|
A Safer Withdrawal Plan - Part One
(Updated 4/8/09)
Preface Part one of this article will discuss conventional withdrawal plans and their variants. Part two will discuss a safer withdrawal plan. Introduction Conventional withdrawal plans start with a nest egg constructed using a balance of stocks and bonds (for example, 50% stocks and 50% bonds). And then, an appropriate initial withdrawal rate is selected, typically 4%. However, a major problem arises with this approach. The conventional 50/50 stocks/bonds portfolio is volatile. And although there are strategies to cope with portfolio volatility, they have their shortcomings. This article will explore a withdrawal plan that may be safer. The Conventional Withdrawal Plan Academic studies have examined the question of how much can be withdrawn from a conventional portfolio composed of 50% stocks and 50% bonds. (See note 1). This chart summarizes maximum initial withdrawal rates:
This chart was created using my Maximum Withdrawal Rate Spreadsheet (xls) So for example, a retiree who started with a $1,000,000 portfolio and took out $40,000 in the first year and increased that withdrawal each subsequent year by the prior year’s inflation rate, after 30 years, the portfolio would have had at least $1 left. The timeframe of 30 years is chosen to encompass the estimated lifespan of the vast majority of 65 year-olds entering retirement.
Data obtained from United States Life Tables, 2004 (pdf) on the National Center for Health Statistics website Conventional Withdrawal Plans are Volatile The drawback of conventional withdrawal plans is that portfolio returns are volatile. (See note 2). The particular concern is that poor returns in the early years will draw down the nest egg. While the 1929 stock market crash is a vivid example, poor returns also occurred in the post-1950 era. Let’s look at 30-year retirements using 50/50 stocks/bonds, a 4% initial withdrawal rate and adjusted for inflation thereafter. The following chart shows portfolio values (inflation-adjusted) over the course of 30-year retirements in the post-1950 era where poor returns occurred in the early years. (See note 3 for detailed procedure.)
Data obtained from withdrawBengen Spreadsheet (xls) While surviving every 30-year period, each of those portfolios declined below $750,000 (25% drop) within the first 10 years. This is shown in the following two charts.
Variable Withdrawals One way to cope with volatile returns is to reduce withdrawals following market declines. This might buy time until the market recovers. The way this would work is instead of setting an initial withdrawal rate of 4% and increase the withdrawal by an inflation adjustment, the 4% is applied to the current portfolio value. So for example, if the value of the portfolio declines from $1,000,000 to $900,000, instead of taking $40,000, the withdrawal amount would be $36,000 ($900,000 x .04 = $36,000). There are several variable withdrawal methods; I discuss them in detail in THIS ARTICLE. One variable withdrawal method is called “Floor and Ceiling”. It follows the same procedure as the above example. Except, it places a “floor” on the minimum withdrawal amount and a “ceiling” on the maximum withdrawal amount. Here is how the “Floor and Ceiling” method would have worked in the 1965-1994 period using a 4% withdrawal rate and a $36,000 “floor”. Values are adjusted for inflation.
This chart was created using my withdrawBengen Spreadsheet (xls) Top chart shows each year’s withdrawal. Withdrawals are taken at the end of each year. Bottom chart shows portfolio value at the end of each year immediately following that year’s withdrawal. Withdrawing less in the 1965-1994 period helped portfolio survival. However, there were other periods that experienced steep portfolio declines despite reduced withdrawals. The following chart shows the 1973-2002 period using a 4% withdrawal rate and a $36,000 “floor”. Again, values are adjusted for inflation.
This chart was created using my withdrawBengen Spreadsheet (xls) Top chart shows each year’s withdrawal. Withdrawals are taken at the end of each year. Bottom chart shows portfolio value at the end of each year immediately following that year’s withdrawal. Alternative to Annual Rebalancing: Bonds First Both conventional withdrawal plans and variable withdrawal plans employ annual rebalancing. In other words, a target equity-fixed split (such as 50% stocks and 50% bonds) is maintained throughout the entire distribution period in retirement. Another alternative strategy to cope with volatile returns does not concern itself with maintaining a target equity-fixed split. Instead, bonds are withdrawn until depleted. At that point, the portfolio may or may not be rebalanced to its target equity-fixed split. Read more HERE. The following chart compares annual rebalancing (blue line) with “Bonds First” (black line). Both portfolios start with 50% stocks and 50% bonds. In the “bonds first” method, withdrawals are taken from the bond side. After the bonds are depleted, the portfolio is rebalanced to 50/50. Four percent is initially withdrawn; the withdrawal amount is adjusted for inflation in each succeeding year. Values shown are adjusted for inflation.
This chart was created using my withdrawRBands Spreadsheet (xls) Withdrawals are taken at the end of each year. Top chart shows portfolio value at the end of each year immediately following that year’s withdrawal. Bottom chart shows the stock allocation at the end of each year immediately following that year’s withdrawal. So while the “bonds first” method ultimately improved portfolio survival in the 1973-2002 period, the retiree still experienced a steep drawdown in the early years. This concludes part one. In part two, a safer withdrawal plan will be examined. |
| Note 1 | The following articles are historical studies that have examined “safe” withdrawal rates.
Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable The Retirement Calculator from Hell Determining Withdrawal Rates Using Historical Data (pdf) Asset Allocation for a Lifetime (pdf) Conserving Client Portfolios During Retirement (pdf)
The following calculators will demonstrate “safe” withdrawal rates using historical data. Max Rate Withdrawal Spreadsheet (xls)
|
| Note 2 |
The following chart shows the inflation-adjusted annual returns that resulted from a balanced 50% stocks and 50% bond portfolio:
Data obtained from my Allocation Spreadsheet (xls) |
| Note 3 |
Withdrawal Procedure:
1. Start with $1,000,000
|
