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    Retirement Withdrawals: What Rate Is Safe When Time Is Short and Uncertain?

    by Carl M. Hubbard

    Retirement Withdrawals: What Rate Is Safe When Time Is Short And Uncertain? Splash image

    “How much can I withdraw?” is the key question facing investors who are living off of their retirement savings. The dilemma is that if they withdraw too much, they prematurely exhaust the portfolio, but if they withdraw too little, they unnecessarily lower their standard of living.

    Many financial studies have examined sustainable withdrawal rates to help answer this question. But most of this research covers payout periods that are typically 15 years to 35 years. The imagined scenario typically focuses on a 65-year old retiree who is planning withdrawals that allow the retirement portfolio to provide income for 15 years to 35 years.

    However, circumstances of life arise that can shorten the expected payout period.

    One example hit close to home when a friend revealed that he had just been diagnosed with a life-threatening disease. Standing plans for a long, enjoyable retirement suddenly evaporated. In their place were guarded expectations of a few years of active life interrupted by periods of struggle for survival.

    “If I carve out a portion of my retirement fund to finance travel and activities that I have postponed until retirement, how much can I consume over a few years?” was his question.

    A similar circumstance faces any individual at an advanced age who recognizes that only a few years of life remain. In each of these circumstances, individuals may wish to accelerate withdrawals from all or perhaps a portion of their retirement portfolio.

    A laddered portfolio of zero-coupon bonds is a common investment plan for a known and rather short payout period with known withdrawals–for example, a four-year plan for college education expenses.

    In the circumstances described above, however, the payout period is uncertain, and exact withdrawal amounts are not required. The individual planning for a five-year payout might actually experience a longer or a shorter period of time. With these uncertainties, a portfolio of cash, cash equivalents, or laddered zero-coupon bonds could easily be consumed too early. In addition, there is very little upside potential in a short-lasting laddered portfolio of zero-coupon bonds and none for cash.

    In contrast, investment in common stocks provides the opportunity for higher returns than do bonds and cash, and higher returns allow for higher sustainable withdrawal rates. In addition, the higher returns to common stocks may provide a significant terminal value for the portfolio, which bonds and cash cannot offer without significantly reducing withdrawals.

    To help retired investors who are faced with these kinds of circumstances, we examined the sustainability of a range of comparatively high withdrawal rates from portfolios of stocks, bonds, and U. S. Treasury bills over five-year payout periods.

    TABLE 1. Stock/Bond Portfolio Success Rates With Monthly Withdrawals Over Five Years: 1946–2003
    (percent of all past payout periods supported by the portfolio)
    Portfolio Allocation Withdrawal Rate as a % of Initial Portfolio Value
    17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27%
      Fixed Monthly Withdrawals
    100% Stocks 100 98 98 96 91 85 78 72 65 54 50
    75% Stocks/
    25% Bonds
    100 100 98 98 91 83 76 69 56 50 39
    50% Stocks/
    50% Bonds
    100 100 100 98 96 81 74 59 46 30 24
    25% Stocks/
    75% Bonds
    100 100 100 100 89 72 57 39 28 20 17
    0% Stocks/
    100% Bonds
    100 100 100 87 67 57 37 28 24 17 7
      Inflation-Adjusted Monthly Withdrawals
    100% Stocks 98 94 89 83 80 78 65 52 48 46 39
    75% Stocks/
    25% Bonds
    98 96 91 83 80 70 61 48 46 35 24
    50% Stocks/
    50% Bonds
    98 96 91 81 72 65 56 41 26 19 11
    25% Stocks/
    75% Bonds
    100 100 100 87 67 57 37 28 24 17 7
    0% Stocks/
    100% Bonds
    94 91 81 65 48 35 26 17 9 6 6

