ETERMINING WITHDRAWAL RATES USING HISTORICAL DATA

1 ETERMINING W I T H D R A W A L RATES . USING HISTORICAL DATA. by William P. Bengen At the onset of retirement, investment ad- planner into trouble was assuming that visors make crucial recommendations to average returns and average inflation clients concerning asset allocation, as well RATES are a sound basis for computing as dollar amounts they can safely with- how much a client can safely withdraw draw annually, so clients will not outlive from a retirement fund over a long time. their money. This article utilizes histori- As Larry Bierwirth pointed out in cal investment data as a rational basis for his excellent article in the January 1994. these recommendations. It employs graphi- issue of the this publication ("Investing cal interpretations of the data to determine for Retirement: USING the Past to Model the maximum safe WITHDRAWAL rate (as a the Future"), it pays to look not just at percentage of initial portfolio value), and averages, but at what actually has hap- establishes a range of stock and bond asset pened, year-by-year, to investment re- allocations that is optimal for virtually all turns and inflation in the past.

2 He dem- retirement portfolios. Finally, it provides onstrated that the long-term effects of guidance on "mid-retirement" changes of certain financial catastrophes, such as asset allocation and WITHDRAWAL rate. the Depression or the 1973-1974 reces- sion, can overwhelm the averages. Such WILLIAM P. BENGEN "events" cannot be ignored, and the cli- ent should be made aware of them. T he year is 2004. You have done a However, you cannot help feeling a gnaw- In this article, I will build on creditable job of building your in g concern that y ou hav e ov erloo ked some- Bierwirth's work, approaching it from a financial planning practice over thing .. slightly different tack. USING the con- the last ten years. Your retirement clients It is 2009. True to your forecast, the cept of "portfolio longevity," I will are particularly well-satisfied. You have stock market has recovered nicely during present simple techniques planners can demonstrated to them the virtue of a diver- the last three years, and most clients'port- use immediately in their practice in ad- sified portfolio of investments to provide folios have regained almost all their lost vising clients how much they can safely income during retirement.

3 The markets nominal value. However, your clients have withdraw annually from retirement ac- have been kind, if not overly generous; a new complaint: they cannot live on the counts. I also will explore the issue of your client's portfolios have enjoyed re- withdrawals they have been making. In- asset allocation during retirement, in- turns well in excess of bank savings ac- flation, averaging eight percent over the cluding some surprising (at least to me). counts and certificates of deposit. They last five years, has so eroded their pur- conclusions. In all cases I will rely on perceive you as having enriched their lives, chasing power that they must substan- actual HISTORICAL performance of invest- and they are grateful .. tially increase their withdrawalsmor face ments and inflation, as presented in It is 2006. The markets have turned a drastically reduced quality of life. When Ibbotson Associates' Stocks,, Bonds, Bills sour as a weak Federal Reserve Board has you compute the effect on your clients' and Inflation: 1992 Yearbook.

4 Allowed inflation to spiral out of control. portfolios of these much higher levels of The stock market has plummeted 35 per- withdrawals, you are shocked: many cli- The Averages cent during the last 2 years, the worst ents will deplete their assets in less than ten losses since the 19 73-19 74 recession. Many years, even though in many cases their life To begin with, let's see how our hypo- of your clients are alarmed, worried that expectancies are much longer. You have thetical planner got into trouble. By re- they will have to cut back on their lifestyles very bad news to tell them. What could ferring to the Ibbotson data (which we to preserve capital in their retirement ac- have gone wrong? will assume had not changed signifi- counts. You soothe them, reminding them cantly by 2004), our planner learned that you carefully computed their RATES of The above scenario is fiction, of course, that common stocks had returned WITHDRAWAL based on average RATES of re- but it could easily have been played out percent compounded over the years, and turns experienced by the markets over the several times during this century.

5 The intermediate-term Treasuries had re- years, and that the markets will recover. logical fallacy that got our hypothetical turned percent. Inflation averaged 3. October 1 9 9 4 1 7 1. ening period for investors. a The "Big Dipper" of 1937-1941. featured a stock decline almost as great as the "Big Bang," but it occurred during a period of moderate inflation and some- what higher bond returns. Therefore, its impact on portfolios was not as severe, though it was still substantial, particu- larly as it followed the " little Dipper" by only half a decade. a The " little Dipper," of course, was the early Depression years. It may sound odd to list its impact as only third behind the previous two events, given the huge decline in stock prices that occurred. However, as you can see from percent over the same period. There- turns and inflation stayed close to his- Table 1, the early years of the Depression fore, a client with a portfolio consisting torical averages.

