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Friday, February 3, 2012

Withdrawal Rate

Source: Capital Pixel
A hotbed of financial planning research is the topic of the maximum safe withdrawal rate on a portfolio of retirement assets aka "the nest egg."  Draw down the nest egg too fast and we end up searching the sofa for nickels and dimes to get enough to go to the grocery.  Draw down too slowly and the permanent resident in the basement will get a few more years where he doesn't have to get a real job.

So what's the right rate?  How can we die broke?  Actually there is a way by going the annuity route; but that gives up control of assets and, though that might be a partial solution, we do need access to some of our assets in case of an emergency.

One good thing is we have a rule-of-thumb that basically gives us a minimum.  This is William Bengen's 4% rule.  He found that, over widely varying 30-year periods, a conservative portfolio drawn down at an inflation adjusted 4% rate would outlast retirees.  This is the starting and ending point for many retirees.  Unfortunately this could leave a lot left over.

So others have improved on this.  Guyton has found that, throwing in some flexibility by foregoing the inflation adjustment in down markets, the rate of withdrawal can be raised as high as 5.5%.  If you are only going to read one article on this subject, read How Retirees Can Spend Enough, But Not Too Much by Lieber.  Lieber describes Guyton's findings.

The difference between 4% and 5.5% draw down rate is obviously significant.  On $1.0 million, it is $55,000/year versus $40,000!

Others argue that even more considerations should be taken into account.  For example, what is the market's P/E ratio when you start.  A lower-than-average P/E ratio would suggest a bit higher withdrawal rate based on the idea that the longer term prospects for the market are relatively positive. Conversely, a higher P/E (think year 2000 and bubble) and the withdrawal rate should be a bit muted.  Kitces has done valuable work in this area.

It's interesting to contemplate that we are still in the infancy of this line of research.  Throwing in some data on life expectancy (the big unknown) can refine the analysis.  In fact, we have sites today (this is for retirees who find they have too much time on their hands!) where we can actually get a prediction on what date we will no longer be concerned with such mundane questions as maximum withdrawal rate. Now the biggest hurdle is market performance on the path we go down ;)!  But this has gotten me into the weeds.

To get a feel for the issues involved here, let's go back to my favorite investment planning tool - the BlackRock Asset Class Returns chart.  The chart shows 20 years of returns, on an annual basis, for several asset classes and for a diversified portfolio.  This time I  want to look at the diversified portfolio which is easily replicated using low-cost, well diversified funds.  It is basically 65% stocks and 35% fixed income.

Assume a person retired in 1990 at age 65 and withdrew 4% of his $1.0 million portfolio on the first day of each year and he was invested in line with the diversified portfolio - this produces the "return" column.  The withdrawal was adjusted each year for 2% inflation as shown in the "income" column.

As shown in the table, the retiree, at the end of the 20 years ended 2009, had a portfolio valued at $2.69 million.  Junior, in the basement, is cheering wildly and spends the day eyeing exotic cars.  Our retiree is kicking himself for not taking that extra cruise a year and continually driving his car into the ground!

Return data from BlackRock
CLICK TABLE TO ENLARGE  In the table, the return is put in the form required to calculate portfolio value.  For example, .97 indicates a -3% return (1-.97).

This, of course, was a good period, despite the sharp downturn in 2008 and early 2009.

As it turns out, each of us will go down a particular path.  This should be kept in mind when we examine research results presented by many studies (based on Monte Carlo studies) that average numerous paths and present probabilities. The message is that retirees need to examine portfolios on a dynamic basis and that adjustments can and should be made.

Clearly the reiree in the table, who is now 85 years old, has the capacity to step up consumption if so desired.  In fact, he could convert part of the portfolio to an immediate pay annuity and get a very attractive payout for the rest of his life.

