Most retirees believes it’s safe to create their retirement paycheck from dividends and interest. Living off the income is intuitive.
Unfortunately, living off dividends and interest is not sufficient for a withdrawal plan. First of all, at the time of this whitepaper, dividend yields, and interest rates are near record lows. Creating a meaningful cash flow plan on dividends and interest would require substantial assets.
Even if you have substantial assets, maximizing the yield on the portfolio introduces concentration risk. A portfolio of dividend stocks clusters the group of stocks into a smaller subset of companies, which are subject to specific company risk versus broad market risk.
Concentration risk leads to larger portfolio drawdowns, which as you’ll learn later is public enemy #1 of a retirement portfolio.
Sustainable safe withdrawal rates are based on the total return of a portfolio. The total return of a portfolio is the combination of dividends, interest, capital gains, and return on principal.
The idea of safe withdrawal rates was discovered through safe withdrawal rate research. The goal of safe withdrawal rate research was to answer the question:
How much can I spend in retirement without running out of money?
To answer this question, researchers, needed to find the “worst date in history” to retire. From that date, they looked at how much a hypothetical retiree could have withdrawn each year before running out of money.
Bill Bengen is the original safe withdrawal rate researcher. He intuitively understood retirees wanted to maintain consistent cash flow. This meant finding an initial withdrawal and providing inflation increases each year. Bill’s research uncovered the famous rule of thumb – the 4% rule.
What this meant is if someone retired with $1,000,000, they could take a $40,000 withdrawal in year 1. Then in the following years, they would increase the prior year’s withdrawal by the inflation rate.
Here is a quick example using a $1,000,000 starting balance:
- Year 1: $40,000
- Year 2: $40,000 + Inflation (ex: 2.3%) = $40,920
- Year 3: $40,920 + Inflation (ex: 3.1%) = $42,189
Bill’s research created a lot of interest in the topic. There are dozens, if not hundreds of papers with various iterations.
One of Bill’s iterations increased the safe withdrawal rate closer to 4.5%. However, there are some indications that “today’s” safe withdrawal rates are closer to 3%.
To keep things simple, I’m going to use a safe withdrawal rate of 5% throughout most of the analysis within this whitepaper. The reason I selected 5% is that it is a reasonable withdrawal rate for most of the data set in our research.
A 5% withdrawal rate is not a recommendation.
If you want a deep dive into the various research, consider Wade Pfau’s book, How Much Can I Spend in Retirement.
Buy-and-Hold Investing and Safe Withdrawal Rate Research
Safe withdrawal research brought attention to a subject that is critically important to a retiree’s success in retirement.
Most safe withdrawal rate research tests fixed and variable withdrawal rate methods.
Fixed withdrawals provide consistent cash flow for retirees. It’s also easy to understand and implement.
The downside of fixed withdrawals is that it may lead to the depletion of retirement portfolios earlier than desired. It also doesn’t address the retiree’s desire to maximize cash flow early in retirement.
Variable withdrawals provide a rule set for maximizing cash flow early in retirement.
The downside of variable spending is that it’s more difficult to understand and implement. It nearly guarantees a change in spending at some point. This isn’t necessarily bad, most retirees have a natural change in their spending patterns throughout retirement. See the “go-go, slow-go, and no-go” retirement research.
Beyond choosing between fixed and variable withdrawal rates, some papers test changes to asset allocation. This research looks at varying the buy-and-hold portfolio’s mix of stocks and bonds (i.e., 30/70, 60/40, 70/30, etc.).
The research focused on changes in asset allocation to maintain a US stock and bond mix. The idea is that adjusting the stock and bond mix at different times may increase the safe withdrawal rate.
The reason researchers focus exclusively on only buy-and-hold equities and bonds is because it’s much more controlled and straightforward.
You might be wondering, what is buy-and-hold investing? According to Investopedia:
Buy and hold is a passive investment strategy in which an investor buys stocks (or other types of securities such as ETFs) and holds them for an extended period regardless of fluctuations in the market. An investor who uses a buy-and-hold strategy actively selects investments but has no concern for short-term price movements and technical indicators.
The average buy-and-hold portfolio is built on a 60% allocation of US Stocks and a 40% allocation of US Bonds.
In 2012, Michael Kitces summarized 20 years of research on safe withdrawal rates. This included papers on fixed and variable spending as well as adjustments to asset allocation.
The article combines the different factors that influence a safe withdrawal rate. This creates a “layer cake,” leading to a safe withdrawal rate.
Michael caveat’s this summary the best by stating:
“…many of the factors discussed here were evaluated in separate research studies, and it is not necessarily clear whether they are precisely additive.”
Even with that caveat in mind, there is a ton of value in understanding how each factor influences your cash flow in retirement.
What are the factors that influence safe withdrawal rates?
1. Controllable –> You 100% control these decisions.
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- Fees net of expected investment outperformance
- Buy and hold vs. Tactical Asset Allocation
- Single country bias vs. Globally diversified portfolio
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2. Preference–> Your preference for prioritizing inevitable trade-offs.
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- Spending flexibility
- Legacy/Longevity hedge
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3. Facts –> These are your facts. You have limited to no control over it.
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- Tax drag on taxable investments
- Time horizon
- Valuation environment
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If we focus only on the controllable decisions, what do we see?
Vanguard’s founder, John Bogel, said it best “we get what we precisely don’t pay for.” Lower your fees and increase the amount you can spend on everything else.
The next bullet point includes “fees net of expected investment outperformance. This is also known as “alpha.” To receive alpha, an investor must use an active trading strategy. Investors who choose a passive buy-and-hold strategy cannot receive alpha. The objective of buy-and-hold investing is to receive market returns before fees. Therefore, expecting alpha is only valid if you’re using a sound investment plan.
The final two factors are
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- Buy and hold vs. Tactical Asset Allocation
- Single country bias vs. Global diversification
Which choices increase your withdrawal rate?
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- Tactical Asset Allocation – 0.20%
- Global diversification – 0.50%
Why do these choices increase your withdrawal rate?
The answer lies in the detailed understanding of the nature of sequence of returns risk.
Want to read the full Retirement Portfolio whitepaper? Click here to download your free copy.
At Calculated Wealth, we partner with families to navigate retirement with personalized guidance and support. Curious about how we can help you create a resilient retirement portfolio? Contact us today for a complimentary introductory call.