Do Income-Oriented Portfolios Reduce Safe Withdrawal Rates?

Among studies of safe withdrawal rates (SWRs) researchers have followed a common path: constructing portfolios with the goal of optimizing total return. This strategy achieves the highest SWR, but retirees often prefer a more income-oriented portfolio. I will illustrate the tradeoff investors make – in terms of a lower SWR – as they increase allocations to income-producing securities. But increasing income also brings a key benefit: lower estimation risk.

Bill Bengen pioneered the concept of SWRs in the 1990s. It is the percentage that a retiree can withdraw annually, adjusted for inflation, from a portfolio over a fixed time frame with a given probability of success (i.e., not depleting one’s assets). For this article, I used a 30-year time horizon and a 3% inflation rate to construct portfolios with a 90% probability of success.

Over the past two decades, a variety of methods have been brought to bear in determining SWRs. Early work assumed portfolios only held two asset classes, stocks and bonds, and used average historical returns and volatilities to determine the allocations that achieve the highest probability of success. Researchers soon showed that diversifying beyond a two-asset portfolio produces higher returns and SWRs.

A second limitation of the classical research into SWRs is too heavy an emphasis on the use of long-term historical U.S. market data. Future returns from equities are not likely to be as generous as those over the last century. For example, record low bond yields virtually guarantee that fixed-income returns will be lower than they have been in the past 30 years. I explored the implications of bond yields for SWRs in a recent article.

An important piece of the SWR puzzle that is unresolved is how to choose between total-return and income-focused portfolios. Financial planners routinely pursue a total-return strategy. But there is no reason why a total-return strategy should be superior to an income-focused strategy. Let’s explore the costs and benefits of total-return and income-oriented strategies as they pertain to SWRs.

The theory

The key justification for focusing on total-return strategies is the seminal research by Modigliani and Miller in the 1950s that concluded that investors should be indifferent to whether their returns come from price gains or dividends. This is referred to as the dividend irrelevance proposition. In theory, managers of a company can reinvest their earnings, buy back shares or pay some portion of their earnings to shareholders. Because markets are assumed to be totally efficient, there is no information content in the payment of dividends and investors have no reason to prefer dividends over the price appreciation that should ultimately result from a company reinvesting its earnings.

Recent research demonstrated that there is a missing piece in this paradigm. When investors consider purchasing an asset, they have to estimate expected future return. This estimate may be qualitative (e.g., stocks will return more than bonds) or explicit. Estimation risk measures the uncertainty in predicting risk and return.

Is estimation risk less for income-generating assets than for non-income assets? While this question cannot be answered conclusively, there is evidence that dividend-paying stocks have a more consistent earnings stream than non-dividend payers, which implies that their estimation risk should be lower. It is easier to estimate the future return for a stock with a 4% yield than for one with no dividend, if they both have the same expected total volatility. The dividend provides a baseline for estimating the total return.

Estimation risk for fixed-income assets is low because return is driven by the yield at purchase, as I discussed in my previous article. If estimation risk is lower for portfolios in which a substantial portion of the total return comes from income distributions, this could make income strategies especially attractive.