Earn CE credits

“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.

Methodology

In most retirement plans, forecasts are based on using “average” growth rates and inflation, i.e. they follow the “Law of Averages.” In contrast, we use “Murphy’s Law” to make sure that extreme events are covered. Murphy’s Law says, “Anything that can go wrong, will go wrong.”

We use actual market history, which we call “aftcasting” (as opposed to “forecasting”). We do not use Monte Carlo simulators.

Aftcasting displays the outcome of all historical asset values of all portfolios on the same chart, and it gives a bird’s-eye view of all outcomes for a given scenario. It provides the success and failure statistics with exact historical accuracy because it includes actual historical equity performance, inflation and interest rate, as well as the actual historical sequencing/correlation of these data sets.

In our analysis, we use the following inputs:

  • Equity benchmark and performance: S&P/TSX, index only, starting in 1919 (earliest available TSX data) until the end of 2013, plus an average dividend yield of 2.5%, less average total costs of 2%.
  • Fixed-income performance: A conventional bond ladder portfolio, held until maturity, no capital gains or losses, net yield after costs is historical 6-month CD plus 0.5%.
  • Asset mix: Optimized for each sustainable withdrawal rate, rebalanced annually when the target mix deviates by more than 3%.
  • Withdrawal amount: Indexed to historical CPI rate for each year.

Keep in mind, any probabilities mentioned here (such as probability of depletion, failure, success, loss of purchasing power, etc.), are based on historical market extremes. Future black swan events might be more extreme than they have been in the past. Therefore, it is important to review retirement plans periodically to include and adjust for future market events and changing client needs. Planning is an ongoing process.

Testing the “4% Rule”

Let’s see how the aftcast of the 4% Rule holds up against our risk criteria.

Example: Bob, 65, has $500,000 in his portfolio with an asset mix of 50%/50%. Starting now, he needs $20,000 annually (4% of the initial portfolio asset value), indexed to CPI until age 96. Figure 2 depicts the asset chart. The green line (“lucky”) represents the top decile and the red line (“unlucky”) represents the bottom decile of all historical outcomes.

Figure 2: The Aftcast of Bob’s Portfolio Assets

As interesting as this asset chart looks, our focus is on lifelong income. For that, we observe the “income carpet” (Figure 3). The horizontal scale shows starting years between 1919 and 2000. The vertical scale indicates the age of the client. Each pixel on the carpet shows the level of income received for that particular starting year and age as percentage of total real income required.

Each color indicates a different range of percentage. For example, green means that 100% of the required income was available. Yellow means that only 90% to 100% of the required income was available. Solid red means no income was available because the portfolio was depleted. In a nutshell, green is good, and any hue of red is bad.

Figure 3: Bob’s Income Carpet

Historically, in the worst case, the portfolio ran out of money at age 87. By age 96, the probability of depletion was 12%. Let’s see how this risk compares to our guidelines:

  1. Essential expenses: For essential expenses, the maximum allowable loss of purchasing power is 10% at any age. That means we don’t mind seeing a few yellow pixels here and there on the income carpet, but no red (or reddish) pixels are allowed. Therefore, the 4% rule violates our test for “reasonable risk” for essential expenses.
  2. Basic expenses: For basic expenses, the maximum allowable probability of depletion is 10%. Here, we have 12% probability of depletion. So, the 4% rule also violates our test for “reasonable risk” for basic expenses, albeit by a small margin.
  3. Discretionary expenses: For discretionary expenses, the maximum allowable probability of depletion is 50%. Therefore, the 4% rule can be comfortably used for discretionary expenses.

Retirement Expenses:

We include a worksheet template (see Appendix “A”) to help you easily prepare the expense list. Enter the annual dollar amount of each expense item in one of the essential, basic, or discretionary columns. Subtotal each page and then add up on the last page. Now you have the total dollar amounts of essential, basic and discretionary expenses for your client.

You might need to prepare separate sets of expense lists to account for varying expenses during different life stages (able, less-able, disabled). For this course, in the interest of keeping it simple, we use only one set of expenses in our SWR calculations.

Keep in mind that you need your client’s input as to how you categorize each expense item. What is essential for one client might be discretionary for another. For example, when we talk about child support expenses, if the child is disabled, then it would likely be essential; otherwise, it would likely be discretionary. Another example: Travel expenses might be essential for one client and discretionary for another. Discuss each expense item with the client to ensure it is entered in the correct group.

Generally, housing expenses, income taxes and most living expenses are essential. You can expect that as the client gets older, essential expenses increase and discretionary expenses decrease. In many cases, if the client owns his home, additional capital for higher future essential expenses can be raised by downsizing or selling the home at a later age.

Income From Other Sources

To complete cash flow calculations, you also need to make a list of expected income from all sources. This list should include income from Canada Pension Plan, Old Age Security, company pensions, annuity income, rental income, business income, royalties and so on. Do not include income from investments (open or registered) because they are calculated separately.

