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Thursday, April 21, 2011

It's Not Just the Rate of Drawdown

One of the stickiest problems in personal finance is determining a safe rate of nest egg draw-down in retirement. Original studies by William Bengen  showed that 4% of the starting portfolio value, adjusted for inflation, worked in many market scenarios for a given asset allocation. This rule-of-thumb has been bandied about and debated ever since. The thing is that, because of the nature of market,s we can never be sure. By definition, we are dealing with averages and probabilities and talking about what worked in the past. The future of course is unknown. What if we (gasp!) run into a 20-year period of down markets?

This subject is presented at "Free Money Finance" and centers on a recent piece in the New York Times. The Times notes that, if you retire near a market peak, then, when the market drops, your probability of success declines as well if you continue to withdraw the same dollar amount.

As a counter, the Times suggests flexibility by allowing the withdrawal rate to vary between 2.5% and 5% depending on market experience. This, of course, borders on the ridiculous as "Free Money Finance" points out. If you can vary your income between $20,000 and $40,000, say, then you're home free. "Free Money Finance" points out more viable solutions.

My quibble with all of this is that the studies tend to be simplistic. They assume stock funds are systematically reduced in down markets as retirees get their income by selling stock and bond funds. But the subject has progressed. Most people today, especially the researchers, know that retirees need a plan in withdrawing assets. Some people say put the assets in buckets with the first 5 years in short-term funds. My approach is to put about 1 year short-term and structure the portfolio to throw off dividends and interest of at least 60% of income needs (2.4% yield) to replenish short-term fund.

Whatever the approach, enhancing the sophistication of the withdrawal strategy greatly enhances the probability of success, i.e. the probability of not outliving your money. In fact, it worked well in actual practice over the nasty downturns of the last decade. The studies need to take this into account.

It's time that studies explicitly incorporate this into their analysis.

4 comments:

  1. Check out Jim C. Otar's Book "Unveiling The Retirement Myth". It discusses this topic at great length.

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  2. @ The Dividend Pig I have read much of Otar's work and admire it and recommend it. He takes us a long way towards getting a realistic view of drawing down the nest egg.
    For those who are interested his website is at:

    http://www.retirementoptimizer.com/

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  3. That site covers a lot of ground! I haven't read Otar's book, this could be a good starting point.

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  4. @MoneyCone It is a good starting point. I believe there will be a tremendous amount of research in this area over the next few years.

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