### The Simplest, Safest Withdrawal Strategy

Few financial planning topics have garnered as much attention as safe withdrawal rates (SWRs), but a key question remains unanswered: Can retirees sustain a 4% withdrawal rate with minimal risk? With the recent introduction of 30-year TIPS, the answer is now yes.

Retirees can withdraw up to 4% per year (on an inflation-adjusted basis) over a 30-year period from a portfolio consisting of solely 30-year TIPS with very high success rates. Unlike a traditional stock-bond portfolio, a TIPS portfolio is not exposed to risk from the equity or fixed-income markets or from unanticipated inflation. The only source of risk is from volatility in real interest rates.

The implications of these results are clear. If a retiree has sufficient funds to support a 4% withdrawal rate over 30 years, then those funds should be invested in TIPS. Funds should only be invested in stocks and bonds if the required withdrawal rate is greater than 4%.

I will discuss how we modeled the TIPS portfolio and then compare it to the results of a 60/40 stock/bond portfolio. I will analyze the performance of a 60/40 portfolio assuming stock and bond returns based on historical averages and show how it performs if more modest “new normal” stock returns are assumed. Lastly, I will look at the results of the 60/40 portfolio if inflation is modeled as a random variable instead of as a constant rate.

Louis Mittel, a member of our research staff, designed and built the Monte Carlo simulation model used in this analysis. Michael Edesess, an economist and mathematician and an advisor to our company, designed the framework for this analysis.

**Modeling the all-TIPS portfolio**

When we constructed our model in mid-July, 30-year TIPS yielded 1.57%, and that was the basis for our analysis. This portfolio is nearly completely protected from inflation, since coupon payments from TIPS are indexed to the CPI-U rate reported by the government. Only to the extent that inflation associated with the retiree’s expenses differs from the reported CPI-U rate is the investor exposed to inflation risk. There is no risk from equity or bond market performance.

Assuming no change in real interest rates, a portfolio of 30-year TIPS can sustain 4% withdrawals, leaving the retiree with $53,220 in present value at the end of 30 years. A slightly higher withdrawal rate of 4.13% would leave the retiree with no remaining principal.

One important source of risk must be considered, however, and that is the volatility of TIPS interest rates (the “real” or inflation-adjusted yield). Increases in real yields will decrease the value of the portfolio and threaten the sustainability of the projected withdrawal rate. Conversely, a decrease in real yields will provide the retiree with additional funds.

We used Monte Carlo simulation to examine the effect of volatility in real interest rates on withdrawal rates in an all-TIPS portfolio. The key assumption in our model was the standard deviation of the annual return for TIPS contracts. We used three sets of assumptions, beginning with 2.59%, which is Vanguard’s calculation for the annual standard deviation of 20-year TIPS. Research by Harvard professor Luis Viceira and Carolin Pfleuger has shown that TIPS are more volatile, however. They found that TIPS volatility ranged between 5% and 8% from 2004 to 2008 and then increased dramatically to almost 14%, based on annualizing daily returns and using 10-year contracts. We ran our model with standard deviations of 6.5% (the mid-point between 5% and 8%) and 14%, to show the sensitivity of our results to changes in this variable.

Our method of simulating each price in a sequence of annual TIPS prices is to generate a random one-year TIPS return using the current yield-to-maturity (YTM) as the expected return and the assumed standard deviation (2.59%, 6.5%, or 14%), then use that one-year return to infer the remaining YTM, from which the price can be backed out.