To gain a bit more perspective, it is worthwhile looking at a person who retired in 2000 with $1.0 million.  This, of course, was at the height of the bubble when portfolios were robust.  Sadly, many got caught up (as is usual) in the hype and weren't well diversified - but what about those who were?  How did they stand at the end of 2009?  This is shown in the following table, again, assuming they invested according to the diversified portfolio and had an inflation adjusted 4% drawdown:

2000 1000000 40000 960000 0.989 949440
2001 949440 40800 908640 0.952 865025
2002 865025 41616 823409 0.902 742715
2003 742715 42448 700267 1.235 864829
2004 864829 43297 821532 1.105 907793
2005 907793 44163 863630 1.054 910266
2006 910266 45046 865220 1.13 977698
2007 977698 45947 931751 1.06 987656
2008 987656 46866 940790 0.772 726290
2009 726290 47803 678487 1.208 819612

The retiree still has over 80% of his portfolio and is in decent shape.  This despite starting the period with the negative market and experiencing an historically sharp drop in 2008.  To me, it is a great illustration of the value of sticking with a portfolio plan and avoiding the shifting of assets on the basis of emotions.

Again, at age 75, he would be in great position to buy an immediate pay annuity.  Also, if in great health, he might even consider putting a small sum towards a deferred annuity to pay at age 85.

The point here is that we will all go down a dynamic path and that our position should be examined on an ongoing basis.

The analyses here show how easy it is to examine questions the reader might have given a bit of playing around with Excel.  For example, it would be easy to collect CD rates, for example, or Treasury rates and see how a retiree would have done putting all of their assets in those particular assets.  I'm going back and doing the analysis using a 5.5% withdrawal rate.

Disclosure:  The information here is for educational purposes only.  Individuals should do their own research or consult a professional before investing.


  1. I would like to bring to everybody's attention that invests in value stocks. Their is one overwhelming fact when it comes to value investing and that is you must buy decent companies with very low price to sales ratios to have a high probability of making a lot of money buying value stocks their is no other way believe me. And what is a very low price to sales ratio. First let me explain very clearly to everyone what a low price to sales ratio is. The price to sales ratio is the market cap of a stock compared to the sales that the company of the stock does on a annual basis. In other words the company I talk about below has a market cap' which is all the shares of the company issued and outstanding of just eight billion dollars. But the comapny does fiftyfive billion dollars in annual sales. In other words the market is valuing bunge at just eight billion dollars but the company does fiftyfive billion dollars in annual sales get the idea. Ok one other thing never forget this warren buffett could never have made the enormous returns buying value stocks unless he was buying value stocks with very low price to sales ratios period' and I am almost certain if you asked him he would totally agree. Bear in mind I would not say something that I cannot back up believe me. I will give an example of a company of really decent quality that I consider really undervalued. The company is Bunge Limited symbol {BG} engages in the agriculture and food businesses worldwide. The stock currently trades around 59 dollars a share. I think the stock could easily get to 450 dollars a share over the next five years. Yes you heard it right four hundred and fifty dollars a share. Assuming their are not stock splits. And what do I base this on If the companies profit margain expands from around 1.75% to 4% over the next five years and if the sales of the company expand from 54 billion to 85 billion thats growth of about 7 or 8 percent a year and if the companies stock than trades at a price earnings ratio of about 20. That would put the price of the stock at 450 dollars a share. It could even be more than 450 dollars a share if you reinvest your dividends the company pays a dividend also if the company does a share buyback this could increase the value of the stock even more. Keep in mind that their are stocks that are popular that trade at much higher price earnings ratios than 20 times earnings one example is whole foods market it currently trades at 35 times earnings. Also keep in mind that bunge is a company of really decent quality not at all a high risk stock. It has the potential to leave a company like proter and gamble in the dust. I understand your skepticsm if you are reading this but go to any stock broker or financial planner CPA that knows how to value stocks and they will confirm everything that Im saying here.

  2. re: Penny Stock If it works for you do it! I subscribe to the approach that Warren Buffett actually recommends for individual as well as institutional investors:

    "Most investors, both institutional and individual, will find the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals".
    -Warren Buffett, Berkshire Hathaway chairman and legendary American investor, Berkshire Hathaway Inc. 1996 Shareholder Letter