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Conserving Client Portfolios
The questions are more than academic. "How much can an
investor afford to withdraw from their portfolio during
retirement, while minimizing the risk of exhausting that
portfolio prematurely?" and "How should a person's
portfolio be invested such that he or she can withdraw the
maximum amount possible?" are very real questions that
investors must address if they want to maintain the same
standard of living in retirement as in their working years.
Indeed, with the decline of traditional pension plans and
increases in longevity and health care costs, millions of
Americans must now consider not only how to save for retirement
but how to preserve their portfolios during retirement.
According to William Bengen, CFP®, author of "Conserving
Client Portfolios During Retirement," the highest
withdrawal rate that produces 30 years of longevity is somewhere
between 3 percent and 6 percent, what he refers to as SAFEMAX —
the "Maximum Safe Withdrawal Rate."
To be sure, each person may have their own SAFEMAX, depending
on such factors as asset allocation and rebalancing, but Bengen
notes that 4.15 percent — assuming a 30-year time horizon — is
perhaps the ideal withdrawal rate when using a portfolio made up
of two asset classes with 64 percent invested in large-company
stocks and 37 percent invested in intermediate-term Government
bonds, and which is rebalanced at the end of each calendar year.
By way of background, this maximum withdrawal rate is based
on a study of "50 retirees" using actual historical
investment returns and rates of inflation to test assumptions
about withdrawal rates, asset allocation, and portfolio
longevity, according to Bengen. This approach contrasts with
approaches that use probability models, such as Monte Carlo
simulation, which use mathematical models of investment
performance and inflation to produce maximum withdrawal rates.
Both approaches, historical returns and probability models, have
their strengths and limitations.
The SAFEMAX can change, however, depending on the number of
asset classes used in a portfolio. For instance, a portfolio
made up of three asset classes with 17.5 percent invested in
small-company stocks, 42.5 percent invested in large-company
stocks and 40 percent in intermediate-term Government bonds will
produce SAFEMAX of 4.4 percent. For his part, Bengen notes that
planners and investors with a high tolerance for volatility and
a desire to maximize their withdrawals could increase the
percentage invested in stocks.
Of note, Bengen reports that investors need not include
long-term bonds in their retirement portfolios given the limited
impact on increasing the SAFEMAX, but investors can replace
intermediate-term government bond funds with money market funds
without any adverse effect on withdrawal rates.
To be fair, the maximum withdrawal rate can also change if an
investor uses a time horizon other than 30 years. Not
surprisingly, the peak SAFEMAX increases as the time horizon
shortens. For instance, the peak SAFEMAX for a person with a
10-year time horizon is 8.9 percent, about twice that for a
person with a 30-year time horizon. In addition, the percentage
that a person invests or allocates to large-company stocks
declines as the time horizon shortens, until about 10 years is
reached, after which it increases with decreasing time horizons.
For instance, individuals with time horizons of about 15 to 20
years will optimize their withdrawal rate with a total equity
allocation of 30 percent.
Individuals with a time horizon of more than 30 years,
meanwhile, can use an initial withdrawal rate of 4 percent for
their tax-deferred portfolio, 65 percent of which would be
invested in large-company and small-company stocks.
What is the risk of higher withdrawal rates? According to
Bengen, increases in withdrawal rates reduced the odds of an
investor's portfolio lasting 30 years. For tax-deferred
accounts, an increase of 1 percentage point above the SAFEMAX in
the initial withdrawal rate reduces the probability that a
portfolio will last 30 years by 15 to 20 percent. An initial
withdrawal rate increase of 2 percentage points above the
SAFEMAX results in just a 55 to 60 percent success rate. For
taxable accounts, the results are slightly different. An
increase of 1 percentage point above the SAFEMAX in the initial
withdrawal rate produces a success rate of roughly 85 to 90
percent and an increase of 2 percentage points results in a 70
percent success rate. The bottom line is that some individuals
may want to trade off a higher initial withdrawal rate for the
near certainty of their portfolio lasting as long as their time
horizon goal.
Investors and financial planners can use other techniques for
increasing the initial withdrawal rates without increasing risk.
For instance, retirees can modify their withdrawals using such
approaches as the fixed-percentage approach or the floor-and-
ceiling withdrawal approach.
In addition, Bengen reports that investors can marginally
increase their initial withdrawal rates by changing the
frequency with which they rebalance their portfolios during
retirement. For instance, many investors are told to rebalance
their portfolios at least every 12 months. But according to
Bengen's research, investors could rebalance every 75 months, or
once every 6 and one-quarter years, and actually improve the
initial withdrawal rate to 4.65 percent.
September 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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