Effect of Buffer on Withdrawal Rates


F

FranksPlace2

I am familar with that article in the Journal of Financial Planning
that recommends 5% or lower withdrawal rates during retirement. I
don't like that answer because to have a withdrawal which is 80% of my
pre-retirement income, I need to have 16X my preretirement annual
income in my retirement accounts. For example to withdraw $60k per
year, I need $1.2M in savings.

My reading of the article indicates withdrawals were in the same
proportion as the portfolio, for example 75% stocks and 25% bonds, and
the result was low stock prices had a major impact on portfolio
longevity. Fidelity did a detailed analysis for me but apparently they
also assumed withdrawals were in porportion the the portfolio mix.

The main reason I hold bonds in my portfolio (about 25%) is to provide
a buffer against low stock prices. My strategy is to withdraw from the
bonds only part of the portfolio and rebalance when the market is up
(like now). At a 5% withdrawal rate, my bonds would last 5 years which
is long compared to stock market declines.

Are there any references or tools that address this "bonds first out"
withdrawal strategy?

Frank
 
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W

woessner

Are there any references or tools that address this "bonds first out" withdrawal strategy?

I remember reading an article a while ago about how pension funds use
bonds as a buffer for fluctuating stock prices. The basic idea was
that the fund moves more toward stocks when the market is down and more
toward bonds when the market is up. A nice side effect was that it
provided automatic balancing between stocks and bonds. I wish I had a
link for you, but this was a while ago. However, I got the impression
that it was at least somewhat common, so maybe if you do some research
in to pension funds, you might be able to come across something like
this.

My personal take is that your idea seems dangerously close to market
timing. Perhaps it would be just as effective to use dollar cost
averaging on your withdrawals. That way, you'll sell some stocks low,
some stocks medium and some stocks high. This will provide some of the
protection you're looking for.

As an aside, the 5% withdrawal rate is, IMO, entirely reasonable. The
(admittedly convservative) Rule of 25 suggests a rate of 4% can be
sustained indefinitely. Depending on your age, you may want to factor
Social Security in to your planning. I'm 27, so I disregard Social
Security when doing any retirement planning. But if you're 57, it
might be a different story.

--Bill
 
E

Elizabeth Richardson

FranksPlace2 said:
My reading of the article indicates withdrawals were in the same
proportion as the portfolio, for example 75% stocks and 25% bonds,
This doesn't sound in the least like a good idea. I wouldn't think selling
stocks for income is practical at all. I have monies invested for income,
like Bonds or a Money Market, and that's where I'll be getting my
withdrawals.
 
D

Douglas Johnson

Elizabeth Richardson said:
This doesn't sound in the least like a good idea. I wouldn't think selling
stocks for income is practical at all. I have monies invested for income,
like Bonds or a Money Market, and that's where I'll be getting my
withdrawals.
I don't understand. Are you saying you don't have any equities at all? If you
do have equities, when do you rebalance?

What's wrong with selling stocks for income as long as you have enough non-stock
assets to ride through bad markets? If you don't sell stocks at some point, why
own them?

Thanks,
Doug
 
J

jIM

FranksPlace2 said:
I am familar with that article in the Journal of Financial Planning
that recommends 5% or lower withdrawal rates during retirement. I
don't like that answer because to have a withdrawal which is 80% of my
pre-retirement income, I need to have 16X my preretirement annual
income in my retirement accounts. For example to withdraw $60k per
year, I need $1.2M in savings.

My reading of the article indicates withdrawals were in the same
proportion as the portfolio, for example 75% stocks and 25% bonds, and
the result was low stock prices had a major impact on portfolio
longevity. Fidelity did a detailed analysis for me but apparently they
also assumed withdrawals were in porportion the the portfolio mix.
I think withdrawal strategies which ignore a cash allocation are
misleading... and withdrawal strategies which involve "just in time"
withdrawals are living on the edge to begin with. I suggest
withdrawing 8 years before you "need" the money and leave this
allocation in cash or inflation indexed securities.

