Thursday, October 27, 2011

Do-It-Yourself Safe Withdrawal Rates

I received a question today from the host of the “Retire Early in India” blog, which I'm enjoying reading through this evening. He had found an article I co-authored with Channarith Meng, which made an attempt to investigate the issue of sustainable withdrawal rates for 25 emerging market countries. This article appeared over the summer in the Journal of Personal Finance. It is called, “Safe Withdrawal Rates from Retirement Savings for Residents of Emerging Market Countries.”

He asked me, what is a safe withdrawal rate for someone in India, and how would it change for someone planning for a 60-year retirement?

First of all, most of the research about withdrawal rates is specific to the United States, and the above paper was meant mostly just to show how answers to this question can be quite different for other countries.  Emerging market countries have rather limited data, and so the idea was just to provide an overview.  I would not recommend using the results shown in the article for India for someone planning to retire in India.

This is because for new retirees, what really matters is what will happen with asset returns in the future, and not what has happened in the past. This notion is not original to me, but I did write an article which summarizes my concerns for recent US retirees called, “Retirement Withdrawal Rates and Portfolio Success Rates: What Can the Historical Record Teach Us?” It appears in the Fall 2011 Retirement Management Journal. I’ve summarized a key argument before on my blog:

Retirees now frequently base their retirement decisions on the portfolio success rates found in research such as the Trinity study. Studies such as those are fine for what they accomplish: they show how successful different withdrawal rate strategies were in the historical data. But it must be clear that this is not the information that current and prospective retirees need for making their withdrawal rate decisions. John Bogle makes clear why in his 2009 book, Enough. Though he was speaking about stock returns, the same idea applies to sustainable withdrawal rates, since they are related to the returns of the underlying portfolio of stocks and bonds. He wrote, “My concern is that too many of us make the implicit assumption that stock market history repeats itself when we know, deep down, that the only valid prism through which to view the market’s future is the one that takes into account not history, but the sources of stock returns” (page 102, original emphasis).

That argument is for the US.  But I think it applies even more strongly to rapidly growing emerging market countries. The future is unlikely to be anything like what was experienced in the past.

So, then, how can we decide on a “safe” withdrawal rate?

I have a new article forthcoming in the January 2012 Journal of Financial Planning called, “Capital Market Expectations,Asset Allocation, and Safe Withdrawal Rates.” It provides my best attempt to give an answer to this. And in thinking about it now, I realize that this article doesn’t discriminate toward any particular country. It is written for Americans and the historical data baseline is US data, but the approach laid out at the end of the article and the graphs I’ve created to accompany the article can be applied to someone living in any country of the world.

I explain how you need to make the best forecasts you can for the asset classes you plan to use [their means, volatilities, and correlations]. Then you use some software to construct what’s known in finance as the “efficient frontier.”  Then you can overlay this efficient frontier onto some graphs I’ve made which are included here, which show lines for maximum sustainable withdrawal rates for different portfolio returns and volatilities, and for different retirement durations and different accepted failure rates.

From this overlay, you can find the point on the efficient frontier which allows for the highest maximum sustainable withdrawal rate. Then you check what the asset allocation is for this point on the efficient frontier, and now you have just found your recommended withdrawal rate and recommended asset allocation for the retirement duration and acceptable failure rate you’ve chosen.

As most safe withdrawal rate studies are created using very specific assumptions about portfolio returns and volatilities, I think the approach I’ve described in the article removes those constraints and allows users to consider any possibilities. These possibilities could be about including a role for market valuations, including additional asset classes like REITs or international funds, or for someone in another country just doing the analysis for their own case in terms of their own currency.

And so, I cannot personally say what the sustainable withdrawal rate is for someone in India, because I do not know what kind of expected returns and volatilities are feasible for someone living and investing there. But I do think you can use the framework I’ve described  in that article to come up with a suitable answer for yourself.

About the issue of a 60-year retirement, so far I’ve only looked at cases of retirements up to 40 years. Sustainable withdrawal rates do get lower as the retirement period lengthens, but they get lower at a decreasing rate. The specific answer would depend on the assumed portfolio returns and volatilities, but if I’d have to give a quick guess about this, my guess is that it would not be too far off base to assume that the sustainable withdrawal rate for 60 years is 1 percentage point less than for 30 years.  For example, 4% would become 3%. Again, that is just a guess.

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