Planning and Annuities

Ensure Financial Security

Retirees commonly fear finding their savings depleted while they are still alive. Other concerns pale in comparison. The obvious challenge is ensuring that limited capital provides an income that lasts a lifetime.

Most investors focus on market risk and rate return as the main factors affecting how long their portfolio will last. However, there is another important variable that is directly under their control: the withdrawal rate. Retirees can draw valuable lessons from a careful examination of how much can be safely withdrawn from a portfolio without depleting the whole nest egg.

While it might be simpler to use "average" returns when planning, in real life returns are variable. An invaluable resource for studying this problem is a paper entitled by Retirement Savings: Choosing a Withdrawal Rate That is Sustainable by three professors from Trinity University–Philip Cooley, Carl Hubbard, and Daniel Walz. The authors focused on actual historical annual stock and bond returns rather than average historical performance.

The Study, Simplified

Using annual stock and bond returns from 1926 to 1995, the authors looked at five possible portfolios ranging from 100% stocks to 100% bonds, and evaluate the impact of fixed annual distributions ranging from 3% to 12% of the initial portfolio value. Stock returns are represented by the S&P 500, while long-term, high-grade, domestic corporate bonds were the proxy for the bond portfolio. The authors examined each portfolio/distribution combination over four payout periods ranging from 15 to 30 years, and calculated the probability of maintaining a given withdrawal amount for each period. A successful portfolio was one that had a terminal value greater than zero at the end of the period.

They repeated the entire process for withdrawals with inflation adjustments. For added comparison, the exercise was duplicated using only the past 50 years' data. As one might expect, eliminating the Depression improved results across the board. Finally, they compiled a terminal value range for each portfolio.

The Findings

Obviously the highest success rates are generated with smaller withdrawal rates At a 3% withdrawal rate, a 100% success rate was achieved with every portfolio, regardless of composition, for every time period.

At 4% and 5% withdrawals, the benefits of asset allocation begin to emerge. Portfolios with some bonds fare better than 100% equity portfolios. On the other hand, an all-bond portfolio has only a 51% chance of lasting over a 30-year period at a 5% withdrawal rate. Clearly, bonds alone are not the ideal solution for retirement accounts. But by reducing portfolio volatility, the use of some bonds can improve success ratios, assuming reasonable withdrawal rates.

At 6% withdrawals, the three mixed stock/bond portfolios outperform either all stocks or bonds. One retiree in ten would have gone broke with a 100% stock portfolio. Only 27% would have had their money last 30 years with a 100% bond portfolio. The 25%/75% stock/bond mix produced a 100% success rate.

Assuming 7% withdrawals, a 50%/50% blend is the optimal mix. Even so, this combination only produced a 90% chance of success. Little consolation for the remaining 10% of investors!

Once withdrawal rates go above 7%, the results are much less favorable. Because of higher average returns, stock-heavy portfolios beat those focused on bonds. But risk of failure also increases dramatically. Though the best returns are achieved with a portfolio composed only of equities, an 8% withdrawal rate fails more than twenty percent of the time.

It should come as no surprise that increasing withdrawal rates to offset inflation further stressed the portfolios and increased failure rates.

Complications

A significant limitation of the study's data is that raw index numbers were used. No adjustment was made for fees or other expenses. Even the cheapest index funds involve such costs, which would decrease real returns. While a select few investors may be able to regularly outperform the indexes even after expenses and thus enhance their portfolio success rates, it would be risky to base a retirement plan on such an assumption.

It's highly possible that a more-sophisticated asset-allocation plan would increase success rates. Unfortunately, the data on alternative asset classes is not available over the study's entire period. So, we are unable to directly "prove" that assumption with parallel data.

The authors are silent on their end-of-year rebalancing strategy. I assume that the distributions were drawn proportionately from both the stock and bond portfolios. It's probable that a policy of harvesting bonds during bad years and stocks during good years would have increased success rates. However, any such gains would not dramatically improve results.

For all the above reasons, it would be very unwise to inflate the study's return assumptions for planning purposes.

Lessons

The moral is clear: Asset allocation matters, but even with the best mix chances of failure rise directly with withdrawal rates. Any withdrawal rate exceeding 6% of the initial portfolio value produces a significant likelihood that a portfolio won't last the duration.

Fortunately, the withdrawal rate is directly under the control of the retiree. Retirees that stress their portfolios with excessive withdrawals run a serious risk of exhausting their capital during their lifetimes. This danger is particularly great for inexperienced investors who often tend to seriously overestimate the appropriate sustainable withdrawal rates.

Here are a few important guidelines to bear in mind:

1. More is better than less in a retirement nest egg.
2. It's never too early to begin to accumulate a sizable retirement nest egg. Each day of delay only increases the chance of not having enough.
3. Those that don't have enough when retirement comes around must consider downscaling their lifestyle or bear an increased risk of financial disaster down the road.

The study's assumption that a retiree will continue a fixed dollar withdrawal program regardless of investment results is, of course, simplistic. However, without this assumption or something like it, no models of any kind could have been derived. In fact, a retiree may be in a position to temporarily decrease withdrawals during down markets until his capital recovers. Or, assuming early results in excess of expectations, the retiree may elect to increase withdrawals as capital increases. In many cases, terminal values were a gratifying multiple of starting capital. So, mid-course adjustments to withdrawal rates are possible and may very well be positive.

If income requirements are variable or capital permits, an alternative policy of making fixed percentage withdrawals against the annual principal values may be an acceptable solution for many retirees. This policy will provide a variable income stream that is automatically adjusted for investment results.

Retirees that can accept a variable income, and withdraw a constant percent of remaining capital rather than make fixed dollar withdrawals, never face the prospect of zeroing out their accounts–no matter how bad their investment results are in the short term.

However, this option is generally only acceptable to retirees with modest income needs relative to their available capital. And this observation leads us back to the concept of planning early to have enough for a stress-free and enjoyable retirement.

Adapted from a column by Frank Armstrong, a fee-only financial planner. The article appeared on the Morningstar internet website, which can be visited at: www.morningstar.net.