Saturday, July 21, 2012

The 4% Solution

2:20 PM


The infamous withdrawal rate

A lot of research has been done in the last decade on determining a "safe" withdrawal rate.

Basically, how much can you take from a fund each year so that the odds of running out of money (the "Probability of ruin") is almost zero over the period of retirement, often taken as 30 years, that is from age 65 to age 95.

The withdrawal rate is not static. It increases each year by the rate of inflation, so your spending power remains the same throughout retirement. If you have $100,000, and the expected rate of inflation is 2.5%, the first year withdrawal is $4,000 in year 1, $4,100 in year 2, $4,202 in year 3, and so on.

There are a few ways to determine the "safe" withdrawal rate, but most often it is the withdrawal rate that has a probability of 95% or more of not running out of money over 30 years, based on assumptions as to the expected annual return and volatility of the investments.

Why invest in equities?

In order to make the numbers more compelling, it is often assumed that funds are invested in equities -- with their higher expected returns and higher volatility.

Investing in equities is wise for the long-term, but with higher returns come higher risk and more chance of failure. Unless you withdraw such a small amount that any adverse investment outcomes will not wipe out your assets. And this is the idea behind the 4% withdrawal rate.

While taking low withdrawals minimizes your risk, it also can be a lost opportunity to enjoy the fruits of your savings. If you leave most or all of your capital untouched at a ripe old age, your inheritors will be grateful, but you could have ticked many more items off your bucket list.

How about bonds?

Is it possible to withdraw more than 4% without taking less risk and have a near zero odds of running out of money?

Consider the following. What would happen if I invested all my money in a bond exchange-traded fund (ETF) such as the iShares DEX Universe Bond Index?

First I can get some appreciation over time, as it did in the last few years, but let's ignore this for now. This ETF (and comparable funds offered by other suppliers) pay monthly dividends. The yield at the date of writing is 4.95%. It has hovered in this area for the last several years.

If I take a 4% withdrawal rate at age 65, earn no appreciation but get a 4.95% yield, I will run out of money after 40 years, at age 105!

Let's look at other possibilities

Withdrawal rate
Years after which money runs out
3%
72
4%
40
5%
29
6%
22

If I take a 6% withdrawal rate at age 65, but earn a modest (and historically occurring) appreciation of 1% plus my 4.95% yield, I will run out of money after 27 years at age 92.

Shortcomings

Here are a few other shortcomings with most safe withdrawal analyses.

They ignore income tax: in real life investment income and withdrawals from registered funds are taxable. What counts is how much after-tax is left for spending. Without a model for income tax, the withdrawal rate is just a number.

Withdrawals also come from various types of accounts: non-registered funds, RRSP, locked-in funds and tax-free savings account (TFSA). Each type of account has its own withdrawal constraints and income tax treatment.

In addition, our needs vary over time: we need more in some years, for example if we don't yet collect Government pensions, and less in others, if we earn income during retirement.
Our needs vary also for each period of retirement: the active, the sedentary period and end of retirement.

Last, withdrawal order from the various types of account is also ignored. It has a significant impact that cannot be ignored.

A few words about GMWB

A segregated fund is a mutual fund packaged with an insurance contract that provides a guaranteed return and a death benefit.

Some insurance companies offer a "guaranteed minimum withdrawal benefit" (GMWB), which is an option to provide an income for life, usually between 3% and 5% of the initial capital. The amount upon which the withdrawal rate is based is usually reset every few years, so if there is good investment returns, the income can grow (but never decline).

The income for life provided falls within the range of easily achievable withdrawal rates, considering the GMWB withdrawal are not increasing unless the investment experience is good enough to cause a reset. Nevertheless, several insurance companies have thrown the towel and suspended sales of these products in the last few months. Those who haven't suspended sales have reduced the lifetime income payout from 5% to 4% or even 3%.

The insurers blame the suspension or benefit reduction on the low interest environment.  There is also another cause: despite high fees, increased capital requirements and volatile capital markets made these products unprofitable for the insurers. For the consumer, the value proposition is not nearly as attractive as it once was.

Course correction

I have a few conclusions to draw from my arguments.

  • Make the early withdrawals reasonable if you have significant exposure to equities to minimize your sequence of returns risk.
  • If you decide to take higher withdrawals, monitor your rates of return and take corrective action by taking smaller withdrawals for a few years after a year or two of bad returns.
  • Use this analysis in your decision to purchase an annuity or segregated fund that provides a guaranteed minimum withdrawal benefit (GMWB). What withdrawal rate does the annuity or GMWB provide?

Last words

The mathematics behind the safe withdrawal rates is clever and sound. But perhaps there is a (small) elephant in the room: money can stretch further with less risk and little effort.

Am I suggesting following the above strategy: it is your decision. I am mostly using the above as a counter-example to disprove the conventional wisdom of the 4% withdrawal rule.

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