Normally, income from other sources pay essential expenses. Retirement assets (open or registered) then pay any remaining shortfall of essential expenses, and only after that, basic and discretionary expenses. This allows a larger SWR from portfolio assets, thus a better withdrawal efficiency.

One of the key objectives of a good plan should be to maximize income from other sources and to minimize withdrawals from retirement assets for essential expenses. Life annuities go a long way towards fulfilling this objective. They not only mitigate the longevity risk, but because of the inherent age credit, the annuity payout rate is always higher than the sustainable withdrawal rate for essential expenses, regardless of the interest rate environment.

Purpose-driven Sustainable Withdrawal Rates

Here are the sustainable withdrawal rates based on our criteria for risk:

Table 1: Sustainable Withdrawal Rate for Essential Expenses:

Retirement AgeOptimum Asset Mix (Equity/Fixed Income)SWR for ESSENTIAL Expenses
6050 / 503.02%
6550 / 503.28%
7050 / 503.65%
7550 / 504.26%

Table 2: Sustainable Withdrawal Rate for Basic Expenses:

Retirement AgeOptimum Asset Mix (Equity/Fixed Income)SWR for BASIC Expenses
6060 / 403.67%
6560 / 404.01%
7055 / 454.49%
7550 / 505.24%

Table 3: Sustainable Withdrawal Rate for Discretionary Expenses:

Retirement AgeOptimum Asset Mix (Equity/Fixed Income)SWR for DISCRETIONARY Expenses
6060 / 404.43%
6560 / 405.02%
7060 / 405.80%
7555 / 457.07%

The optimum asset mix indicated in these tables should be used only as a guide. Your client’s personal risk tolerance always supersedes the optimum. Make sure to respect that at all times. But keep in mind that deviating from the optimum reduces the SWR somewhat.

Step-by-Step Action Plan

Step #1: Make a list of all assets

Step #2: Make a list of all other income expected during retirement

Step #3: Make a list of retirement expenses. Discuss with your client each expense item and define it as essential, basic or discretionary

Step #4: Calculate how much income you need to withdraw from retirement assets for essential, basic and discretionary expenses

Step #5: Calculate and see if there are sufficient assets to pay essential expenses.

If “yes” then go to Step #6.

If “no” then discuss one or more of these potential remedies: delay retirement; save more; spend less; downsize home; sell home; rent part of the home; buy life annuity; work part-time after retirement. Revise list of retirement expenses and go to Step #1.

Step #6: Calculate and see if there are sufficient assets to pay basic expenses.

If “yes” then go to Step #7.

If “no” then discuss one or more of these potential remedies: delay retirement; save more, spend less; downsize home; sell home; rent part of the home; buy life annuity (only to cover essential expenses); work part-time after retirement. Revise list of retirement expenses and go to Step #1.

Step #7: Calculate and see if there are sufficient assets to pay discretionary expenses.

If “yes” then go to Step #8.

If “no” then discuss one or more of these potential remedies: consider reducing discretionary expenses; buy life annuity (only to cover essential expenses). Revise list of retirement expenses and go to Step #2.

Step #8: Relax, you have a good plan. Review it regularly.

Worked Example:

Bob (65) and Jane (65) retired last month.

Step #1: Assets: Their portfolios are worth $830,000.

Step #2: Other Income: Their combined CPP and OAS benefits are $32,000/year. They have no other income.

Step #3: Expenses: They need a total of $70,000/year income. Of this amount, $40,000 is for essential, $22,000 is for basic, and $8,000 is for discretionary expenses.

Step #4: Calculate income they need from their assets:

For Essential Expenses: $8,000 / year, calculated as $40,000 (essential expenses) less $32,000 (other income)

For Basic Expenses: $22,000 / year

For Discretionary Expenses: $8,000 / year

Calculate assets required to generate this income:

Step #5: For Essential Expenses:

Look up the SWR on Table 1 for age 65; it is 3.28%.

They need $243,902, calculated as $8,000 / 3.28 X 100%. Look up the optimum asset mix: It is 50%/50% for this portion of assets.

They have $830,000; therefore they have sufficient assets for essential expenses.

Step #6: For Basic Expenses:

Look up the SWR on Table 2 for age 65; it is 4.01%.

They need $548,628, calculated as $22,000 / 4.01 X 100%. Look up the optimum asset mix: It is 60%/40% for this portion of assets.

After setting aside $243,902 for essential expenses, they have $586,098, (calculated as $830,000 less $243,902) which is more than what they need to pay for basic expenses.

Now, they have only $37,470 left to pay for discretionary expenses, calculated as $830,000 less $243,902 less $548,628.

Step #7: For Discretionary Expenses:

Look up the SWR on Table 3 for age 65; it is 5.02%.

They need $159,363, calculated as $8,000 / 5.02 X 100%.

However, they have only $37,470 left for discretionary expenses–not enough to pay for discretionary expenses.

Question: Do they have enough assets?

