Thursday, October 11, 2012

What is the Safe Withdrawal Rate?

Dirk Cotton's guest post this week has triggered lots of interesting discussions about the 4% rule at a variety of message boards. I think I understand Dirk's message, or at least I know my interpretation about the meaning of the article. 

In my view, the point of the article, or my own view about the matter, is not, as one commenter wrote, this:

The alternative that I believe Wade advocates is to pay a HUGE additional cost, in terms of reduced effective withdrawals, to shore up the remaining 5% - be it through simply lowering SWR, using VERY costly annuities, or dooming us to work until we're 80. Regardless of however you go about it, to go from 95% to approaching 100% will require an exponential order cost, not a linear one. "True" safe withdrawal isn't worth the cost, IMO...

I don't think anyone is saying that you have to lower the withdrawal rate to some truly safe level (i.e. zero). 

So, what is the safe withdrawal rate?  Actually, I was asked this question in the "Retirement Roundtable" in the current October 2012 issue of the Journal of Financial Planning. I answered:

 I’m not really thinking about a safe withdrawal rate any more. It’s more like the lifetime satisfaction maximizing safe withdrawal rate, or something like that, that allows for the chance of wealth depletion or of potentially making cutbacks later on, like Jonathan was saying, with having the rules in place to have a dynamic withdrawal rate and to cut spending if we did have bad market returns….
I think we really have to consider now that the bond yields are so low, and that with bonds being a big component of someone’s retirement portfolio, I wouldn’t be that comfortable going much higher than 3.5 percent at the current time.
Let me explain this a bit more, because I wish I hadn't said the last paragraph. I felt pressured to give a number for the "safe withdrawal rate" even though I think the safe withdrawal rate is not particularly relevant to a well-designed and complete retirement income strategy.

For starters, I occasionally still see references to a prediction I made in an August 2011 JFP article saying that my best guess for a sustainable withdrawal rate for a 2010 retiree is 1.8%. I've since backed off from that prediction. The regression methodology I use in that article is hurt by the fact that we've never before experienced the market conditions of recent years, and that specifically creates problems for using the regression methodology. It specifically has trouble making these sorts of out of sample predictions. The main lesson from that article is that we cannot continue to treat 4% as safe in the market environment from recent years.

An alternative I've suggested to determine a safe withdrawal rate is to design assumptions reflecting current market conditions to feed into Monte Carlo simulations, as I explained in a January 2012 JFP article. I explain about this specific application for the article's methodology in a past blog post.

As well, and this gets to what I think is the main point of Dirk's guest post, one matter which has been clear to me is that the classic "constant inflation-adjusted withdrawals until wealth is depleted" strategy of the safe withdrawal rate research is the worst-possible strategy to use. Anything that makes adjustments for the actual market performance or revised remaining life expectancy will provide an improvement. These are the conditional probabilities of which Dirk wrote. The situation changes conditional on the experienced portfolio returns and conditional on having survived another year. This is a point emphasized both in my article here, and in the article I just recently reviewed from Morningstar

My most recent evolving views about safe withdrawal rates are highlighted in my most recent article, "An Efficient Frontier for Retirement Income."  What I argue there is to forget about success rates, failure rates, safe withdrawal rates, etc. What matters from the financial side of retirement is how to best meet two objectives: to meet as well as possible one's lifestyle (or at least one' minimum) spending needs, and to preserve a buffer of financial assets to manage risks regarding unexpected expenses. Then I look at how different strategies, which include the possibility of partial annuitization, perform with regard to meeting these two objectives. There is a lifestyle spending goal in that article, but there is no safe withdrawal rate.  And anyone who complains that annuities are too expensive must understand the current reality that everything is expensive in this low yield world. The 4% rule is not magically saved from failing in current circumstances just because it would have succeeded for retirees between 1926 and 1982. 

And that is how I view, or rather don't view, the question of the safe withdrawal rate.