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.
Rob Brown, PhD, CFA, is the Chief Investment Strategist for United Capital Financial Advisers, LLC. The views expressed are his, and may not reflect the position of United Capital.