Sustainable Withdrawal Rates

The first piece of the puzzle is how much can we safely withdraw each year for our expenses?

Old Assumptions Are Hazardous To Your Wealth

The traditional financial planning assumption about retirement income generation goes something like this: You will make 10% on average, withdraw 6% per year, each year your account balance and income will grow by an average of 4%, you will die rich, and your children will receive a windfall. This sounds wonderful in theory, but it’s a bust in the real world.

The fatal problem with the traditional assumption is that it does not account for the variability of returns in the real world facing the retiree. We know from past experience that projecting average returns forward straight line is totally inappropriate. Average returns count for nothing if your retirement precedes a period like the Depression or 1973-1974. Your nest egg stood a high chance of self-liquidating.

The real world that you face is much more complicated and risky than an “average” return might indicate.

A pioneering study

Three business professors from Trinity University of Texas, Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz,  broke new ground with their paper: “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable”. They employed historical back testing to demonstrate the relationship between withdrawal rates, time horizon, and asset allocation. The results reveal that portfolio failure rates are directly related to time horizon and withdrawal rates, and influenced by asset allocation.

Using the S&P 500 and bonds in various combinations over varying time periods commencing in 1926, the study tracked failure rates against withdrawal amounts. Even in the best possible case where there were no taxes, no expenses or transaction fees, and the optimum portfolio was known in advance, significant failure rates occurred above 6%. 

The Cooley, Hubbard, Walz study highlights the need for conservative withdrawal rates, and by implication the need to accumulate liberal amounts of capital to fund a comfortable retirement. Historical back testing is a useful tool and provides a powerful “sanity check”. Like any modeling tool, it has limitations. In this case, we are stuck with only one series of data. Unless we believe that the past results will re-occur in exactly the same sequence our findings will not be as robust as we might hope. For instance, running the sequence backwards or any other re-shuffling will result in entirely different results. Furthermore, historical back testing leaves us with no simple method to vary either rates of return or volatility in the sample set.

New and more powerful modeling tools confirm these principles and add additional insight, but do not replace the need for very conservative assumptions if the retiree wishes to have a high probability of success.

Next: Recognizing the effect of volatility

Copyright ã 2000 Francis C. Armstrong

Frank Armstrong, CFP, is the author of Investment Strategies for the 21st Century, published here, President of Managed Account Services, Inc., a fee-only Registered Investment Advisor, and Chief Investment Strategist of DirectAdvice.com.