• Probability of Failure: 5 percent. There is a 95 percent chance that the retiree will be able to withdraw an inflation adjusted $40,000 for all 30 years of retirement.
• Cost of Surplus: 20.8 percent. On average, 20.8 percent of the initial portfolio value ($208,000) ends up as excess funds that were not used during retirement. Looked at another way, the retiree could have spent $208,000 more in today’s dollars over the course of retirement if he had utilized an optimal withdrawal strategy.
• Risk-Adjusted PV of Withdrawals: $795,000. The value of all withdrawals adjusting for the time value of money and the higher relative value of cash in future states of the world where security returns are lower.
We applied a number of simple dynamic spending rules and then recomputed the three statistics to show the improvement relative to the 4 percent rule. One potential rule is to withdraw 4 percent of the current, instead of original, portfolio balance, subject to a floor. For more conservative retirees willing to live on $30,000 in down markets, we can set the floor at $30,000. This reduces the probability of failure from 5 percent to 1.1 percent while maintaining a similar cost of surplus (21.1 percent) and risk-adjusted present value of withdrawals ($790,000).
For investors who are willing to take more risk in return for higher potential withdrawals, we can set the floor at $40,000. This reduces the cost of surplus from 20.8 percent to 14.6 percent and the risk-adjusted present value of withdrawals from $795,000 to $856,000, while leaving the probability of failure nearly unchanged at 5.3 percent.
We can get even better results by making our rule more dynamic. One way of achieving this is to choose the percentage of the current portfolio value withdrawn based on the ratio of current portfolio balance to years of retirement remaining. For example, if we have less than $30,000 per year of retirement in the portfolio, we will withdraw 4 percent, if we have $30,000-$40,000 per year of retirement we will withdraw 5 percent and so on. With this strategy we improve on all three metrics: The probability of failure is 1.8 percent, the cost of surplus is 6.1 percent and the risk-adjusted present value of withdrawals is $940,000.
These dynamic withdrawal rules improve on the 4 percent rule because they are reactive to the realized market path, not predictive. Predictive models are most effective when current market conditions mirror history. The traditional 4 percent rule depends strongly on the assumption that future markets will look like past markets.
Despite all this talk of dynamic withdrawals, some level of stability for withdrawals is necessary for budgeting purposes. It seems best for withdrawals to be dynamic, but not changing daily like the financial markets.
Continuing with the theme of matching the nature of spending with that of the funding source, portfolio behavior should in turn be more stable. Most individuals and firms have little to no ability to control the financial markets, so how can they possibly make portfolio returns more stable?
More stable portfolio behavior can be achieved using quantitatively enabled tactical strategies to protect against drawdowns. By effectively safeguarding capital in turbulent market regimes, investors with specific withdrawal needs can increase spending without an increased probability of prematurely exhausting their asset pool.
We illustrate the value of combining dynamic withdrawals and drawdown management with an example. Assume that the retiree uses the withdrawal strategy whereby the percentage withdrawn varies depending on the ratio of portfolio value to years remaining in the retirement horizon. In addition, assume that portfolio drawdowns are limited to 10 percent. With these assumptions, the probability of failure is reduced to zero, the cost of surplus to 1.8 percent and the risk-adjusted present value of withdrawals to $1,013,000. Combining dynamic withdrawal management with downside portfolio protection can allow retirees to spend more in retirement while also having more peace of mind that their nest egg with last.
However, for drawdown protection to be truly successful in a retirement context, it must not only avoid large losses but also do so without sacrificing too much upside. This requirement along with continued elevated correlation levels across asset classes eliminates most traditional portfolio risk management techniques, including options and diversification, from consideration. In today’s market environment, tactical portfolio management provides the best avenue to achieve the necessary asymmetric return profile in a cost-effective manner.