Thursday, April 12, 2012

Lower Future Returns and Safe Withdrawal Rates

Busy week at the blog!

On Monday, I reported on a Scott Burns column about a March 2012 Journal of Financial Planning article I co-authored with Michael Finke and Duncan Williams.  Our essential argument was that when a retiree properly considers their available resources outside of their financial portfolio (such as Social Security, fixed income annuities (SPIAs), pensions, etc.) as well as their flexibility to reduce spending in their later years, it may make sense to choose a retirement income strategy with a much higher failure rate than is commonly considered in safe withdrawal rate studies. That study was based on Monte Carlo simulations calibrated to the historical data.

On Wednesday, I updated my explanations about a paper I published in the August 2011 Journal of Financial Planning in which I argued that historical data does not provide a proper basis for determining forward-looking safe withdrawal rates. Future returns and sustainable withdrawal rates are connected to the current market environment, not historical averages. Some great comments followed that post, including a question about why we used historical averages in the March 2012 article, given what I reported in August 2011. As well, one commenter made a good point which ultimately means that the out-of-sample predictions connected to low recent dividend yields may not be reliable.

About the issue of why we used historical averages in March 2012, my basic view is that there are many changes I would like to consider for retirement income studies, but not all the changes should be made at the same time. Rather, I think it is more helpful to change assumptions one at a time so that it is easier to see the impacts of each of those assumptions. We should certainly redo the March 2012 with alternative returns assumptions at some point though.

Today I would like to make some initial efforts toward this end. In doing so, I harken back to my January 2012 Journal of Financial Planning article, "Capital Market Expectations, Asset Allocation, and Safe Withdrawal Rates." The whole point of that article was to provide a framework for seeing how any types of assumptions about returns and asset classes choices impact the results for safe withdrawal rates. I think this article provides a framework for re-considering the August 2011 article framework too, though admittedly it is not super-straightforward about how to do this since it is very hard to know about proper assumptions for the means, standard deviations, and correlations for each asset class.

Nonetheless, in moving toward today's post, Joe Tomlinson's new column at Advisor Perspectives this week is also excellent (it compares GLWBs and deferred income annuities). While I'm not talking now about his results, I do want to adapt his general data assumptions methodology. He is thinking about things in the right way, and I want to show what happens when you apply his approach to the framework from my January 2012 article. 

Here are three tables of data assumptions which will provide the general summary of the impacts from changing assumptions. Again, though I am not following Joe exactly, I am adapting his ideas here. First, Table 1A shows the historical data parameters which I use when I say I am calibrating things to the historical data. This is real data after adjusting for inflation. Then, Table 1B keeps the same historical equity premium over bonds, but it adjusts all of the returns downward by 1.52%. This is to get the real bond return to more closely match current real bond yields. Current yields are the best predictor for longer-term bond returns, even if not held to maturity. Finally, in Table 1C, I maintain the lower bond returns and also adjust the stock return downward as well to assume a lower equity premium than historically witnessed. The equity premium in 1C is only 4% instead of 6.18%. I don't try to mess with standard deviations or correlations.

Next, it is just a matter of seeing what happens when using these alternative sets of assumptions. The next table is the same Table from my January article showing results for the historical data parameters seen in Table 1A. As I explained in a recent blog entry, I think this table provides a lot of nice advantages for thinking about safe withdrawal rates in the classical safe withdrawal rate framework introduced by William Bengen and the Trinity study. [Though, the March 2012 article points in a whole different direction for thinking about safe withdrawal rates].  Here is the table with advice calibrated to the historical data:

You can study it, but to keep the discussion manageable I will focus on one specific row from the table to describe differences for the varying assumptions. Consider a 30-year retirement duration for a retiree willing to accept a 10% chance for failure. That is, the retiree accepts that with constant inflation-adjusted withdrawals, there is a 10% chance that wealth will run out before the end of 30 years. Also, there is no bequest motive or no worry about the magnitude of failure [my Advisor Perspectives column scheduled for publication on April 17 will delve further into these issues]. The table shows a recommended withdrawal rate of 4.3% and an optimal asset allocation of 45% stocks and 55% bonds. No cash.  Another purpose of that article was to show that asset allocation does not matter all that much, as a stock allocation anywhere between 28% and 69% supports as nearly as high of a withdrawal rate as the optimal asset allocation.

Next, let's move to Table 1B, in which returns drop downward to get future real bond returns of 1% and the same historical equity premium.  This figure compares the efficient frontiers for the historical data (in red) and this revised scenario (in black) for the 30-year retirement and 10% failure rate example:

And we need a table to accompany that figure to show about the asset allocation. This Table 2.3B is produced using the modified return assumptions in Table 1B:

Feel free to study and compare the tables. Again, to keep things manageable, I focus only on the one row. With a 30-year retirement and 10% failure, the sustainable withdrawal rate has dropped from 4.3% down to 3.6%. Actually, I don't think asset allocation should change when all returns drop the same amount. The small changes are an artifact of 10,000 simulations not being enough to get the perfectly exact results. There is still some fuzziness due to random variation, but as it was my rather souped-up computer had to run for 72 hours last August just to get the background info guiding this analysis with 10,000 simulations.