    Our Approach to the Problem

    We examined the sustainability of withdrawal rates over five-year payout periods using rolling historical time period returns advancing annually from January 1946 through December 2003, for a total of 54 five-year payout periods. The Standard & Poor’s 500 index represents stocks and long-term, high-grade corporate bonds represent the bonds. Each portfolio starts with an initial $1,000, and monthly withdrawals are made at the assumed withdrawal rate as a percentage of the portfolio’s initial value. We examined both fixed monthly withdrawals and inflation-adjusted withdrawals in which the initial withdrawal is increased by the inflation rate in subsequent months. Throughout each 60-month period, a portfolio is assumed to retain the desired stocks/bonds asset allocation percentages by monthly rebalancing. A withdrawal rate is considered sustainable if the initial $1,000 portfolio completes the 60-month payout period with a positive value. Any portfolio that is depleted prior to the conclusion of the 60-month process of accruing returns and making withdrawals is a failure. A higher portfolio success rate suggests greater sustainability of the related withdrawal rate over a five-year payout period.

    Portfolio Success Rates and Terminal Values

    Table 1 presents portfolio success rates for a range of annual withdrawal rates (17% to 27%) from various portfolio allocations of stocks and bonds and for fixed monthly withdrawals and inflation-adjusted withdrawals.

    For example, consider the 17% withdrawal rate for the all-stock portfolio. Historically, the all-stock portfolio supported 100% of the 54 five-year periods when 17% of the initial portfolio value was withdrawn each year in fixed monthly installments. If we increase the monthly withdrawals to reflect inflation in the preceding year, then the portfolio success rate drops to 98% (one failure in the five-year period ending 1977).

    As shown in Table 1, higher annual withdrawal rates and periodic inflation adjustments to withdrawals reduce portfolio success rates. Also, increasing the percentage of bonds in portfolios tends to lower portfolio success rates. Because of the relatively short payout period (five years), annual inflation adjustments are less important than for longer periods of 25 years or 30 years. Still, individuals who prefer larger payouts in later years and smaller payouts in earlier years may choose inflation-adjusted withdrawals.

    TABLE 2. Terminal Value of a $1,000 Initial Portfolio After Monthly Withdrawals for Five Years: 1946–2003
    Portfolio Allocation Fixed Monthly Withdrawals Inflation-Adjusted Withdrawals
    Withdrawal Rate as a % of Initial Portfolio Value ($)
    19% 20% 21% 22% 23% 19% 20% 21% 22% 23%
    100% Stocks
    Average ($) 569 501 435 373 315 476 410 348 288 234
    Midpoint ($) 568 498 430 364 297 436 348 259 172 97
    Minimum ($) — — — — — — — — — —
    Maximum ($) 1,707 1,612 1,518 1,423 1,328 1,632 1,534 1,435 1,336 1,237
    75% Stocks/25% Bonds
    Average ($) 476 411 346 287 231 383 320 261 206 160
    Midpoint ($) 459 389 321 252 190 346 265 191 118 52
    Minimum ($) — — — — — — — — — —
    Maximum ($) 1,281 1,198 1,115 1,032 949 1,213 1,126 1,039 952 865
    50% Stocks/50% Bonds
    Average ($) 394 330 267 210 159 301 242 189 142 100
    Midpoint ($) 365 305 246 187 124 276 212 151 82 18
    Minimum ($) 43 — — — — — — — — —
    Maximum ($) 1,042 958 874 790 706 915 825 734 643 567
    25% Stocks/75% Bonds
    Average ($) 320 258 199 146 104 233 178 131 91 59
    Midpoint ($) 254 192 134 75 15 196 138 79 19 —
    Minimum ($) 57 3 — — — — — — — —
    Maximum ($) 1,101 1,016 932 848 763 973 882 791 699 608
    100% Bonds
    Average ($) 253 196 147 107 77 176 129 93 64 42
    Midpoint ($) 195 135 73 13 — 101 47 — — —
    Minimum ($) 26 — — — — — — — — —
    Maximum ($) 1,152 1,067 982 898 813 1,023 931 840 748 657

    Why Not Simply Hold Cash?

