Friday, July 13, 2012

Safe Withdrawal Rates in a Low Return World


The message of today’s blog entry is simple and obvious. That is, sustainable withdrawal rates depend on the underlying portfolio returns and volatilities. The following figure shows how just how important these connections can be. Now we are in a low-yield environment, and further decreasing returns from already low points cause accelerating increases in failure rates.

In a low interest rate environment, assuming that portfolio characteristics will match historical averages will result in overly optimistic expectations for low failure rates.

Update: this is for a 4% inflation-adjusted withdrawal rate.

10 comments:

  1. What is the assumed withdrawal rate? 4% with inflation indexing?

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    1. Oops, I forgot to mention. Yes, 4% with inflation adjustments.

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  2. Since the Monte Carlo uses annual returns, then shouldn't the SD also be on an annual basis? The annual SD for the market is about 37%, but then again, I do not know the makeup of the allocation

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    1. Both the returns and SD are annual. There is no particular asset allocation, as I am just illustrating the impacts of different assumptions.

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  3. Wade ... I propose a new rule ... everytime you give some bad retirement news like this, you need to have a corresponding post that has something happy, like this video:

    http://www.youtube.com/watch?v=jFOqAuxbCzE&feature=results_main&playnext=1&list=PL4E634299BB057984

    Let's call it the "bad news / care bear ratio", or something like that.

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    1. That's a good idea. I should add more good news. I'll try to think of something.

      People are living longer and are more healthy!

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  4. Idea for research ....
    You have shown on your graph of max sustainable rates in past, that the current dividend yield of the S&P has provided a floor for the SWR. Never has the SWR at retirement been lower than the yield at that time when the portfolio is 100% stocks.

    That idea has led a lot of dividend investors to promote the idea that as long as you only spend your dividend income in retirement, you will never run out of money.

    That in turn has led to the idea that if you don't feel like living off the current 2.5% S&P yield, you simply own stocks with a higher yield, and presto, you are free to spend their (eg) 4% without any risk of failure.

    Is is possible to do some back-testing of the viability of (say) a 30 stock portfolio of the S&P components at the time of retirement that yield (say) 1% more than the then current index yield. Start with the years 1960-1965 when the SWR was touching the dividend yield to start with.

    This would help answer the question, "Are slightly higher yielding stocks just as sustainable". The dividends do provide some protection from sequence of returns risk (see second page of spreadsheet http://www.retailinvestor.org/DivVsGrowth.xls ).

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    1. Thanks, it is an interesting idea. I haven't done much to explore that. In Bill Bernstein's new e-book, he thinks it is reasonable to consider the amount equal to half of the current dividend yield times wealth as a reasonably safe inflation-adjusted amount, since dividend amounts can fall.

      The trouble is that with potential capital losses, it is not clear that just because the strategy worked in the past, it will be okay.

      I hope to look at dividends more some day.

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  5. The way I read this chart, you can accept roughly a 4% increase in SD if you also receive an extra 1% in real return, with no change in failure rate. That's pretty close at 5% failure rate, less return than that is OK at higher failure rates. That could help shape asset allocations.

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  6. Yes, there is a complicated relationship between returns and volatilities for those returns. I did notice there was a point at about 6% failure for each curve in the graph, showing what you are saying about how 1% more return and 4% more volatility keeps you at the same place in terms of failure.

    The magnitude of failure (how soon wealth runs out) could be different though.

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