Finally, let's consider about Table 1C which also reduces the equity premium.  Here is a figure again showing the efficient frontiers for the historical data (in red) and this revised scenario (in black) for the 30-year retirement and 10% failure rate example:

And here is a corresponding Table 2.3C produced using the modified return assumptions in Table 1C:

With a 30-year retirement and 10% failure, the sustainable withdrawal rate has dropped from 4.3% down to 3.2%. That equity premium reduction cut another 0.4% off the 3.6% withdrawal rate in Table 2.3B. It also leads to a lower optimal stock allocation, as the lower equity premium penalizes the more volatile stocks and makes them less attractive. The optimal stock allocation dropped from 45% to 29%, with the range of nearly optimal stock allocations falling to between 18% and 48%. 

And so, assumptions about future returns do matter a lot!  But the problem is: we don't know what the future will bring. It pays to be cautious and flexible. Don't rely completely on the idea of 4% being a safe withdrawal rate, because you only get one whack at the cat.


  1. Wade --

    Terrific! In all of this, uncertainty about future return-rate means is a BIG issue, and in this entry you're right on it.

    Those graphs of iso-withdrawal-rate lines of yours, on which one can superimpose frontiers, or model portfolios, or individual portfolios based on one's own future market assumptions, are superb. I think you should tell the readers -- or if you did, I'll repeat it -- you have a whole treasure chest of those iso graphs for various assumptions such as time horizon and failure rate, in your blog entry of last Aug. 24 with the title beginning "Capital..." I think a reader can go right to it with this link:

    Dick Purcell

    1. Dick,

      Thanks for the reminder! I haven't forgotten about those graphs and I will talk about them again at some point.

      Best wishes, Wade

  2. Sorry about the deletion (my error). What I wanted to say:

    As always, Wade -- both excellent and useful. Thanks.

  3. Great post,always appreciate your work and insight. How does the withdrawal rate change if using a fixed % withdrawal rather then inflation adjusted?
    Thanks, Drum

    1. Drum, thanks, and thanks for the question. I've started addressing this in my newest blog entry.

  4. A logical retirement would be to have required income baselined by (eg.) not taking social security until 70 (delay gives about 7.2%/yr real return) and supplementing that if needed with TIPS ladder or annuity. Since remainder is risk capital one would want to maximize this by avoiding reverse dollar cost averaging. With baseline spending covered one can take larger payouts when market is up and much less when it is down. My historical (1926-2010) 30 yr simulations suggest one gets 5%, worst sequence, 9% mean and median, incomes with taking 2.5% of current balance when real capital < starting value and 10% when > starting value. All in real dollars.

    Also works with a floor of 2.5 of initial capital.

    It would be nice to see some variable withdrawal rate simulations from someone with your capabilities. Your current work inadvertently implies reverse dollar cost averaging is a good strategy, I don't think this is what you intend.
    Thanks for all the good work. John

    1. Thanks John,

      You've made some good points. Finally, I'm getting started on looking at this, though my first attempt is more basic than what you are writing about here. Thanks for sharing.

  5. Wade: I cannot begin to tell you how helpful your blog is. You clearly delineate the issues in planning for a successful retirement. Have you read Jim Otar's work? I see similarities in your approach and his work. I would appreciate your thoughts on his book on retirement income generation and his modeling. thanks.


    1. Thanks a lot,
      I have both of Jim Otar's books, but I must admit that a glaring hole in my reading is that I haven't read his books yet. I do need to do that sometime. Thank you.

  6. It might be prudent to comment on the affect the government required withdrawl rate ( minimum distribution rate) might have on someones portfolio as they may be forced to take out more than they want over time?
    What impact might this have on ensuring that the portfolio lasts longer than prescribed?

    1. Thanks, though there will be tax implications when withdrawing from your IRA, there isn't anything to stop you from re-investing the excess amount in a taxable account. I think this mostly gets into the issue of the implications of taxes on safe withdrawal rates, and that is not something I've explored too deeply yet. One of these days...

  7. Wade,

    Interesting analysis that is eye opening.

    I agree with John that variable withdrawal rate simulations would be very interesting -- especially since that is probably closer to reality. I wonder if there is good data out there on the common withdrawal patterns of Do they tend withdraw more early, etc.

    I especially like your probabilistic approach towards retirement failure. There's always risk and it often times makes a lot of sense to take on a little bit extra risk for a substantial gain.


    1. Thanks David. I'm looking at variable withdrawal rates a lot lately, so please stay tuned.

      The issue of actual withdrawal patterns is a bit tricky. There are some informal surveys out there, but I think we really need more research on this. Existing work is insufficient. I covered some of this here:

      Thanks for reading.