    Taken together, the results of Table 1 might seem to indicate that investors should not invest in either common stocks or long-term bonds when facing a short-term payout period such as five years. Quite literally, an investor could stuff his or her money in a mattress and withdraw 20% a year for five years with a 100% success rate. The table indicates that for an investor to withdraw the same 20% per year from a portfolio consisting equally of equities and long-term bonds, the probability of portfolio success is 98%. In other words, Table 1 seems to indicate that investing in equities and bonds is worse than putting your money in a mattress!

    The one issue this ignores, however, is the value of the portfolio at the conclusion of the payout period. Taking out 20% per year for five years from under a mattress guarantees a portfolio terminal value of $0. A portfolio that includes stocks—for example, the 50% stocks/50% bonds portfolio in Table 1—offers the opportunity for a higher withdrawal rate and a significant terminal value, neither of which is offered by the “stuffing cash in the mattress” strategy.

    Table 2 presents portfolio values at the end of the five-year payout periods. You can see from the table that, despite the monthly withdrawals for five years, in many cases the portfolios still retain significant value.

    Consider the case of fixed monthly withdrawals and a 20% annual withdrawal rate from the 50% stocks/50% bonds portfolio. Based on a $1,000 initial portfolio, the average and midpoint terminal values are $330 and $305. The highest terminal value ($958) occurred for the five-year period ending in 1986. There was only one failure among the five-year payout periods, and that occurred in November 1977, two months shy of success. One failure out of 54 five-year periods causes the portfolio success rate to be less than 100%—i.e., 98%. Only when the portfolio success rate in Table 1 equals 100% will the minimum terminal value in Table 2 be a positive number. And only a person who is so risk averse that no portfolio failures are tolerated would choose cash in a mattress over a portfolio that contained some reasonable allocation to common stocks.

    Over-reliance on long-term bonds in this unique circumstance likewise is not the best strategy. As the percentage of bonds in the portfolio increases, the average and midpoint terminal values decrease because of the limited upside potential of bonds. The maximum terminal value, however, is not as well-behaved as the average and midpoint. The maximum decreases when the bond allocation percentage increases but only to a point, then the maximum increases. The increases in the maximum are an artifact of the unusual and dramatic increases in bond prices caused by precipitous declines in interest rates during the mid-1980s. For both the fixed monthly withdrawals and inflation-adjusted withdrawals, maximum terminal values should be viewed as the outliers that they are—rare and unusual.

    Adding Treasury Bills to the Mix

    Table 3 provides information similar to that presented in Table 1, the only difference being an additional security and different portfolio allocations. For short-term payout periods such as five years, individuals may wish to include cash equivalents in their portfolio. Table 3 presents portfolio success rates for portfolios consisting of stocks, bonds, and 30-day U.S. Treasury bills.

    TABLE 3. Stock/Bond/Cash Portfolio Success Rates for Withdrawals Over Five-Year Periods: 1946–2003
    (percent of all past payout periods supported by the portfolio)
    Allocation Withdrawal Rate as a % of Initial Portfolio Value
    17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27%
    Fixed Monthly Withdrawals
    80% Stk/
    0% Bd/
    20% T-bill
    100 100 100 96 94 89 85 76 63 54 44
    60% Stk/
    20% Bd/
    20% T-bill
    100 100 100 98 96 87 76 63 52 43 28
    40% Stk/
    40% Bd/
    20% T-bill
    100 100 100 100 96 83 67 56 35 24 15
    20% Stk/
    60% Bd/
    20% T-bill
    100 100 100 100 93 80 48 37 22 20 9
    0% Stk/
    80% Bd/
    20% T-bill
    100 100 100 98 72 61 41 24 20 11 6
      Inflation-Adjusted Monthly Withdrawals
    80% Stk/
    0% Bd/
    20% T-bill
    98 96 91 87 80 76 61 48 46 35 22
    60% Stk/
    20% Bd/
    20% T-bill
    98 96 94 85 78 67 52 46 33 19 13
    40% Stk/
    40% Bd/
    20% T-bill
    100 96 94 83 70 63 46 30 22 9 6
    20% Stk/
    60% Bd/
    20% T-bill
    100 96 91 80 65 50 28 19 9 7 4
    0% Stk/
    80% Bd/
    20% T-bill
    98 91 87 69 46 30 20 13 7 6 2

