Academic studies and advisor conversations about retirement strategies typically focus on what withdrawal rates ensure that clients won’t run out of money. But what about those clients who seek to preserve their capital for the rest of their lives and beyond?
A confluence of factors like increasing longevity, historically low interest rates and high stock prices are prompting some advisors to rethink this entire subject. Some are concluding that clients who want to be sure they don’t outlive their money probably need to consider a withdrawal rate closer to 3% than the traditional 4% or 4.5%.
For those whose goal is to avoid “dipping into principal,” the quandary is more acute. This problem was the subject of a fascinating presentation from a different angle by Richard Marston, the James R.F. Guy professor of finance at the Wharton School, speaking at the Investments & Wealth Institute annual investment advisor conference earlier this year.
Imagine you were charged with managing a $100 million endowment with the goal of allowing it to give away money in perpetuity at a 3% rate. It’s the same problem, albeit with a different client.
Marston chose to examine this question with two different withdrawal rates, 3% and 5%, making it relevant to many types of retirees. He began his presentation, entitled “Investing in a World of Lower Returns,” by noting that industrial nations in the post-World War II era have been blessed by an extended period of peace and prosperity. Economies in North America, Japan and Western Europe have thrived thanks to early 20th century innovations. Marston cited the work of Northwestern University economist Richard Gordon who has argued that breakthroughs like electricity, antibiotics, running water and refrigeration changed the modern world far more dramatically than PCs and the internet.
Since 1951, equities as measured by the S&P 500 have generated 7.0% real returns while 10-year Treasury bonds have earned 2.6%. Marston’s 3% spending rule is applied to a portfolio that is 75% in stocks and 25% in bonds. Using these historical returns for endowment spending of 3%, Marston found there was a 25% chance the $100 million would grow to more than $263 million in inflation-adjusted terms during its first 20 years. There was a 20% chance it would grow to more than $120 million. Moreover, there was only an 18% chance it would decline by 18% or more.
There is one particular problem for U.S. private foundations. They are required to spend 5% annually by a 1981 law, a rate considered sustainable in the early 1980s. With a 5% rule, Marston found there was only a 50% chance of keeping the entire $100 million and a 10% chance that the portfolio would fall to $26.4 million in two decades.
Two Decades Of Low Returns
Since the financial crisis, there has been widespread discussion about the markets experiencing lower returns going forward. The fact that equities have soared in the last decade makes lower returns going forward even more likely, according to numerous academics.
Recently, a wealthy family asked Marston to develop an investment policy statement. He surveyed four private banks on what sort of investment returns they expected over the next 20 years. Many investment firms like to view the world through rose-colored glasses for marketing purposes, so the Wharton professor approached four private banks without brokerage arms.