6 The circumstance that was a deflationary period, so the impact of 60-percent stocks and 40-percent upset the arrangement was an "event," of the decline in stock values was cush- bonds could expect an average com- consisting of a severe stock-market ioned by an advance in purchasing power pounded return of percent, assum- downturn and high inflation. for the dollar, as well as by modestly ing continual rebalancing. The "real" What similar events have actually positive bond returns. return, adjusted for inflation, would be occurred in the past? There have been other events of almost percent. shorter duration, such as in 1946, but This planner's clients wanted to The Events the above represent the most significant spend as much as possible each year financial cataclysms of the last three from their retirement accounts, while Table 1 lists the three largest stock- quarters of this century.

7 As planners, we m a i n t a i n i n g a c o n s i s t e n t lifestyle market declines since 1926 that have know such events are likely to recur in throughout retirement. Given the above occurred over periods of more than one the future. But just how detrimental analysis , it seemed to the planner that year. (The "crash" of 1987 does not have these past events been on the long- the clients could safely withdraw all the appear, as stocks showed a gain for the term performance of a retirement port- "real return" each year, or about five full year.) Because of my interest in folio? percent, and leave the remainder in the astronomy, I have nicknamed them, re- portfolio. The clients could thus increase spectively, the "Big Bang," the "Big Dip- The Portfolio Scenarios In Figures 1 (a)-l(d), a series of graphs illustrates the HISTORICAL performance of Assuming a minimum requirement of 30 years of portfolios consisting of 50-percent in- portfolio longevity, a first-year WITHDRAWAL of 4 percent, termediate-term Treasury notes and 50- followed by inflation-adjusted withdrawals in percent common stocks (an arbitrary subsequent years, should be safe.)

8 Asset allocation chosen for purposes of illustration). I have quantified portfolio performance in terms of"portfolio longev- ity": how long the portfolio will last before their withdrawals each year by three per," and the " little Dipper," reflecting all its investments have been exhausted by percent, keeping pace with inflation. At their relative impact on the value and withdrawals. This is an intuitive approach the same time, the value of their portfo- purchasing power of investors' portfo- that is easy to explain to my clients, lios would increase with inflation, satis- lios. These impacts will be more pre- whose primary goal is making it through fying their secondary goal of leaving cisely quantified in the section below on retirement without exhausting their wealth for their heirs. The Portfolios. funds, and whose secondary goal is ac- Thus, the planner recommended a The "Big Bang" of the 1973-74 cumulating wealth for their heirs.

9 The that his clients withdraw five percent of recession was the most devastating be- graphs themselves afford rapid compari- their portfolio's initial value at the end of cause it occurred during a period of high sons between many different investment the first year, and annually increase their inflation. Not only did investors suffer scenarios. I have made several assump- withdrawals by three percent, the antici- large paper losses in their portfolios, but tions in preparing these graphs. These pated rate of inflation. This plan worked the purchasing power of what remained assumptions are detailed in the Appen- well for several years, as investment re- was reduced substantially. It was a fright- dix. 172 Journal of Financial Planning In Figure l(a), the first vertical bar on the left represents the portfolio of a FIGURE l(a). Number of Years Portfolio Assets Will Last (Withdrawals Vary Each Year with client who began retirement on Jan.)

10 1, Inflation). 1926. He made a WITHDRAWAL of 3 percent v-- 80. of the portfolio the first year, followed by inflation-adjusted withdrawals each I-- succeeding year. The next bar repre- ,,i 6 0. sents the portfolio of a client who began retirement on Jan. 1, 1927, and so on. 0. As you can see from the graph, the 0~ 40. IJ. 1926 client was able to make withdraw- o als from his portfolio in this manner for Q" 2 0. 50 years. Actually, the portfolio would <. UJ. have lasted much longer than this. I have >- chosen 50 years arbitrarily as the longest ~ 0. 26 28 30 32 34 38 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76. period to show on the charts, as few Y e a r Portfolio withdrawals begin (withdraw end of y e a r ). clients enjoy more than 50 years of re- tirement. Figure l(a) (three-percent with- FIGURE l(b). drawal rate) is as exciting as a crewcut. Number of Years Portfolio Assets Will Last (Withdrawals Vary Each Year with It shows that all clients, regardless of the Inflation).