Sustainable withdrawal
A sustainable withdrawal rate is a projection, based on historical data, of the maximum annual amount that may be withdrawn from a portfolio at the start of retirement. One of the common questions facing an individual upon withdrawing money from his or her portfolio is, "How much can I withdraw safely?" Conversely, the retiree wonders, "How long will my portfolio last?" Unfortunately, as will be shown, the answer to these questions depends not only withdrawal rate and the underlying rate of return of the portfolio, but also on the variability of returns and the sequence in which good or bad years occur.
The decumulation method discussed in this article calls for constant dollar amounts to be withdrawn every year (with adjustments every year for inflation), so a clearer name for it is the "constant real dollar method", which constrasts it with strategies that call for flexible spending. In previous, mostly US, studies, the constant real dollar method has had good success producing income for 20 or 30 year retirements, but "sustainable" should not be confused with "perpetual".
 | The constant real dollar strategy is often called "the 4% safe withdrawal rule", and is often considered a "rule of thumb". However, because it is based on past returns, not future returns (which are unknown), there can be no guarantee that a retiree withdrawing a fixed inflation-adjusted 4% of his or her initial portfolio will not in fact run out of money. Thus, the "4% rule" should be considered no more than a starting point. |
Initial studies
Bengen (1994)[1] used US data on stocks and bonds from 1926 to the early 1990s to look at what initial rates of withdrawal would have worked in the past, in terms of retirement length and asset allocation. The objective of the retiree is to avoid complete portfolio depletion before death ("ruin"), while spending a constant inflation ajusted dollar amount. The retiree is assumed to withdraw a percentage of the initial portfolio, between 1% and 8%. This provides the withdrawal amount in year 1. For example, a 4% initial rate yields a $40k withdrawal on a $1M portfolio. The withdrawal amount, in dollars, is then adjusted yearly to keep up with inflation, hence the name "constant real dollar".
With a 50% stocks, 50% bonds portfolio, a 3% initial rate was always sustainable over 50 years or more, based on past experience. With a 4% initial rate, the portfolio would have always lasted 33 years or more. Increasing the initial rate to 5% was dangerous in the past, with portfolios lasting as little as 20 years. Results would have been better with 75% stocks, given the high stock returns during the studied period. Based on this, Bengen concluded that for a 30 year retirement, a 4% initial rate should be safe in the future, based on past experience, with a portfolio of 50-75% stocks and the rest in bonds.
This was followed by an study by three professors at Trinity University, commonly called the Trinity Study.[2] The conclusion of this work was also that a withdrawal rate of 3-4%, adjusted for inflation, would not exhaust a portfolio of stocks and bonds over 30 years. The Trinity study is discussed in detail by the Bogleheads wiki under Safe withdrawal rates.
4%, really?
Finke et al. (2013) write that "the success of the 4% rule in the U.S. may be an historical anomaly" and that using it in a low interest rate environment may lead to high failure rates.[3] Examination of safe withdrawal rates in countries other than the US, using 109 years of data for 17 developed market economies, shows that a 50% stocks, 50% bonds portfolio cannot typically sustain 4% withdrawal over 30 years.[4]
MacDonald et al. (2013) report that "most studies that support a fixed 4% withdrawal rate are based on pre-expense withdrawals", i.e. investment fees were not taken into account.[5]
Effect of market valuations
Suppose that Anne and Gilbert have saved $1 million in 2008, and the market crash reduces their portfolios to $800,000 in 2009. Anne, however, retires in 2008 while Gilbert waits until 2009. The constant real dollar method bases withdrawals the value of their portfolios at the start of retirement. As a result, even though their situations are almost identical, with a 4% rule, because Anne retired in 2008 she is allowed to withdraw $40,000 plus inflation adjustments in 2009; while Gilbert, despite being in an almost identical situation, would be allowed only $32,000 in 2009.
This absurd example results from the same initial withdrawal rate (here, 4%) being applied regardless of current valuations. But Pfau[6] has suggested that market valuations can be used to estimate sustainable withdrawal rates. He says:
This study suggests that a 4 percent withdrawal rate cannot be considered as safe for U.S. retirees in recent years when the cyclically-adjusted price-earnings ratio has experienced historical highs and the dividend yield has experienced historical lows. What must be clear, as I explain at length in the article, is that the events that have taken place since about 1990 have very little impact on the results of the updated Trinity study, even though it uses data through 2009. What we have experienced in terms of record-high PE10 levels and record-low dividend yields during the past 15 years explain why the model predicts sustainable withdrawal rates falling below 3 percent since 1999, and even below two percent in the years since 2003.
