Drawing an income
High withdrawals, volatility can deplete savings
Many retirees are at a loss for ideas when faced with having to generate the cash flow they need from their investment portfolios. As we've discussed here before, many are opting for high-payout balanced funds and others that promise unrealistically high cash distributions. What is rarely mentioned, however, is the level of withdrawals that can "safely" be taken out of a portfolio over a long period of time. While the past is no guarantee of the future, it can certainly give us some insight into the factors affecting sustainable withdrawal rates.
Returns and volatility
Volatility refers to the magnitude of price swings - both up and down. Recent research I did into the topic of regular portfolio withdrawals suggests a very strong correlation between the likelihood of running out of money early and volatility.
Consider the up and down swings of stock prices. When stocks launch into a declining trend, constant dollar withdrawals will drive portfolio values down even deeper. Suppose you draw down 6 per cent of your portfolio during a period, which sees its value drops by 10 per cent. The bottom line is roughly the same as the portfolio losing 16 per cent of its value. That's a very significant loss to make up when you consider that the withdrawals continue - and increase slightly each year with cost of living increases.
The thing to remember here is that generating high returns isn't enough to sustain an investor's desired withdrawal. Generating the return consistently is critical. In my research, I illustrated this point in an example.
George had $290,000 in his RRSP and needed to withdraw $23,371 in his first year of retirement, and rising by an assumed 2.5 per cent annual inflation rate thereafter.
Let's assume George invested all of his RRSP in U.S. stocks; kept it there as he drew down from it each month; and started this at the beginning of 1926. His portfolio ran out of money in just over 19 years, a period that saw U.S. stocks return 6.2 per cent annually.
By contrast, if George had invested in something that guaranteed him a constant 6 per cent per year, his portfolio would have lasted a full 23 years. Hence, even though the guaranteed option posted a slightly lower return, its perfect consistency made it last nearly four full years longer than the more volatile "all-stock" portfolio.
(Note: An investment's "standard deviation" measures the average amount by which the investment's rates of return deviate from its average return - i.e. volatility. This statistic is reported for mutual funds.)
Order of returns
Aside from volatility, the order in which returns occur also seems to seal the fate of a portfolio's "life expectancy". Continuing with George's situation from above, I compared two scenarios to illustrate this point.
As noted above, taking the monthly returns of U.S. stocks starting at the beginning of 1926, the portfolio lasted just over 19 years. I took the same monthly returns and changed the order in which they occurred. I fixed it so that the first half of the period saw much higher returns than the second half. Result: At the end of the same 19 years, the portfolio was still worth more than $250,000 - as opposed to zero in the initial scenario.
To summarize, each of the 19-year periods saw equally volatile returns of 6.2 per cent per year, but the scenario that started with much higher returns lasted much longer.
Why? Because more money is actually invested in the early years. If the higher returns don't happen until much later on, there won't be enough money remaining to make a meaningful impact on the longevity of the portfolio.
Sustainable withdrawal rate
Taking these factors into consideration and using history as a guide, it becomes clear that any withdrawal strategy that begins above 5 per cent of the initial portfolio value may be at significant risk of running out of money too early. This conclusion has a couple of built-in assumptions - namely that the income is required for at least 25 years (standard for many retirees) and that the income must rise regularly to match cost of living increases. After all, if you took $15,000 from your investments this year, you may want and/or need much more than that in five or ten years to sustain the same standard of living.
Incidentally, withdrawing an amount from a balanced portfolio (60 per cent U.S. stocks and 40 per cent U.S. bonds) that starts at 8 per cent of the initial portfolio value and increases each year with inflation has historically run out of money in less than twenty years more than half of the time.
When getting close to drawing regular amounts from your investments, make sure your portfolio is structured in a manner that nicely balances volatility and return. Guess what? That brings us back to some age-old advice: take a balanced approach. It's such a clichi but it's so true.
Setting up your portfolio for regular withdrawals requires that close attention is paid, not only to return potential, but to minimizing how volatile those expected returns will be. Take a cue from our country's largest pension plans, OTPP and OMERS. Each has about 60 per cent invested in stocks, with the remainder in bonds, cash, and other assets that protect against inflation.
How each investor should structure their respective portfolios depends entirely on individual circumstances; but hopefully this article will be a useful starting point.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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