Sunday, October 30, 2011

Cliff Notes for "An International Perspective on Safe Withdrawal Rates" (December 2010 JFP)

I wrote the following last December, but never ended up using it for anything. It summarizes my research article from the December 2010 Journal of Financial Planning.  Big thanks to the Oblivious Investor and Monevator for including it in their weekend reading lists. 


Conventional wisdom states that when it comes to retirement withdrawal planning, the 4 percent withdrawal rate rule is safe. That rule, dating back to William Bengen’s 1994 article in Journal of Financial Planning, says that a new retire can safely withdraw 4 percent of their savings in the first year of retirement and adjust this amount for inflation in subsequent years. This will be safe in the sense that the strategy will not lead the retiree to use exhaust all of their remaining assets for at least 30 years. The 4 percent rule has been widely adopted by the popular press and financial planners as an appropriate general rule of thumb for retirees. Since Bengen’s paper, a number of researchers have developed strategies to allow retirees to safely exceed a 4 percent withdrawal rate. Though the safe withdrawal rate fluctuates a bit from study depending on the dataset and assumptions used for its calculation, in this paper I calculate a safe withdrawal rate for the U.S. of 4.02 percent. That was the highest amount that could be sustained in the worst case retirement year. It happened in 1969 with a 57/6/37 for stocks/bonds/bills, which was the best possible asset allocation.

Prospective retirees must consider whether they are comfortable basing retirement decisions using the impressive and perhaps anomalous numbers found in the past U.S. data. The problem is that most every study about sustainable withdrawal rates is based on the same Ibbotson Associates dataset on U.S. financial market returns since 1926. The time period covered by this data may have been a particularly fortuitous one for the United States that will produce misleadingly large and dangerous "safe" withdrawal rates if asset returns fail to be so stunning in the future. Indeed, the U.S. consistently enjoyed among the highest inflation-adjusted returns and lowest volatilities for stocks, bonds, bills, and inflation. For stocks, only 3 countries enjoyed higher returns, and the only 4 countries experienced less volatility in stock returns. This combination of high returns and low volatility is remarkable for the U.S. and helps to support higher withdrawal rates. The story is similar for bonds, bills, and inflation as well. For bonds, only 3 countries enjoyed higher real returns, and only two countries enjoyed less volatility for those returns. Only two countries experienced lower average inflation than the 2.98 percent value in the US. As a consequence, tests using US data should provide for relatively high sustainable withdrawal rates from retirement savings. From an international perspective, the United States enjoyed a particularly favorable climate for asset returns in the twentieth century, and to the extent that the US may experience mean reversion in the current century, "safe" withdrawal rates may be overstated in many studies.

The results have shown that from an international perspective, a 4 percent withdrawal rate has been anything but safe. The SAFEMAX exceeds 4 percent in only 3 of the other 16 countries: Canada, Sweden, and Denmark. As for other countries, the most unfortunate retiree of all was a Japanese person retiring in 1940, whose maximum sustainable withdrawal rate was a miserably low 0.47 percent. Six countries experienced withdrawal rates below 3 percent: Spain, Italy, Belgium, France, Germany, and Japan. In Italy, the 4 percent rule failed in 62.5 percent of cases, and in Japan, withdrawals were sustainable for only 3 years in the worst-case scenario. For stock allocations between 30 and 90 percent, the United States enjoyed higher sustainable withdrawal rates than any country except for Canada. For the US, the maximum occurs at 57 to 60 percent stocks, but unlike many of the countries that show a much more pointed hump, the maximum is only slightly less for stock allocations between about 30 and 80 percent. Except for Switzerland, retirees in the various countries were generally better off by holding at least50 percent of their savings in stocks. Safe withdrawal rates do not obtain their safety from conservative asset allocations.

A few additional comments are warranted about the assumptions built into this study. In several ways, the assumptions provide an overly optimistic view of withdrawal rates. In each year for each country, I assume that retirees have the perfect foresight to choose the specific fixed asset allocation among their country’s stocks, bonds, and bills that would provide the highest withdrawal rate. Relaxing this, for instance, with a 50/50 asset allocation for stocks and bonds would cause the 4 percent rule to fail at least once in every country. As well, I assume that retirees do not have to pay any portfolio management or advisor fees from their assets beyond what they otherwise withdraw for their expenses. On the other hand, researchers have demonstrated that including more financial assets, using dynamic rules to adjust withdrawals to market conditions, and changing rebalancing strategies can all serve to increase safe withdrawal rates, and these modifications have not been incorporated here. As well, some of the worst outcomes were connected with World Wars I and II, and investors who are confident that world war is a relic of the past may feel comfortable ignoring those cases, or may at least assume that retiring comfortably would be the last thing on their mind.

These findings may be rather frightening. After all, who but the wealthiest could possibly save enough to live comfortably from the global safe historical withdrawal rate of 0.47 percent? From the perspective of a U.S. retiree, the issue is whether the future U.S. will experience the same asset return patterns as the past U.S., or whether Americans should expect some kind of mean reversion that could lower asset returns to levels more in line with what many other countries have experienced. It may be tempting to hope that asset returns in the twenty-first century United States will continue to be as spectacular as in the last century, but it should not be counted on.