We know a portfolio’s Sustainable Withdrawal Rate (SWR) is the maximum amount a client can withdraw throughout retirement with an acceptable risk of depletion. It’s based on a reasonable risk of running out of money. This raises questions: What’s reasonable risk? Is a 0% probability of depletion too stringent? What about 50% probability of depletion?

The answer depends on what your clients need the money for. To determine this, you should categorize your clients’ expense items into one of three groups.

01 Essential

Expenses that are necessary for survival under normal circumstance. Our risk criterion is that the occasional loss of purchasing power must not be larger than 10% at any age. This implies the probability of portfolio depletion must be zero. We don’t want to plan for our client going on a continuous dog-food diet, but we accept occasional belt-tightening.

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02 Discretionary

Expenses the client is flexible with—the opposite of essential expenses. Donation expenses are an example. The client can accept a 50% probability of occurrence: if she doesn’t have the money, she just won’t donate. This category of expenses affords a much larger SWR. Here our risk criterion is that median outcome must last until death (i.e., 50% probability of depletion).

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03 Basic

These are expenses for things the client wants, but they’re not critical for survival. For example, she may love going south each winter, but when push comes to shove financially, she can do without. While it’s a non-essential expense, it’s more important than a discretionary expense. Here, our risk criterion is that the probability of portfolio depletion should not exceed 10%. That means there’s a 10% chance the retiree might have to forego this type of expense.

Once we allocate each expense to one of these groups, we’ll have three piles of retirement expenses, each with its own 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 of the purpose-driven SWR.


SWR versus acceptable risk for different types of retirement expenses

Originally published in Advisor's Edge Report

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