353 months (29.42 years) could be thought of as the couple’s prime retirement years. At the end of this period, an end-of-life annuity contract would kick in, funding any potential remaining years.
Simulations And Results
Using the 138-year data set, I looked at exactly 1,300 separate and distinct 353-month-long retirement windows. Each window framed a uniquely different financial journey, and many of these passed through one of the depressions. Figure 2 shows the results the couple would have seen if they had invested everything in stocks.
Note that if the couple annually withdrew $41,940 (an initial 4.194% of the starting principal), they had a 5.00% probability of running out of money before the end of their almost 30-year retirement window. Even more instructive is what happened if they included bonds in their portfolio, which significantly increased the likelihood of exhausting their money (unless they drew down at the lowest percentages). These results are shown in Figure 3.
If the couple shifted from 100% stocks to a 50/50 stock/bond mix, they increased their probability of running out of money from 5.00% to 10.31% at the initial 4.194% starting principal withdrawal rate (the $41,940 figure). Figure 4 shows the lowest risk portfolios for different starting annual dollar withdrawal rates. Recall that the term “lowest risk” means the portfolio has the least likelihood of running out of money before the end of the retirement window.
For initial withdrawal rates at or below 3.75% ($37,500 of the $1 million initial investment), the lowest risk portfolio was 70% stocks and 30% bonds. Such a portfolio generated a 0.00% probability of failure. In other words, it never failed during the 1,300 unique trails that incorporated the three different depressions. However, for withdrawal rates at or above 4.516%, the lowest risk portfolio was 100% stocks. Initially, one might find such a result counterintuitive, i.e., that stocks deliver a more conservative and safer journey than bonds. But recall that in extended withdrawal scenarios (in this example, almost 30 years long), growth is of absolute importance and the stability that results from the inclusion of bonds is of minimal relative importance. For extended periods, growth trumps stability. Thus, the all-equity solution dominates mixed stock/bond portfolios.
4% Failure
September 4, 2013
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Comments
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Quote: “A couple taking $47,500 annual withdrawals would have run out of money during their 237th month, only 67% of the way through their retirement†Easy for him to say, its not his money. If his client runs out of money, does he just shrug, say “And It’s Gone,†( http://www.youtube.com/watch?v=-DT7bX-B1Mg ) and wait until he gets sued? Would you go skydiving if the jumpmaster said its possible there's a 57% chance your chute won't open?
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Nice article. To those who follow this advice...make sure your E&O is paid up, and get ready to go to court. There is not a client alive who will not S^%T the bed if their life savings see a draw down of 20%. In the real world (not the academic world) they will be calling you asking / telling you to get them out. Then what happens to the returns and probability of failure? Next they will be shopping a lawyer who will take their case and ding your U-4. Remember, your U-4 is the only thing that will prevent you from getting new clients in the future.
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Rob, I agree with ShaneBarber. There are a lot of additional factors to consider. Most importantly, why no mention of the impact of the advisor fee? Clearly, an additional 1%+ in annual fees needs to be accounted for and will materially reduce the safe withdrawal amount. Also, the methodology only looks at full 30 year periods, so we have no data on the most relevant period which is the one we are in now. No way someone who retired in 2000 or 2007 with a safe withdrawal rate of 5% and 100% in equities will have survived just fine. Your research does not include this information because the 30 year period starting from 2000 has not ended. It just seems to me that too many advisors are using "fuzzy" math to get to a pre-determined conclusion. Why not consider a low cost income guarantee in conjunction with a higher equity allocation. Put a floor in place and then try to maximize returns.
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Rob, ALL risk tolerance questionnaires are flawed. They simply identify how much risk a couple is WILLING to assume at a given point in time...specifically, the day they fill it out. Beyond that day, it means nothing. What is more important, and you never get there in your article, is how much risk they NEED to assume in order to achieve their individual retirement goals. If the answer is zero, they shouldn't be assuming risk at all. Rules of thumb, like the 4% rule, are silly. They're meant to give someone a rough idea of what they might be able to safely generate from their investments, but nothing more. Every couple has different needs and goals, dreams and desires, and those are what an advisor should be focused on. After all, if you aren't helping your clients achieve those things, you aren't doing your job. I understand what you are getting at in the article, and it has merit, but focusing on the allocation, or the withdrawal stream, without considering the things I just mentioned, is a waste of time, and an abdication of an advisor's responsibility to his clients. Additionally, your model doesn't take into account the effects of taxation of money coming out of different tax buckets on the overall success of the withdrawal rate. If the money is tax deferred, the increased withdrawals to keep up with inflation will result in a larger and larger tax bill, while taxable money, or tax free money will not. The same goes for the taxation of their social security income, as withdrawals from tax deferred accounts will cause more and more of the couple's social security income to be taxed as ordinary income, further complicating things. Even income from municipal bonds counts toward the taxation of social security benefits, so they lose a lot of their appeal as an income source once the couple has elected to start social security. My point is that this is way more complicated than a simple withdrawal percentage and asset allocation problem. If you consider the allocation and withdrawal percentage, along with all of the things I've mentioned, as a whole, it will dramatically affect a couples probability of running out of money before they run out of life. In fact, you will find serious doubt cast on your conclusion that a larger allocation to stocks is a wise decision in a host of cases.
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