A recent study titled “Low Bond Yields and Safe Portfolio Withdrawal Rates” provides insight into the likelihood of retirees running out of money in retirement in a low interest rate environment. Co-authored by David Blanchett, Michael Finke, and Wade Pfau and released in January, the study looks at the impact that a low interest rate environment has on a retiree’s ability to provide the necessary income for a 30 to 40 year retirement.
The results of the study challenge some of the traditional thinking on safe withdrawal rates for retirees during periods of low interest rates. Studies originating in the mid-nineties found that a 4 percent initial withdrawal rate with a portfolio comprised of 50 percent stocks and 50 percent intermediate-term treasuries were sustainable for 33 years based on historical investment returns for the stocks and treasuries. A study a few years later found that a retiree seeking a 75 percent probability of success could sustain a 4 to 5 percent initial withdrawal rate with a portfolio comprised of 50 percent or more large company common stocks, based on historical returns. And several studies in the early 2000s found that portfolios with lower equity allocation weightings had a higher probability of failure (running out of money) than portfolios with higher equity allocation weightings over extended retirement periods.
But all of the studies mentioned above assumed that fixed income investments provided returns at historical average rates. When fixed income investment returns are at historical lows, how do sustainable withdrawal rates change?
The study by Blanchett, Finke, and Pfau examines the impact currently low bond yields have on a decades-long retirement, while allowing bond yields to drift towards historical average over time in simulations.
One of the key findings of the study is that the traditional 4 percent “safe” withdrawal rate in the low bond yield environment would result in only a 50% probability of success (not running out of money) over a 30-year period. Furthermore, the study found that a retiree seeking a 90% probability of not running out of money with a portfolio containing 40% equities would be limited to an initial withdrawal rate of only 2.8%. This lower withdrawal rate means that to produce the same dollar amount of income for a retiree, the portfolio in the low-yield environment would have to be 42.9% larger than the portfolio that sustains a 4% withdrawal rate.
While a 40% equity weighting is probably too conservative for an early retiree in his or her early to mid-sixties with a thirty to forty year retirement horizon, a 60% equity weighting is very appropriate for many early retirees. The study found that aiming for a 90% probability of success would limit initial portfolio withdrawal rates to 2.7%. An 80% probability of success allows initial withdrawal rates to rise to 3.2%.
One of the assumptions in the study understates the returns for equity asset classes. In order to be conservative with the study, the authors reduced the average annual historical return for the S&P 500 index by 2.0%. Because of this assumption, the validity of the study is in question. With the lower equity returns used in the analysis, the simulated portfolios cannot sustain higher withdrawal rates at the same level of probability. Had the researchers used historically accurate data, the withdrawal rate associated with a 90% probability of success may very well have reached or surpassed 4.0%.
The validity of the numbers notwithstanding, the study does point out an important reality for retirees and pre-retirees today. The low interest rate environment we are in presents serious challenges for retirees seeking to generate sufficient income from their retirement savings. If retirees wish to receive the same amount of income from their portfolio, they will need to increase their equity exposure in the short term until bond yields increase to “normal” levels. If retirees are unwilling to shift their portfolio weightings to compensate for lower bond yields, then they run the risk of drawing down their retirement portfolios too quickly and running out of assets sometime deeper into their retirement.
Clients of Bollin Wealth Management have already had this conversation with us, and most portfolios have been re-allocated to compensate for the low-yield environment. If you are not yet a client of Bollin Wealth Management, or have questions as to what to do now, please give our office a call.
Sources: Investment News, “Low Bond Yields and Safe Portfolio Withdrawal Rates”