“Purpose-driven sustainable withdrawal rate” is eligible for CE credits, see Accreditation details for more information

Course summary: Financial planner and market theoretician Jim Otar walks advisors through sustainable withdrawal rates (SWR) for Canadian portfolios. In this course, he shows market history is not the only variable that impacts the SWR. The intended use of withdrawals is also a large factor in determining the SWR.

What is Sustainable Withdrawal Rate (SWR)?

SWR is the maximum amount of money you can withdraw from a portfolio throughout retirement with an acceptable risk of depletion. It is usually expressed in terms of a percentage, such as the famous “4% rule.” This particular rule suggests that if you start withdrawing the dollar amount that is equal to 4% of your assets at the beginning of retirement and then index these withdrawals to CPI throughout retirement, you would have income for 30 years at a reasonable risk.

Different sources publish different SWRs depending on what input they have used. Some of the factors that affect the SWR are:

  • Asset mix: Does the analysis use an arbitrary asset mix or is it optimized for the withdrawal rate?
  • Equity index: Which equity index has been used? There are significant differences between how Canadian and U.S. market behave. Generally, Canadian equities perform better in inflationary periods.
  • Total return versus index return: Using the total historical return will paint an overly optimistic picture, because the current average dividend yield is half of what it was pre-1990s.
  • Man-made simulators versus actual historical data: Simulators have significant deficiencies in modelling market behavior. They use smoothened data, which suffer from “loss of memory” of correlations and black swan events. On the other hand, actual historical data (aftcasting) preserves the sequence of returns as well as all correlations between stocks, bonds, interest and inflation rates, resulting in a much more reliable SWR.
  • Portfolio costs: These can be an important part of SWR calculation (see our course “Determinants of Growth in Distribution Portfolios”). The higher the portfolio costs, the lower is the SWR.
  • Underperformance: We generally observe that most fund managers and investors underperform the index over long periods of time, either because of behavioral risk factors or fund size and dynamics. This needs to be addressed in the SWR analysis.

In addition to these factors, there is one other important factor that we need to address: We already know that the SWR is based on a “reasonable risk” of running out of money.  This raises additional questions: “What is reasonable risk?”; “Is a 0% probability of depletion too stringent?”; “What about 50% probability of depletion? Is that an acceptable risk level?”; “What is a tolerable loss of purchasing power throughout retirement?”.

Here is the simple answer: It all depends on what you need this money for. For that, we categorize each expense item in one of these three groups: Essential, Basic, and Discretionary.

  1. Essential Expenses: These are expenses that are necessary for survival in a normal setting. Here, our risk criteria is. the occasional loss of purchasing power must not be larger than 10% at any age. This implies that the probability of portfolio depletion must be zero. We don’t want to plan for our client to go on a continuous dog food diet, but we accept occasional belt-tightening.
  2. Discretionary Expenses: These are expenses that the client is flexible with, exactly the opposite of essential expenses. For example, if we are talking about donation expenses, the client can accept a 50% probability of occurrence. If he does not have the money, he just won’t donate. This category of expenses afford a much larger SWR. Here, our risk criteria is, the median outcome must last until death, i.e. 50% probability of portfolio depletion.
  3. Basic Expenses: These are the expenses that the client wants, but they are not that critical for survival. For example, if a client loves going south each winter, when push comes to shove (financially), he can probably do without it. So, this is a non-essential expense, but it is not as non-essential as a discretionary expense. Here, our risk criteria is, the probability of portfolio depletion should not exceed 10%.  That means there is a 10% chance that the retiree might have to forego this type of expense.

Once we allocate each expense item to one of these three groups, then we have three piles of retirement expenses, each with its own specific degree of acceptable risk. This risk level is lowest for essential expenses, a little higher for basic expenses, and a lot higher for discretionary expenses (See Figure 1). This is the basis for the “purpose-driven sustainable withdrawal rate.”

Figure 1: SWR versus Acceptable Risk for Different Types of Retirement Expenses

As for longevity risk, we want 90% certainty that the client dies before his portfolio is depleted. As a default, we use 95 as the age of death for male clients and age 97 for female clients or couples. However, in this course, we use age 96 for the sake of simplicity.

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