A common misconception about retirement income planning is that if a portfolio doesn’t grow as planned, all you need to do is bring down withdrawals for a year and it will be back on track for lifelong income.
This may work in some cases, but for most clients it’s more challenging. It can mean anything from foregoing a few steak dinners a month to outright destitution. Where do you draw the line? When does the strategy make sense and when does it become disastrous?
This course has three main parts. The first explains what the chances are of recovering from a loss. Part two explains how much of a pay cut is necessary to ensure a lifelong income. The third provides examples of withdrawals based on portfolio value and growth, applicable mainly to situations where the client can accept intermittent or variable income streams.
In most retirement plans, forecasts are based on “average” growth rates and inflation, i.e. they follow the Law of Averages. In contrast, we use Murphy’s Law – anything that can go wrong, will go wrong – to ensure extreme risks are covered.
We use actual market history, which we call “aftcasting” (as opposed to forecasting). It uses the market history starting in 1900 and ending at the end of 2011. We do not use Monte Carlo simulators.
Aftcasting displays, on the same chart, the outcome of all historical asset values of all portfolios since 1900, as if a scenario starts in each one of the years between 1900 and 2000. It gives a bird’s-eye view of all outcomes. It provides the success and failure statistics with exact historical accuracy, as opposed to simulation models because it includes the actual historical equity performance, inflation and interest rates, as well as the historical sequencing of all these data sets.
Part 1: What are the Chances of Recovering from a Loss?
Example: Bob is 65 and has $500,000 invested — 40% in S&P500 index and 60% in fixed income. He is worried about losses in his portfolio during retirement. Let’s look at four different scenarios:
Scenario A: No withdrawals
Bob has plenty of other income, so he doesn’t need it from this portfolio. Thus, his initial withdrawal rate (IWR) from this portfolio is 0%. You, as his advisor, tell Bob, “Don’t worry about losses. Over the long term, markets always come back.”
The chart in Figure 1 shows the chances of recovering from a loss using actual historical data since 1900. The vertical scale indicates the probability of a lower portfolio value. The horizontal axis indicates age.
Figure 1: Chances of recovery from a loss, no withdrawals
The chart shows that one year later, there was a 27% chance that Bob’s portfolio would be lower than what he started with. However, the portfolio inevitably recovered from the loss by age 73 in the worst case. In other words, if there are no withdrawals from the portfolio with this 40%/60% asset mix, historically it recovered from the worst loss after about 8 years.
Scenario B: 3% Initial Withdrawal Rate
In this scenario, Bob needs to withdraw $15,000 annually, indexed to CPI, starting at age 65, for the rest of his life. This is an initial withdrawal rate of 3% — well below the sustainable rate. As his advisor, can you still say, “Don’t worry about losses, markets always come back”?
The chart in Figure 2 shows the chances of recovering from a loss. One year later, there was about 37% chance that Bob’s portfolio would be lower than what he started with. What’s worse, even with a low withdrawal rate of 3%, there was a 20% chance that his portfolio would never fully recover from a loss. I am not saying he will run out of money; but I am suggesting you not say to the client, “Don’t worry about losses because markets always come back.” In this case markets do come back, but the portfolio might suffer a permanent loss.
Figure 2: Chances of recovery from a loss, 3% initial withdrawal rate
Scenario C: 5% Initial Withdrawal Rate
Let’s increase Bob’s withdrawals to $25,000 annually (5% IWR), indexed to CPI, starting at age 65, for the rest of his life.
The chart in Figure 3 shows the chances of recovering from a loss. The odds are Bob will never see the original amount of his investment ($500,000) after a loss.
Figure 3: Chances of recovery from a loss, 5% initial withdrawal rate
Scenario D: 8% Initial Withdrawal Rate
Now we increase Bob’s withdrawals to $40,000 annually (8% IWR), indexed to CPI, starting at age 65, for the rest of his life.
The chart in Figure 4 shows that after 10 years, there is 100% certainty that Bob will never see his portfolio’s initial value of $500,000 after a loss.
Figure 4: Chances of recovery from a loss, 8% initial withdrawal rate
It is important to understand that the concept of “investing for the long-term” applies only to accumulation portfolios. As soon as a portfolio is switched from accumulation to distribution, the concept of “long-term” no longer applies and the “luck factor” takes control of the outcome — even if withdrawals are below sustainable.
If withdrawals are below sustainable, then luck determines how much money is left to estate.
If withdrawals exceed sustainable, then luck determines how soon the portfolio depletes. If you don’t want to rely on luck for lifelong income, then you need to pool the risk.