Sequence of returns risk
Should a retiree be unfortunate enough to run into a bear market - that is, a severe drop in stocks - during the first few years of retirement, the portfolio will be further depleted by withdrawals and may never recover.[7] Conversely, if the retiree is fortunate enough to have good returns in the first few years, sufficient reserves may be built up that the portfolio is never depleted and a significant estate remains.
Consider the following graphs. The left-hand graph shows the actual S&P 500 return sequence from 1970 to 2000 (blue line) as well as the return sequence ordered from best to worst (green line) and worst to best (red line). The right-hand graph shows the effect of a constant withdrawal, unadjusted for inflation, of 6% of the initial amount. This gives a relatively constant residual portfolio based on the actual return sequence (see the blue line in the right-hand graph), and a larger estate if the returns are ordered from best to worst. However, if all the bad returns had been clustered at the beginning, the portfolio will be exhausted in 34 months.[8] This effect is called sequence of returns risk.[9]
According to Pfau (2014), solutions to reduce sequence of returns risk include varying spending in response to market performance and reducing portfolio volatility (downside risk).[7]
Probability of ruin
The term "Probability of Ruin" has been used by Milevsky[10] to cover the concept that a retiree may run out of money during retirement. The calculation can be performed on spreadsheets available from QWeMA[dead link], as well as additional calculations discussed in a 2012 book.[11] Alternatively, a simple Excel spreadsheet that is based directly on the IFID paper is available here.
Alternative strategies
If there is a good chance that the retiree may run out of money, he or she may wish to consider alternatives. The simplest strategy is to vary the withdrawal amount, spending less following years with poor returns. Another alternative is to consider purchasing an annuity with some of the available funds, since this will provide a guaranteed lifetime income. Very sophisticated investors may also consider purchasing put options to guard against a major market drop. Milevsky and Macqueen[12] have championed the purchase of "Guaranteed Lifetime Withdrawal Benefit Products" from life insurance companies to supplement pensions and portfolio withdrawals.
Any chosen strategy that involves transfer of risk from the retiree to another party will incur additional costs.
See also
Calculators
- The QWeMA Group (academic papers and calculators)[dead link]
- Firecalc
- Pfau market valuation spreadsheet[dead link]
There are also several withdrawal spreadsheets at gummy stuff.
References
- ^ Bengen WP (1994) Determining Withdrawal Rates Using Historical Data, Journal of Financial Planning, January 1994, p. 14-24, viewed January 26, 2024.
- ^ Cooley PL, Hubbard CM, Walz DT (1998) Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable, AAII Journal, v. 10, p. 16–21, also available on ResearchGate
- ^ Finke MS, Fpau WD, Blanchett D (2013) The 4 Percent Rule is Not Safe in a Low-Yield World, Journal of Financial Planning, v. 26, p. 46–55, viewed February 7, 2018, available on SSRN
- ^ Pfau WD (2010) An International Perspective on Safe Withdrawal Rates: The Demise of the 4 Percent Rule?, Journal of Financial Planning v. 23 p. 52–61, viewed February 7, 2018, available on SSRN
- ^ MacDonald B-J et al. (2013) Research and Reality: A Literature Review on Drawing Down Retirement Financial Savings. North American Actuarial Journal, v. 17, p. 181-215, viewed April 2, 2018.
- ^ Pfau WD (2011) Can We Predict the Sustainable Withdrawal Rate for New Retirees?[permanent dead link], Retirement Researcher Blog, Monday May 6, 2011. Viewed June 12 2012.
- ^ a b Pfau WD (2014) The Lifetime Sequence of Returns—A Retirement Planning Conundrum, Journal of Financial Service Professionals, v. 68, p. 53-58, viewed February 7, 2018, available on SSRN
- ^ "gummy", about Random Walks and Investing, viewed June 11, 2012.
- ^ Annuity Digest, Sequence of returns risk, viewed June 12, 2012.
- ^ M.A. Milevsky, Sustainability and Ruin, IFID Center Research Magazine, April 2007.
- ^ Milevsky, Moshe A. (2012). The 7 Most Important Equations for Your Retirement: The Fascinating People and Ideas Behind Planning Your Retirement Income. John Wiley and Sons, Canada Ltd. ISBN 978-1118-29153-5.
- ^ Milevsky, Moshe A.; Macqeen, Alexandra C. (2010). Pensionize Your Nest Egg. John Wiley and Sons, Canada Ltd. ISBN 978-0-470-68099-5.
Further reading
- Financial Wisdom Forum topic: "Sustainable Withdrawal Rates"
- Financial Wisdom Forum topic: "Pensionize Your Nest Egg"
