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Update: JR Robinson will present on this topic in the upcoming webinar, “Beyond the 4% Rule: What Factors Matter Most in Helping Your Clients’ Nest Eggs Last Longer“
Rethinking the Spending Paradigm
In this post, we are going to consider one of the most important and underappreciated factors in determining how long your clients’ nest eggs may last and, in doing so, we will also challenge some of the traditional ideas about portfolio management in retirement.
Specifically, there are two popular retirement spending maxims that are widely perceived or assumed to be sound. The first is the notion that retiree portfolios should become more conservative as they grow older. Implementation generally entails spending the stock portion of one’s nest egg down first, and leaving the bond portion of the portfolio to protect against market risk later in retirement. Belief in this approach remains prevalent among individual investors and is consistent with the long-established behavioral finance principle that investors grow more risk averse as they get older.
The second maxim, which is almost universally illustrated in retirement planning software and which has been widely adopted in the financial planning community, suggests that spending proportionally from each asset class and rebalancing each year to maintain a constant allocation is efficient.
In this piece we will examine a progression of withdrawal strategies. We will begin by illustrating the aforementioned “stocks-first” and “constant allocation with rebalancing” strategies. Next we will consider a variation on the constant allocation with rebalancing model that incorporates a simple decision rule to refrain from selling stocks following down years. We refer to this approach a “guardrail” strategy. Lastly, we will consider the opposite extreme of the stocks-first spending approach by illustrating a “bonds-first” spending strategy.
Model Design & Analysis
For illustration purposes we will apply our analysis to the following standard portfolio model design –
- $1,000,000 Initial Nest Egg Value
- Time Horizon = 30 years
- Initial Withdrawal Amount = $40,000 (4%)
- Annual Cost of Living Adjustment = 3%
- Broad Asset Allocation = 60% Stocks, 40% bonds
- Detailed Equity Allocation = 45% large Cap, 30% small/mid-cap, 25% foreign
- Assumed annual rate of return on bonds = 2%*
- Investment Expenses = 1%
* This assumed rate of return is based upon what an investor in intermediate term bonds can realistically expect to earn today. 2% is currently the approximate rate an investor might earn on a 5 year CD or the 10 year treasury.
To generate our analysis we entered the basic input data from the model into Nest Egg Guru’s retirement stress testing software. This software employs a simulation methodology called bootstrapping that involves random sampling of monthly return data from 1970 to 2014 (the modern era of the markets). The output from the 5,000 simulation results that were produced is summarized in the table below. The “Success %” row represents the percentage of the 5,000 simulations that had remaining balances after 30 years. The portfolio values represent the remaining balances at the end of the 30 year time horizon from the Median simulation result to bottom 1% result (i.e. the bottom half of the sim results).
* Assumes proportional withdrawals from each asset class each year followed by rebalancing to maintain a constant allocation throughout retirement.
** Assumes proportional withdrawals with annual rebalancing. However, a single simple decision rule is applied – no withdrawals are made from stocks following down years.
The results in this table serve to highlight the importance of withdrawal strategy in determining portfolio sustainability. In particular, the table strongly suggest that the widely held consumer belief that retiree portfolios should get more conservative (i.e., bond-weighted) over time may be naïve, and that following such an approach may be seriously detrimental to both wealth and the prospects for sustainability.
Equally noteworthy is the observation that constant allocation with annual rebalancing leads to significantly worse outcomes than the simple guardrail strategy that was presented as well as the bonds-first strategy. Intuitively, this finding may be attributed to the fact that the guardrail strategy better insulates the portfolio from sequence of returns risk (the risk of portfolio depletion caused by prolonged severe down markets early in retirement). The magnitude of the advantage of the bonds-first withdrawal strategy also serves to drive home the impact that the current low interest rate environment may have on portfolio sustainability. The results illustrated in this table suggest that bond-heavy portfolios may be unwittingly exposed to sequence of returns risk in bonds.
While the findings in this table may be surprising to some readers, they are consistent with other published empirical research over the past decade. In a 2007 Journal of Financial Planning paper entitled, Is Rebalancing a Portfolio During Retirement Necessary, Professors John Spitzer and Sandeep Singh concluded:
“While the wisdom of rebalancing in the accumulation phase of the life cycle is widely accepted, the wisdom does not appear to extend to the withdrawal phase.”
“Rebalance is shown to be the least effective harvesting method and Bonds First the best for maximizing PIBR [remaining balance]” – Professors John Spitzer & Sandeep Singh
A similar conclusion was reached by renowned retirement researchers Wade Pfau and Michael Kitces in their 2013 Journal of Financial Planning piece, Reducing Retirement Risk with a Rising Equity Glide Path:
“Results show, surprisingly, that rising equity glide paths in retirement—where the portfolio starts out conservative and becomes more aggressive through the retirement time horizon—have the potential to actually reduce both the probability of failure and the magnitude of failure for client portfolios”.
While it is hoped that the clarity of this analysis will be useful to advisors in presenting these concepts to their clients, it should be noted that the four withdrawal methodologies illustrated in this post are merely intended to raise awareness of the importance the choice of withdraw strategy has in determining how long a given nest egg may last. Although the strategies illustrated are practically implementable at the retail client level, it should not necessarily be assumed that a bonds-first withdrawal strategy is the most efficient method available. Indeed, a large body of research has been devoted to this topic, and there are many more sophisticated dynamic methods that may be more efficient than the simple strategies presented herein.
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J.R. Robinson is the owner of Financial Planning Hawaii and a co-founder of Nest Egg Guru, a unique retirement stress testing app for financial advisors. He is the co-author of two award-winning papers on retirement income sustainability and his contributions have appeared in numerous peer reviewed academic and professional journals. Follow Nest Egg Guru on Twitter at @.