New Studies Offer Guidance as to “Safe” Withdrawal Rates From Investment Portfolios for Retirees

Posted on March 10th, 2014 at 5:00 PM

From the Desk of Jim Eccleston at Eccleston Law Offices:

Nothing worries a retiree more than the thought of running out of money in retirement.  Financial advisers need to have the (sometimes unpleasant and disappointing) discussion of how much money can be withdrawn from an investment portfolio during retirement.    

For years, the discussion has focused on two basic assumptions.  First, an assumption regarding the sustainable withdrawal rate.  Second, an assumption regarding the projected investment return that the portfolio can generate.

Recently, the discussion has become more advanced, focusing on a third factor: the so-called “sequence” of investment returns.  New studies reveal how critical timing is to the success of a safe withdrawal rate plan.  Let’s examine those studies, as summarized in a recent presentation by Pinnacle Advisory Group.

Return sequencing poses several critical questions.  First, what happens if the “average” return on a stock portfolio over 30 years is 10% but the returns vary from year to year?  Second, what happens if the first two years have a return of 0% and the last two years of the 30 year time frame have a return of 20%?  Third, what happens if the first two years have a return of 20% and the last two years of 0%?  Quite simply, the consequences are dramatic.  In short, early, unexpected negative investment returns (less than the average return assumed) will damage the portfolio, and likely torpedo any “safe” withdrawal plan.  On the other hand, early, unexpected positive returns (greater than the average return assumed) will benefit and ensure the success of a safe withdrawal plan. 

The level of volatility within the portfolio is crucial as well.  While no one can predict the future, there are various ways to hedge against the negative effects of volatility.  Studies show that the impact of volatility can be reduced by building in a “safety margin” of approximately 2% less than the historical average.  By examining historical returns as a way of predicting future returns, research has shown that a safe withdrawal rate of approximately 4% to 4.5% of the account’s initial balance would have weathered many of the market scenarios that we have seen to date.  Similarly, while studies vary within a range of 40% to 70%, it seems that a portfolio allocation of approximately 60% equities is optimal to survive volatility in the market.

While exact predictions are impossible, there are various ways of forecasting market returns.  Through examining the components of long-term stock returns, such as dividend yield, earnings growth and change in the P/E multiple, advisers are able to forecast future returns and safe withdrawal rates, which are highly correlated with early portfolio returns.  Examining P/E multiples has proven to be one of the most effective ways of predicting safe withdrawal rates.  High P/E ratios have an inverse relationship to 15-year returns, which are positively correlated to safe withdrawal rates.  Consequently, studies have shown that the valuation environment is predictive of safe withdrawal rates.  With regard to portfolio allocation, in a risky environment, an examination of the relationship between P/E and safe withdrawal rates revealed there are significant diminishing returns in portfolios with greater than a 60% allocation in equities.

As the original research regarding safe withdrawal rates was based on portfolios containing only two asset classes, equities and bonds, it is important to consider how greater diversification within a portfolio may affect the safe withdrawal rate.  In addition to asset allocation, factors such as market valuation, interest rates, a retiree’s risk tolerance and spending flexibility can impact safe withdrawal rates.  Importantly, in cases where a retiree has materially uneven spending patterns, tools such as the Monte Carlo analysis may be necessary to further refine the safe withdrawal rate. 

Recent research has shown that adjusting certain factors based upon client-specific circumstances can greatly refine an adviser’s recommendations to a retiree.  It is also important for advisers to take into account the impact of expenses and taxation on the safe withdrawal rate.  Moreover, as average life expectancy has increased, advisers should also consider recommending that clients build a “cushion” into their portfolios for after age 90.

In the current environment, advisers have a myriad of factors and considerations to evaluate and weigh for their clients.  While there (unfortunately) is not a crystal ball into which advisers can look and see the future, there are many tools in their toolbox which can aid them in making client-appropriate and client-centric recommendations.   

The attorneys of Eccleston Law Offices represent investors and advisers nationwide in securities and employment matters. Our attorneys draw on a combined experience of nearly 50 years in delivering the highest quality legal services.

Related Attorneys: James J. Eccleston

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