Should Retirement Draw Downs Deplete Portfolio

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SpartanBull
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Should Retirement Draw Downs Deplete Portfolio

Post by SpartanBull »

Hello,
I regularly read that the traditional "rule of thumb" retirement withdrawal rate is 4%. I've also hear more conservative suggestions such as 3%. Regardless, here is my question. When you'd decided to retire and follow one of these suggestions for withdrawal rate, is your portfolio value really even going down over time? Or is the concept that you do this for 20-30 years, etc, and then you run out of money? It seems to me that if your withdrawing 3%(for the sake of argument), and your (lets say 60/40) portfolio has a decent change of averaging 3% real during your retirement, wouldn't this mean that you could be more or less breaking even, or better (in real terms) while living off your 3% withdrawals. I'm perfectly aware that theres just as good a chance that returns are worse than 3% real, which would mean you are depleting portfolio value.
I suppose the general nature of my question would be is the purpose of the "safe withdrawal rate" to sort of create portfolio that will last "forever" or at least not lose any/much value in real terms? OR is the purpose to last you the rest of your retirement, and then you run out of money at the end of your life when you no longer need it. For the sake of this question, we're not thinking about leaving money for children, people inheriting it, etc etc. I'm strictly asking in terms of a retirement for one person, one person and their spouse/significant other, etc.
Thanks in advance for any helpful responses. I placed this in "Theory" because I don't think it relates to me directly, I'm more just trying to see what the purpose/end game of this withdrawal strategy is. Thanks.
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David Jay
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by David Jay »

First of all, the 4% rule should NOT be used as a strategy, but rather as a gauge as to whether you have adequate resources to retire.

That being said, the 4% studies do include a drawdown of principle. A 2.5% rate is commonly considered to be a "perpetual" portfolio - one that can support you indefinitely (for instance, retire at age 40).

Under ideal conditions, 3% may well mean you do not draw down the principle. So much depends on the sequence of returns in the early years of retirement. Five or ten good years for the stock market at the start of retirement makes a huge difference.
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Spirit Rider
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by Spirit Rider »

Yes, when you are talking about safe withdrawal rates, you are referring to that rate that has a high degree of confidence that the portfolio will last a specified period of time. This assumes that there could be significant draw downs and/or appreciation in the portfolio balance.
LuigiLikesPizza
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by LuigiLikesPizza »

So much depends on the sequence of returns in the early years of retirement. Five or ten good years for the stock market at the start of retirement makes a huge difference.
....but if, for example, 50% of your retirement income comes from pensions, annuities, SS, - you can adjust for that...I assume.
NotWhoYouThink
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by NotWhoYouThink »

Keep in mind the published recommendations are generally

- start with X% of your portfolio value, and increase the withdrawal amount annually based on inflation.

Which is different from

- withdraw X% per year from your portfolio.

the first method provides a smooth income stream, but you may run out of money or deplete your portfolio. The second provides a jagged income stream, but you will never fully deplete your portfolio.


Most people don't quite do either one. Some play it by ear, and others analyze the possibilities endlessly on this site. You can learn something from them.
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iceport
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by iceport »

SpartanBull wrote:Hello,
I regularly read that the traditional "rule of thumb" retirement withdrawal rate is 4%. I've also hear more conservative suggestions such as 3%. Regardless, here is my question. When you'd decided to retire and follow one of these suggestions for withdrawal rate, is your portfolio value really even going down over time? Or is the concept that you do this for 20-30 years, etc, and then you run out of money? It seems to me that if your withdrawing 3%(for the sake of argument), and your (lets say 60/40) portfolio has a decent change of averaging 3% real during your retirement, wouldn't this mean that you could be more or less breaking even, or better (in real terms) while living off your 3% withdrawals. I'm perfectly aware that theres just as good a chance that returns are worse than 3% real, which would mean you are depleting portfolio value.
You note, appropriately, that the average real return could be less than 3%. However, I think you are missing the concept of "sequence of return risk." Not only will the average real return likely differ from any assumption, the actual annual returns will certainly differ enormously from that average return assumption.

Here is a good introduction to the concept from Michael Kitces: Understanding Sequence Of Return Risk

You'll get more insight into your question by reading the methodology and studying the output of the FIRECalc calculator: http://www.firecalc.com/index.php

If you read about the calculator, you'll find that it works by following actual historic data along actual, specific sequences of historic returns. This type of analysis is the basis for the 4% rule. If you play around with the calculator, what you will find is that, assuming a 4% withdrawal rate, there are a small percentage of 30-year (the default period) sequences that approach a zero portfolio balance, or that actually result in portfolio depletion.

The percentage of failures might be small, but that type of failure is what people are trying to prevent by selecting a conservative enough withdrawal rate.
Last edited by iceport on Sun Nov 06, 2016 3:31 pm, edited 1 time in total.
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Tyler9000
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by Tyler9000 »

SpartanBull wrote:I suppose the general nature of my question would be is the purpose of the "safe withdrawal rate" to sort of create portfolio that will last "forever" or at least not lose any/much value in real terms? OR is the purpose to last you the rest of your retirement, and then you run out of money at the end of your life when you no longer need it. For the sake of this question, we're not thinking about leaving money for children, people inheriting it, etc etc. I'm strictly asking in terms of a retirement for one person, one person and their spouse/significant other, etc.
There are several ways to approach this.

