4. Annuitizing Payouts
The bond market and insurance products are valuable reference points for estimating a benchmark, but at some point you’ll need to crunch the numbers directly for a deeper level of perspective. There are several possibilities, including a foundational concept for projecting an annuitized stream of payments via Excel’s PMT function.
Two veterans of the institutional money-management world recently explained that “constructing a spending rule is itself an annuitization problem at heart but does not require purchasing an actual annuity.” Spending down an investment portfolio in an annuitization-based framework can be effective, too, advised M. Barton Waring (former Barclays Global Investors strategist) and Larry Siegel (advisor to Ounavarra Capital and the former director of investment research at the Ford Foundation) in this year’s January/February issue of the Financial Analysts Journal (“The Only Spending Rule Article You Will Ever Need.”)
Calculating payouts with a periodic re-annuitization method comes in two basic flavors—one for a portfolio of “riskless” assets (government bonds) vs. a risky portfolio (i.e., stocks, bonds, etc.). The key issue, the authors emphasized, is recognizing that the spending estimate must be recalculated throughout the spending period to reflect changing conditions.
5. Modeling Uncertainty
Another actuarial-based framework reverses the modeling focus by estimating the probability of ruin for a given withdrawal rate. The goal is figuring out the potential risk that a portfolio will run dry too soon. Rather than approximate the optimal withdrawal rate, this methodology identifies the price of so-called “ruin risk” for a given spending plan.
The analytical details tap into some high-level mathematics, but the heavy quantitative work has been boiled down to a single formula that’s easily executed in Excel, according to two finance professors at Canada’s York University—Moshe Milevsky (a leading authority on retirement issues) and Chris Robinson. For details, see their 2005 essay in the Financial Analysts Journal (“A Sustainable Spending Rate Without Simulation.”)
The stochastic present value (SPV) approximates the risk of ruin based on four inputs:
• Life expectancy at the time of retirement
• Expected withdrawal rate
• Expected average portfolio return
• Expected portfolio volatility (standard deviation)
The garbage-in-garbage-out caveat applies, but assuming reasonable estimates, the SPV formula offers a quantitative tool for evaluating the risk that’s embedded in a given spending plan.
Take, for example, a 65-year-old at the start of retirement with a life expectancy of 19 years (the median for that age group), a 4% withdrawal rate and an investment portfolio of stocks and bonds that are projected to earn an annual return of 7% with 20% volatility. His probability of running out of money is 12.3%, according to SPV’s estimate. Too high? Drop the rate to a 3% withdrawal rate and the probability of ruin risk falls by around half, to 6.7%. Another way to reduce the ruin risk without paring the spending rate: design a portfolio that, all else equal, exhibits less return volatility, according to SPV projections.