Fine-tuning a withdrawal strategy that can apply no matter what the market brings
The Study: Testing Our Recipe in a Different Kitchen
This blog is part of a series. Click to read part 1 and part 2.
In our third post on safe withdrawal rates, we dig into different withdrawal strategies. Recall that the 4% Rule and the research done by Cooley, Hubbard and Walz does not instruct you to customize the withdrawals but rather treats your portfolio as a whole. Under this strategy you would withdraw the entire amount from your total portfolio, regardless of how the individual assets are performing. But it is possible (and even likely) that when equities are down, stocks are up, and vice versa. This is the motivation behind looking at different strategies: can we mitigate the dreaded sequence-of-returns risk by changing the way we withdraw money?
The portfolios we studied are again made up of one equity fund (SPY, an ETF designed to track the S&P 500Ā®) and one bond fund (VUSTX, a long-term treasury fund).Ā¹ We explored two different, simple strategies compared to the classic flat withdrawal rate of Cooley, Hubbard and Walzās 4% Rule. Specifically, we looked at a bucketing strategy and a consumption reduction strategy.
The bucketing strategy treats each asset inside the portfolio as a different bucket from which to draw.
- If the equity portion experiences a loss in a particular month, then you take that monthly withdrawal from fixed income and vice versa.
- If both equity and fixed income are down in a particular month, then you take from the one that lost less that month.
- If both are up in a particular month, then you treat it as the classic case and take from both equally that month.
The consumption reduction strategy follows a similar pattern of action to the bucketing case, but you look at the portfolio as a whole like in the classic case.
- If the overall portfolio experiences a loss in a particular month, then you adjust the withdrawal from that particular month to 75 percent of the chosen withdrawal rate.
- In months where the portfolio does not experience a loss, you take the original withdrawal rate.
Reducing the withdrawal rate by 25 percent in months the portfolio experiences losses is a discretionary choice in this experiment. In reality the consumption reduction strategy could reduce the withdrawal rate by any amount that is acceptable to the investor. The more the retiree is able to reduce consumption in months where the portfolio realizes a loss, the more effective the strategy will be. There are practical limitations to this approach for each investor as some will need more than others depending on expenses.
In order to compare the performance of different withdrawal strategies, we repeated the same randomized bootstrapped paths we used in part 2. Though the original 4% Rule assumes a thirty-year retirement, we have included results for forty years as well in all iterations of this study because life expectancy has been generally increasing for decades. For each thirty- and forty-year path we imposed a three- or five-year recession at the start of the withdrawal period. Keeping everything the same as in part 2 will allow us to fairly compare the classic withdrawal method and the alternatives described above when you retire right at the start of a multi-year, severe recession.
Welcome to the Danger Zone
The reason we have been studying a recession at the start of retirement is because of what Michael Kitces (a popular expert in the financial planning field) calls āThe Danger Zoneā: the years just before and after you retire are when the probability of running out of money before you die is particularly vulnerable to sequence-of-returns risk. Big losses early are hard to overcome.
Letās take a look at the results of implementing the bucketing and consumption reduction strategies. I will analyze each equity/bond allocation separately below and then summarize any overarching results.
20 Percent Equity and 80 Percent Fixed Income
See plots of results here
The first thing that sticks out is that the length of the recession greatly impacts the benefit of the bucketing strategy, in which you evaluate each investment separately for withdrawals. The longer a recession at the beginning of your retirement, the more the bucket method will increase your success rate.
The benefit of the bucketing strategy is allowing your equity to bounce back instead of spending it down when it is at a loss.
Taking a closer look at the performance of the individual assets might shed some more light on why certain withdrawal strategies do better than others. For the 5-year recession, VUSTX has more months of losses on average compared to SPY during these paths, and VUSTX is a large chunk of the portfolio, so we are seeing the magic of compound interest. If you withdraw from a big position when it is down, you donāt regain as much as you could have when it eventually bounces back.
- This is an example of the portfolio size effect and the danger zone (discussed in detail here). The portfolio size effect means that positive returns produce a larger dollar amount of gains on your portfolio, but negative returns also produce a much larger loss!
40 Percent Equity and 60 Percent Fixed Income
See plots of results here
With this portfolio we see a similar pattern in length of recession compared to success of bucketing. The longer the recession in the beginning of retirement, the more you want to use the bucketing strategy.
This could be an artifact of the portfolio size effect. Using the bucketing strategy means that the equity:bond allocation ratio does not necessarily stay constant. It is likely that there will be times where you see slightly higher equity exposure by spending down from just the fixed income bucket during periods of equity losses.
Here, we start seeing that holding more equity means you should lean towards the adjusting consumption strategy rather than withdrawing from individual assets. With the 40 percent equity portfolio, you would benefit from adjusting consumption lower if the recessions at the beginning of retirement are 3 years or less in length.
The good news is that with this allocation while adjusting consumption works better in shorter recessions and bucketing works better for longer recessions, both strategies improve your chances of success compared to a flat withdrawal rate.
60 Percent Equity and 40 Percent Fixed Income
See plots of results here
As you move towards more equities than fixed income in your portfolio, it becomes clearer that you will want to use the adjusting consumption strategy in months where you are experiencing losses.
With equity of 50 percent or more, this pattern is consistent across retirement time horizons and lengths of recession. It is clear-cut that adjusting consumption outperforms both the bucketing case and the classic case.
When equities are up you do not want to take everything from equities; you want to split your withdrawals because you want to maintain your equity exposure. Holding more equities increases your chance of success of making your money last through retirement. This, again, is in line with the findings of Kitces and his danger zone research.
80 Percent Equity and 20 Percent Fixed Income
See plots of results here
We continue the patterns seen in the 60/40 allocation, but on a larger scale.
A Strategy for Success
Overall, we start seeing the benefits of withdrawing from the portfolio as a whole (rather than from a selection of individual investments) when the portfolio has 40 percent equity or higher. This withdrawal strategy does require that retirees are somewhat flexible with their withdrawal rate.
Kitces claims that an optimal approach is to be conservative in your investments leading up to and during the first few years or retirement, but then to slightly increase your equity exposure after that. The lower your equity, the more you want to consider the bucketing strategy, whereas the higher your equity, the more you might want to consider reducing your consumption on months with portfolio losses. The big benefit for lower-equity portfolios using the bucketing strategy is that it will allow your asset allocation to float towards more equity during the times you need it most to recover from earlier losses.
Your withdrawal strategy should be a function of your investment horizon, asset allocation, and severity of market drawdowns or recessions faced at the start of retirement. Cardinal Retirement Planning can help you find a path you can follow no matter what curves life brings.
Anessa Custovic, PhD
1. All data for the comparison study was pulled from Yahoo Financeās database of historical data, which includes a large number of publicly-listed investments.
