Withdrawal Rate (Part 2)

 In the last post, we took a look at some withdrawal rates using actual data over the recent past by examining returns on a diversified portfolio.  The latest update to that data source is the  BlackRock table of asset returns.  As I've said a hundred times, this is an extremely useful resource from which all kinds of questions can be addressed.  Admittedly, it is one path we have come down; but it has been especially rocky at times and gives a bit of insight into how asset classes have performed and how various strategies would have fared.

Along these lines I, thought it would be interesting to go back and look at a retiree who retired in 2000 and decided on a 5% withdrawal rate.  Where would he stand today?  I would also like to introduce another resource that is often used in this research - the Shiller Price/Earnings (P/E) ratio.  This ratio is sometimes used to set the initial withdrawal rate.  Simply, if the ratio is high (stocks potentially overvalued on an historical basis) then, other things being equal, the retiree should start with a lower withdrawal rate (for example 4%).  If the P/E ratio is lower, then a higher initial withdrawal rate should be considered.

Here is a graph of the Shiller P/E ratio:

Source: Online Data - Robert Shiller

CLICK TO ENLARGE  The graph shows that the market P/E in 2000 suggests it was not an especially good time for the retiree to have a high withdrawal rate.  Instead of 5% or higher, the Shiller P/E suggests 4% as a more appropriate rate.  Given this caveat, let us see where the retiree who, in fact, instead chose 5% would stand today if he achieved the BlackRock diversified portfolio returns.  Again, we assume a $1.0 million portfolio starting value and a 2% inflation adjusted income taken on 1/1 of each year.

YEAR	ASSETS (1/1)	INCOME	PORTFOLIO	RETURN	ASSETS (12/31)
2000	1000000	50000	950000	0.989	939550
2001	939550	51000	888550	0.952	845900
2002	845900	52020	793880	0.902	716080
2003	716080	53060	663020	1.235	818829
2004	818829	54122	764707	1.105	845002
2005	845002	55204	789797	1.054	832447
2006	832447	56308	776139	1.13	877037
2007	877037	57434	819603	1.06	868779
2008	868779	58583	810196	0.772	625471
2009	625471	59755	565716	1.208	683385
2010	683385	60950	622435	1.13	703352
2011	703352	62169	641183	1.018	652725

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The table shows that the 77-year-old retiree would now have 65.2% of his nest egg left to draw on.  The similar exercise using a 4% withdrawal rate would have 83.6% of the nest egg still available at the end of 2011.

Again, recognizing this is one path, it still yields some valuable insights into varying withdrawal experiences, the potential value of taking into account initial conditions (i.e. the  p/e ratio), and the dynamic nature of the experience of drawing down the nest egg.

Looking back at the Shiller P/E suggests that today's retiree can consider a slightly higher withdrawal rate.  For those interested in doing further research, you may want to consider redoing the results and starting with the 5% rate but not taking an inflation adjustment when markets are down, as suggested by Jon Guyton.

Also, those interested in this research may want to review the Shiller P/E.  It is not, to say the least, your typical trailing 12 months p/e ratio.

Disclosure:  This information is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.

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 dot.com 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 dot.com 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:

YEAR	ASSETS (1/1)	INCOME	PORTFOLIO	RETURN	ASSETS (12/31)
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.