Most of the traditional retirement studies that the 4% rule are based on used the assumption that a retiree depleted a portfolio to zero in the worst 30-year timeframe. One can also look for a perpetual rate that maintained inflation-adjusted principal instead. And VPW fans take sortof a hybrid approach and intentionally deplete the portfolio at a sufficiently old age. There are other options as well, and they all have different tradeoffs.

You might try these two tools to look at the problem from a few different perspectives. The first calculates the safe and perpetual withdrawal rates for a given asset allocation. And the second studies the effects of withdrawal methodology on retirement spending and longevity.
Last edited by Tyler9000 on Sun Nov 06, 2016 3:47 pm, edited 1 time in total.
avalpert
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by avalpert »

SpartanBull wrote:OR is the purpose to last you the rest of your retirement, and then you run out of money at the end of your life when you no longer need it.
At what point will you have a good degree of certainty when the end of your life will be? If you plan to run out when you turn 88 and then go on to live to 100, you are in trouble. If you plan to run out when you turn 100 and die at 88 you will have some left over.

Since the 'safe' part of a safe withdrawal rate is designed (within whatever probabilistic parameters you choose) to ensure you don't run out of money in it will almost guarantee, by definition, that for most situations you leave some on the table.
dbr
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by dbr »

SpartanBull wrote: I suppose the general nature of my question would be is the purpose of the "safe withdrawal rate" to sort of create portfolio that will last "forever" or at least not lose any/much value in real terms? OR is the purpose to last you the rest of your retirement, and then you run out of money at the end of your life when you no longer need it. For the sake of this question, we're not thinking about leaving money for children, people inheriting it, etc etc. I'm strictly asking in terms of a retirement for one person, one person and their spouse/significant other, etc.
As one poster pointed out "4%" is not a plan for retirement. The analysis that leads to this concept was done originally to disabuse people of using much too high and risky withdrawal rates due to not understanding how sequence of return risk can cause a severe retirement failure in the worst case.

A previous poster pointed you in the direction of FireCalc, which is a good way to see what actually happens. Safe withdrawal rate is rather more complicated than your supposition. You are correct in supposing that the idea is to just run out of money at the point you die. The complication is that portfolios don't behave so nicely as to allow that. Also when you are going to die is an unknown which can be estimated statistically but does not have a certain answer in the individual case.

Therefore what is done in "4%" studies is find the withdrawal rate that still works in the worst case using either a fairly long fixed duration to death or even rolling in survival probabilities. Of course then all the other cases would have supported more spending, maybe a lot more, or you would usually end up with a lot of money left over. That is not a very good plan for using money in retirement. A solution that goes to the opposite end of the spectrum is to invest the money in an inflation indexed SPIA which thereby guarantees the income, has no risk of the investor lasting too long, and has no risk to the principal as the value of the assets stays at exactly zero the whole time. In the real world people do not convert all their assets to an SPIA and it is not clear that 100% SPIA is an optimum anyway.
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nisiprius
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by nisiprius »

The usual "safe withdrawal rate" assumptions mean that you accept a real possibility that your terminal wealth at the end will be less than at the beginning of retirement. Quite possibly less in real terms, quite possibly less even in nominal terms, number of dollars. You have to look at the details of actual simulations to see how the odds break down. It isn't symmetrical. Usually, if the chance of actually running out of money is small, then the chance of losing money is small, too; the "average" case usually involves real growth and the "lucky" cases usually involve a lot of real growth.

But, yes, the usual framing of safe withdrawal rates is "to be sure you don't run out of money, but quite possibly substantially depleting your portfolio."

If your goal is "to be reasonably sure that your portfolio has grown in real turns at the end," then your withdrawals need to be more conservative than the "safe" withdrawal rates mentioned in studies.

Maybe not that much lower, because the scenarios in which the portfolio is depleted are unstable, "death spiral" situations.
Last edited by nisiprius on Sun Nov 06, 2016 5:39 pm, edited 1 time in total.
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dbr
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by dbr »

nisiprius wrote:The usual "safe withdrawal rate" assumptions mean that you accept a real possibility that your terminal wealth at the end will be less than at the beginning of retirement. Quite possibly less in real terms, quite possibly less even in nominal terms, number of dollars. You have to look at the details of actual simulations to see how the odds break down. It isn't symmetrical. Usually, if the chance of actually running out of money is small, then the chance of losing money is small, too; the "average" case usually involves real growth and the "lucky" cases usually involve a lot of real growth.

But, yes, if your goal is to be reasonably sure that your portfolio has grown in real turns at the end, then your withdrawals need to be more conservative than the "safe" withdrawal rates mentioned in studies.
Models that model depletion to zero can usually also model depletion to real or nominal starting value. All such models are inherently uncertain to some degree. It is also possible to construct a portfolio that does not have uncertainty, but inevitably that means using instruments with low returns, which may not be optimum. For example, if you are willing to set the term to 30 years (or some available shorter terms than that) a 30 year TIPS will return the invested principal (allowing for premium or discount at purchase) and the investor can "withdraw" the coupon payment, currently 0.72%, but the payout would be CPI indexed. That and the annuity sort of put some extremes on the ends of the proposition.
MathWizard
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Re: Should Retirement Draw Downs Deplete Portfolio

Post by MathWizard »

Yes, the studies do consider the plan a success even if the portfolio goes to zero upon the last full
scheduled withdrawal.

However it need not, and the common 4% rule historically left a higher balance than
at the start (in nominal terms) in 96% of the cases, and higher in real terms 69% of the time. See:

https://www.kitces.com/blog/what-happen ... e-horizon/
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