The Power of Diversification and Safe Withdrawal Rates
When Bill Bengen published his seminal research in 1994, a 4% safe withdrawal rate (SWR) was clearly attainable with a variety of asset allocations. But bond yields are lower now than they were then, and equity returns for the next 20 years are unlikely to exceed those of the prior two decades. Indeed, a new paper by three highly respected researchers showed that SWRs for stock-bond portfolios are well below 4%. But as I will demonstrate, a 4% SWR is still possible with a more diversified portfolio – and without subjecting clients to additional risk.
The 4% rule is increasingly being called into question. A March article in the Wall Street Journal,Say goodbye to the 4% rule, and a New York Times article, The 4% rule for retirement withdrawals may be outdated,summarized the growing sentiment that historically low bond rates may be with us for an extended period, as global economies continue to struggle.
The three researchers – David Blanchett, Michael Finke and Wade Pfau (BFP) – published Asset Valuations and Safe Portfolio Withdrawal Rates in June. They showed how stock market valuations and bond yields at the time of retirement affect sustainable income draws during retirement. Their article followed an earlier one in January that focused on bond yields.
The central theme of their research was that the amount of income that you can draw from a portfolio is a function of key fundamental variables at the time of retirement, along with how these variables evolve during retirement. They used Shiller’s PE10 to predict expected equity returns and current bond yields to predict expected fixed-income returns. While classic work in this area (by Bengen, for example) used long-term historical average returns to determine safe withdrawal rates, BFP based their analysis on market conditions at retirement. If bond yields are low or stocks are expensive, the SWRs will be lower than if one retires into an environment with high bond yields and a depressed stock market.
BFP’s research concluded that the traditional ”4% rule” is far too aggressive for the current environment. Using a portfolio allocated 20% to equities and 80% to bonds, the authors found that a 4% rate now has only a 48% chance of being sustainable for a 30-year retirement. When they included a portfolio expense ratio of 50 basis points, they found that a 90% success rate for funding a 30-year retirement could only be achieved a maximum 3% income draw rate. A 40% equity/60% bond portfolio can sustain a 2.8% draw rate. This was consistent with the authors’ January article.
This research raises a number of critically important issues for advisors. How can one best estimate SWRs without unnecessarily relying on long-term historical data? What are the alternatives for incorporating valuation measures into forward-looking estimates of returns from other asset classes?
A limitation of the work to date is that very few portfolios are invested in just stocks and bonds. The additional diversification benefits from other asset classes will improve risk-adjusted returns. How can we test the potential impact of emerging-market stocks, commodities or other asset classes on SWRs?
I will explore an alternative approach to estimating SWRs and then use this approach to identify better strategies for constructing retirement portfolios. Let’s begin by examining the framework for predicting future bond and equity returns and the source of uncertainties in those estimates.
Managing estimation risk
Estimation risk is an important idea that is implicit in BFP but was not discussed. Our ability to estimate future equity returns is far worse than for bond returns. As BFP showed, future returns from bonds can be accurately predicted on the basis of current yields, while no such methodology lends itself to forecasting equity returns. The r-squared of the linear relationship between current yield and future 10-year annualized return for the Ibbotson Intermediate-Term Bond index was 92%. The r-squared between the PE10 and future 10-year annualized return was 24% (r-squared is a standard measure of the strength of a relationship; higher r-squared corresponds to higher predictability). Attempts to predict SWRs will be more robust if they first focus on estimating fixed-income returns.
We must estimate equity returns, however, and to address the substantial difference in predictability one can incorporate asset class risk premia into this analysis. There is a link between expected returns on stocks and bonds. Low bond yields in the current market drive investors to stocks. This drives up the valuations and drives down the expected future returns from stocks. Expected returns from stocks and bonds, therefore, will be commensurate with their respective risk levels.
Estimating future risk and return
I will use a form of portfolio analysis that I developed and incorporated into Quantext Portfolio Planner (QPP). The starting assumption is that stocks, bonds and other asset classes and sub-classes have a consistent linear relationship between risk and return, with the slope of this relationship established by the equity risk premium (ERP), expressed as the average annual return expected from the S&P 500. All analysis used data through June 2013.