Total portfolio allocation and withdrawal

Overview
This article describes the "total portfolio" approach to asset allocation and withdrawal.

The total portfolio approach means that the present value of future savings and retirement income, valued using the safe bond rate, is counted as bonds in the portfolio. A fixed asset allocation is maintained on this "total portfolio." Retirement withdrawals are calculated by amortizing the total portfolio over retirement years (amortization based withdrawal).

The advantage of the total portfolio approach is that total risk is kept consistent from year to year. This has two benefits:


 * 1) The more even spreading of risk across years reduces the total risk that the retiree would need to take to achieve a given expected return.
 * 2) It prevents surprises like risk increasing unexpectedly as the real value of a pension declines and the retiree relies more heavily on the savings portfolio.

Planner with Monte Carlo Simulation
This planner uses Monte Carlo simulations to show the impact of planning choices. The user adjusts their plan until they are satisfied with the simulation results.


 * For investors in the accumulation phase:
 * Download planner: Excel
 * How to add/delete rows to customize the planner.


 * For retirees:
 * Download planner: Excel
 * How to delete rows to customize the planner

Simulator
While the Monte Carlo simulator in the Planner repeats the simulation 500 times by drawing randomly from the given sequence of returns, this simulator calculates withdrawals for only the one given sequence of returns. This is useful for backtesting.


 * For investors in the accumulation phase: Excel or Google Sheets
 * For retirees: Excel or Google Sheets

The following spreadsheet shows a way to adjust historical returns so that its expected return becomes equal to the expected return of the return distribution you want to use for the simulation:


 * Returns for simulation: Excel or Google Sheets

Relation to Merton's strategy
The allocation and withdrawal strategy of TPAW aligns with the optimal allocation and withdrawal derived in Merton (1969). This spreadsheet shows the link between the two strategies. You can enter the inputs for Merton's strategy and obtain the corresponding inputs for TPAW:


 * Merton's inputs matched to TPAW inputs

Deviations from Merton's strategy
TPAW deviates from Merton's strategy in the following ways:


 * No borrowing: While Merton assumes borrowing, TPAW assumes no borrowing. If Merton's strategy calls for borrowing to invest (i.e. asset allocation >100% stocks, likely in early career), TPAW uses an an asset allocation of 100% stocks instead. And if Merton's strategy calls for borrowing to consume (a possibility in early retirement before pensions begin), TPAW only withdraws whatever is available in the savings portfolio.


 * Extra withdrawals: Merton's model assumes no extra spending needs in any year. TPAW allows the user to schedule extra withdrawals in any desired year through the "essential expenses funded by safe bonds" and the "extra withdrawals funded by risk portfolio" columns.
 * No savings strategy: Besides the optimal withdrawal strategy during retirement, Merton's model also gives the optimal savings strategy when working. TPAW takes savings as given and does not model the savings decision.

TPAW with borrowing
This spreadsheet implements TPAW with borrowing, which makes it closer to Merton's strategy. The assumption that the user can borrow as much as they want simplifies calculations. Answers can be obtained with formulas and don't require simulations (e.g. what is the probability of withdrawals falling below $40,000 at age 70?). But it is not directly implementable in a world with borrowing constraints. So care should be taken when using the spreadsheet to understand if and when borrowing is being assumed and the consequences of not being able to borrow as assumed. The larger the savings portfolio is relative to future income, the less likely the model is to require borrowing. The model is most likely to call for borrowing (to invest) in early career when the savings portfolio is at its lowest and future savings is at its highest. For people with large pensions relative to savings, it might also call for borrowing (to consume) in early retirement before Social Security and pensions start. Users are advised to use the "Planner with Monte Carlo Simulation" above to ensure that their strategy will work well without borrowing. Those who don't want to explore the theory behind TPAW and are looking for the quickest route to an implementable strategy that does not involve borrowing can ignore this spreadsheet and rely solely on the "Planner with Monte Carlo Simulation" above to devise their strategy.


 * For investors in the accumulation phase: Excel or Google Sheets
 * For retirees: Excel or Google Sheets

Sequence of Return Risk
Sequence of return risk is the risk that poor returns occur when a savings portfolio is large (typically around the start of retirement) and are not fully compensated by good returns that occur when the savings portfolio is small (typically early career and late retirement). This leads to concern that a market crash right around retirement can permanently damage a retirement because portfolios are at their peak value and very sensitive to returns. TPAW manages this risk by maintaining a fixed asset allocation on the total portfolio and employing amortization based withdrawals. This results in a strategy that is well diversified across time, making the outcome less sensitive to the timing of returns. A crash and subsequent recovery would have no harmful effect on retirement even if it occurred just prior to retirement when the savings portfolio is at its peak. During retirement, no matter when the crash occurs, the loss would be limited to reduced income during the depressed years. The income will recover fully if and when the market recovers. There would be no permanent damage to the portfolio that persists after the market has recovered.

Support
On-going discussion and support is in Bogleheads® forum topic: Total portfolio allocation and withdrawal (TPAW)