Rethinking Safe Withdrawal Rates: The Meaning of Failure
Merely knowing the probability that an investor’s wealth will be depleted at some point is not enough to build a retirement strategy. That is the traditional measure of failure in safe withdrawal studies, and it’s time to move beyond it.
Instead, investors should consider additional factors such as how long a retiree might live after depleting his or her wealth. One must also consider other retiree goals, such as spending as much possible or leaving a bequest, other income sources that may still be available when portfolios run dry, which dampen the impact of wealth depletion, and how much flexibility retirees have to reduce their spending, should the need arise.
Let’s look at how recent research reported in the Journal of Financial Planning – including some of my own – pushes toward a more complete perspective on defining the viability of retirement income strategies.
By a withdrawal rate, for the purposes of this article, I mean the percentage of the portfolio an investor withdraws in the first year of retirement. Subsequent annual withdrawals adjust this amount for inflation. Withdrawals take place at the start of the year and do not account for taxes or fees.
My analysis below used Monte Carlo simulation incorporating historical means, standard deviations, and correlations for annual total returns data since 1926 from Ibbotson Associates' Stocks, Bonds, Bills, and Inflation (SBBI). Stocks were represented by the U.S. S&P 500 index (large-capitalization stocks). Bonds were intermediate-term U.S. government bonds. Applying inflation data, I calculated real asset returns, real remaining wealth, and inflation-adjusted withdrawal amounts.
My assumptions are generous, so a few caveats are in order. To be consistent with most existing research, I based my analysis on historical averages, though it is advisable to also reconsider these results in light of current low bond yields. Retirees may tend to live longer than implied by the mortality data used herein. Moreover, retirees will of course start cutting back on spending before their wealth dissipates entirely, but the fixed spending until depletion assumption used here at least demonstrates the eventual need, in some simulated outcomes, to lower the standard of living late in retirement.
Shortfall probabilities approach to retirement planning
The 4% safe withdrawal rate for systematic withdrawals from a volatile portfolio provides a rule of thumb designed to make failure less likely over the course of a 30-year retirement. (Failure, in this case, is narrowly defined as portfolio depletion at any point before the end). Since Bill Bengen’s seminal 1994 article on safe withdrawal rates, related studies have commonly used either historical or Monte Carlo simulations over a fixed time horizon to determine the probability of failure for different withdrawal rate and asset allocation strategies.
Figure 1 presents the classic Monte Carlo simulation approach to safe withdrawal rates over a 30-year horizon. Failure rates for the 4% rule are under 10% for stock allocations between 20% and 70%. A 40% stock allocation yields the lowest failure rate, just 7%. Though Bengen found that 4% always worked in historical simulations, my Monte Carlo simulations based on the same data show that wealth exhaustion is a possibility. Retirees increase their withdrawal rate above 4% at their peril; the lowest failure rate for a 5% withdrawal is 23%, with a 70% stock allocation. Higher withdrawal rates increase both the failure rates and optimal stock allocations.