Answer: Bob and Jane certainly have enough assets to meet all their essential and basic expenses. However, they have only $37,470 for their discretionary expenses, less than the required amount of $159,363. They will have to cut back their discretionary expenses.

Considerations for the Shortfall of Discretionary Expenses

  1. Don’t do anything, spend the money: They can spend $8,000/year on discretionary expenses. The money will likely last about 5 years. After that, there is no money left for discretionary expenses. The time horizon is short, so this money should be placed in cash or near-cash assets.
  2. Cut back their discretionary expenses: If they want to bring their risk down to 50% probability, then they need to decrease their discretionary expenses from $8,000/year to $1,881/year, calculated as $8,000 X $37,470 / $159,363. Look up the optimum asset mix: It is 60%/40% for this portion of assets.
  3. Buy a life annuity: The shortfall of essential expenses is $8,000. This is paid by the $243,902 portfolio. On the other hand, the cost of a life annuity (joint-and-survivor, fully indexed to CPI, 10% pay-cut upon first death, 10-year minimum guarantee period) to pay the same $8,000/year is about $215,000 (March 2014 rates). This is $28,902 less than the $243,902 that they need in the investment portfolio to provide the same income.

By buying this annuity, they have $66,372 of assets available for discretionary expenses, calculated as $37,470 plus $28,902. Look up the optimum asset mix: It is 60%/40% for this portion of assets.

Therefore, they can now have $3,332/year for discretionary expenses, calculated as $8,000 X $66,372 / $159,363. This is 77% more than #2 ($1,881/year) and the longevity risk on essential expenses has been eliminated.

Figure 4 shows the payout from the life annuity compared to SWR from the portfolio.

Figure 4: Life Annuity Payout compared to SWR (payout rate as of March 2014)

A good retirement plan starts with a careful and comprehensive discovery process. It takes time to go over each expense item and categorize it as essential, basic or discretionary, but it is well worth the effort. The reliability and robustness of a plan with this degree of attention to detail can create significant respect for your expertise among clients. This will differentiate you from others who might sweep this important step under the carpet by saying, “let’s assume you need $70,000/year during retirement….”

Appendix A: Retirement Expenses Estimation Worksheet

Essential Expenses Annual $Basic Expenses Annual $Discretionary Expenses Annual $
Housing expenses:
Mortgage
Rent paid
Condominium Fees
Property Insurance
Property Tax
Heating
Water
Electricity
Security & Alarm
Maintenance
Repairs
Other:
Other:
Other:
Household and living expenses:
Food, Groceries
Dry Cleaning & Laundry
Decorating & Painting
Carpet Cleaning
Gardening
Pool Care
Pet Care
Kennel
Maid Service
Computer equipment & maintenance
Pocket Money
Clothing
Footwear
Dependent Support 1
Dependent Support 2
Gifts
Donations
Other:
Other:
Other:
PAGE SUBTOTAL:
Essential Expenses Annual $Basic Expenses Annual $Discretionary Expenses Annual $
Transportation expenses:
Car Loan Payments
Lease Payments
Maintenance & Repairs
License Fees
Fuel
Oil Change
Parking
Tickets
Car Insurance
Car Rental
Public Transportation
Other:
Other:
Other:
Investment and insurance expenses:
Investment Loan Payments
Professional Fees: Accounting
Professional Fees: Legal
Professional Fees: Other
Subscriptions
Insurance Premiums 1
Insurance Premiums 2
Insurance Premiums 3
Insurance Premiums 4
Other:
Other:
Other:
PAGE SUBTOTAL:
Essential Expenses Annual $Basic Expenses Annual $Discretionary Expenses Annual $
Personal and healthcare expenses:
Hair Care
Beauty Supplies
Personal Care
Manicure, Pedicure
Doctors
Dentists
Prescription Drugs
Nutritional Supplements, Vitamins
Visiting Home Care
Live-in Home Care
Medical & Support Equipment
Other:
Other:
Other:
Communication expenses:
Telephone
Mobile Phone
Cable TV
Satellite TV
Pay TV
Internet
Other:
Other:
Other:
PAGE SUBTOTAL:
Essential Expenses Annual $Basic Expenses Annual $Discretionary Expenses Annual $
Recreational and entertainment expenses:
Club Memberships
Travel
Camping
Sports Equipment
Books
Newspapers
Adult Education
Hobbies
Dining Out
Entertaining at Home
Theatre, Ballet, Concerts
Sports Events
Tobacco, Alcohol
Other:
Other:
Other:
Income taxes:
Income Taxes
Other:
Other:
Other:
Page subtotal:
Total expenses:

Now that you’ve finished reading, complete the exam to receive your CE credits. If your score is 85% or higher, send an e-mail to jim@retirementoptimizer.com with your name and proof of your score (a screen shot will do) to get a free retirement calculator based on aftcasting, and a free, read-only pdf copy of Jim Otar’s 525-page book, “Unveiling the Retirement Myth.”

Next steps