    In general, the addition of Treasury bills in the portfolio produces larger changes in success rates for higher withdrawals than for lower withdrawals. Because Treasury bills reduce the variation of portfolio returns, portfolio success rates for stock-heavy portfolios in the 21% to 24% range are enhanced by the presence of Treasury bills in the portfolios. A comparison of the portfolio success rates net of inflation-adjusted withdrawals in Tables 1 and 3 shows no advantage to holding short-term Treasury bills or cash equivalents. Because inflation consumes the returns to Treasury bills, inflation-adjusted withdrawals are better supported by stocks and bonds.

    Table 4 provides terminal values for a range of withdrawal rates, both for fixed monthly withdrawals and inflation-adjusted withdrawals. The average and midpoint terminal values of portfolios reported in Table 4 are lower than those in Table 2. The maximums in table 4 also are lower than those in Table 2. Thus, including as much as 20% cash in a portfolio reduces the opportunity for higher terminal values at the conclusion of the payout period.

    Maximum Sustainable Annual Withdrawal Rate

    What maximum annual withdrawal rate as a percentage of initial portfolio value can be sustained over a five-year period?

    The answer depends on portfolio allocation, whether or not withdrawals are adjusted for inflation, and the portfolio success rate that is required.

    To illustrate, consider a portfolio comprised of 50% stocks and 50% bonds. Assume that monthly withdrawals are not adjusted for inflation, and that a portfolio success rate of approximately 75% is required for a withdrawal rate to be deemed sustainable. Table 1 shows in this case that a 23% annual rate is sustainable since historically such portfolios have successfully supported that rate 74% of the time.

    This strategy worked roughly three out of four times in the past, but it failed one out of four times. Because of potential failure, the withdrawal rate may have to be reduced for the portfolio to last for five years. Such mid-course corrections are not unusual and should be expected, even though for planning purposes, 23% may be a reasonable withdrawal rate.

    In many cases in the past, the 23% annual withdrawal rate could have been increased because of good fortune in the capital markets. The 74% success rate means that 40 of 54 past five-year periods were supported by the 50% stock/50% bonds portfolio even though 23% of the initial portfolio value was withdrawn each year. Moreover, the value of the portfolio at the end of the five-year period in these 40 cases ranged from $4 to $706 per $1,000 initially invested. As shown in Table 2, despite the annual withdrawal over five years of $230 per $1,000 initially invested, many of these portfolios retained substantial value, over half in excess of $100 per $1,000 initially invested.

    TABLE 4. Terminal Value of a $1,000 Initial Portfolio That Includes Treasury Bills After Monthly Withdrawals for Five Years: 1946–2003
    Portfolio Allocation Fixed Monthly Withdrawals Inflation-Adjusted Withdrawals
    Withdrawal Rate as a % of Initial Portfolio Value
    19% 20% 21% 22% 23% 19% 20% 21% 22% 23%
    80% Stocks/20% Treasury Bills
    Average ($) 479 415 353 293 236 387 323 264 207 157
    Midpoint
    ($)
    498 429 361 292 224 380 293 206 125 48
    Minimum ($) 12 — — — — — — — — —
    Maximum ($) 1,255 1,172 1,089 1,006 923 1,201 1,112 1,023 934 844
    60% Stocks/20% Bonds/20% Treasury Bills
    Average ($) 411 348 286 227 173 320 258 201 149 106
    Midpoint ($) 403 335 268 204 139 310 229 149 81 19
    Minimum ($) — — — — — — — — — —
    Maximum ($) 990 913 836 759 682 924 844 763 683 602
    40% Stocks/40% Bonds/20% Treasury Bills
    Average ($) 349 288 227 170 120 259 200 147 102 64
    Midpoint ($) 320 258 196 137 77 240 179 114 52 —
    Minimum ($) — — — — — — — — — —
    Maximum ($) 877 798 719 640 561 755 670 585 500 414
    20% Stocks/60% Bonds/20% Treasury Bills
    Average ($) 292 232 174 121 81 206 151 103 66 39
    Midpoint ($) 224 167 110 54 — 176 118 59 1 —
    Minimum ($) — — — — — — — — — —
    Maximum ($) 918 839 760 681 602 795 710 624 539 453
    0% Stocks/80% Bonds/20% Treasury Bills
    Average ($) 239 182 131 92 62 161 112 76 48 30
    Midpoint ($) 198 138 77 18 — 96 42 — — —
    Minimum ($) — — — — — — — — — —
    Maximum ($) 954 875 796 717 638 831 745 660 574 488

    Fourteen of the 54 past five-year periods, or 26%, ended in failure. In each of these cases the portfolio became depleted prior to the end of the five-year period because of the annual withdrawals. But when did failure take place? Failure just before the end of the five-year period would seem less serious than failure well before the end. In fact, 12 of the 14 failures occurred in the six months prior to the end of the five-year period, meaning that they missed being counted as successes by only a few months. The most severe failure occurred in month 50 and the second most severe, month 54. In such cases small mid-course reductions in withdrawals would have allowed the portfolios to succeed.

    Using similar analysis suggests maximum sustainable annual withdrawal rates for other scenarios, including:

    • 21% for the 50% stock/50% bond portfolio with inflation-adjusted withdrawals;

    • 22% for the 40% stock/40% bond/20% Treasury bills portfolio with fixed monthly withdrawals; and

    • 21% for the 40% stock/40% bond/20% Treasury bills portfolio with inflation-adjusted withdrawals.

    Conclusion

    The maximum sustainable annual withdrawal rate from a portfolio over a five-year period depends on the mix of securities—stocks, bonds, and bills—in the portfolio. What rate is judged as sustainable also depends on an individual’s degree of risk aversion with respect to falling short of the five years.

    Despite the subjectivism necessarily introduced by the degree of risk aversion, we offer the following conclusions:

    • Based on historical returns in the capital markets, the maximum sustainable annual withdrawal rate as a percentage of initial portfolio value is in the range of 21% to 23% for stock-dominated portfolios.

    • In contrast to long-term payout periods, for short-term payout periods such as five years, individuals are less likely to demand inflation adjustments to the monthly dollar withdrawals. If such adjustments are required, however, then the annual withdrawal rate needs to be lowered by one or two percentage points.

    • The addition of bonds and Treasury bills to the portfolio increases the success rates at low withdrawal rates. The addition of stocks to the portfolio—because of their upside potential—increases success rates at high withdrawal rates.

    • While it might seem that these results are not much superior to “stuffing the money in a mattress,” in fact, investing in long-term assets even for this relatively short-term period produces real benefits. By investing in stocks (50%) and bonds (50%) and withdrawing 20% per year for five years, the individual will have almost the same 100% portfolio success rate as the “mattress investor,” but will have an expected portfolio terminal value of $330 per $1,000 invested instead of zero with the mattress strategy. For stock-dominated portfolios and annual withdrawal rates up to 23%, terminal value is likely to be substantial at the end of five years. That terminal value can be used to maintain constant expenditures beyond year five, or to step up spending in the latter years, or it can be given to heirs.


    Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz are professors of business administration at Trinity University in San Antonio, Texas

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