If the example you gave above, consider taking 8*60k and putting it in
CASH the day you retire. Regardless what the market does the next 8
years, you are OK. 60k in money market, 60k in a 1 year CD, 60k in a
two year CD, 60k in a 3 year CD, then 4*60k into some type of inflation
security. Roll one index bond into a 3 year CD, and replenish the
indexed securities from the equity investments each year (in up
markets).

The remaining 580k of the portfolio needs to sustain 60k annual
withdraws, but only withdraw when the market is UP. If market goes
down and stays down for 8 straight years (or even 4 of the 8), everyone
will have bigger problems.

I do consider this market timing... but if a big risk to porfolio is a
down year or two early in retirement, I would hedge against this risk
with cash. 4 years into this system, the inflation indexed securities
should help portfolio do quite well generating the income needed.
Takes more cash up front, though (than traditional withdrawal models).
 
J

joetaxpayer

FranksPlace2 said:
The main reason I hold bonds in my portfolio (about 25%) is to provide
a buffer against low stock prices. My strategy is to withdraw from the
bonds only part of the portfolio and rebalance when the market is up
(like now). At a 5% withdrawal rate, my bonds would last 5 years which
is long compared to stock market declines.

Are there any references or tools that address this "bonds first out"
withdrawal strategy?
The way the studies are worded you are offered a 90% success rate of not
outliving your money at the suggested 4% withdrawal rate.
You need to keep in mind a few things. The Monte Carlo simulations that
generated these numbers are based on the past 70 or so years which I
believed averaged 10.5% for the simulation. Given the 10.5% average,
along with its standard deviation (somewhere around 18%) the 4% number
includes a 3% inflation factor, i.e. it includes raising the withdrawal
by about 3% per year from the initial amount.
Consider that if you could invest at 7% fixed, in perpetuity, you'd be
able to take the 4% and leave the 3% to grow your principal (yes, I've
ignored taxes for sake of simplicity). So the reason that the Monte
Carlo gives you this based on 10.5% average is the volatility. You don't
know which year will be up or down. Given all of this, there has been
discussion here suggesting that the next 30 years are likely to under
perform the historical numbers. That 7-8% is the more likely growth rate
to expect.
Next, commentary along with these studies suggests different tweaks or
adjustment rules to help bump the percentage up. One rule is that you
don't take the inflation bump after a down year. Since on average 1 in 3
years or so are down, you may object, that you will trail long term
inflation by 1/3. I understand. Back to your original question, though.
The studies do assume the withdrawals are based on the same mix within
the portfolio, that at the end of each year you are rebalanced to the
original plan. This matches just what you plan. If the market is up,
then to rebalance you would need to sell stock. If the market has
dropped, well, then the bond portion is too high and you'd buy stocks
when down. To call this 'timing' is a matter of semantics. Rebalancing
causes one to buy stocks when low and sell when high.
Lastly, if you choose stocks with high dividends, (I'm thinking the DVY,
iShares Dow Select Dividend) your stock portion will yield 3%, this is a
good chunk of what you need, if 80% of your funds are in such high yield
stocks, there's 2.4% of the 4% (or 5% as you desire) and the rest will
take a smaller bite from your cash position. You question is
straightforward, the answer is not.
JOE
 
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E

Elizabeth Richardson

Douglas Johnson said:
I don't understand. Are you saying you don't have any equities at all? If you
do have equities, when do you rebalance?

What's wrong with selling stocks for income as long as you have enough
non-stock

See jLMs response for clarification. I don't necessarily advocate the
ultra-conservative 7-8 years in cash/cash-like, but neither would I
subscribe to something as risky as selling equities for income.

Elizabeth Richardson
 
J

joetaxpayer

jIM said:
If the example you gave above, consider taking 8*60k and putting it in
CASH the day you retire. Regardless what the market does the next 8
years, you are OK. 60k in money market, 60k in a 1 year CD, 60k in a
two year CD, 60k in a 3 year CD, then 4*60k into some type of inflation
security. Roll one index bond into a 3 year CD, and replenish the
indexed securities from the equity investments each year (in up
markets).

The remaining 580k of the portfolio needs to sustain 60k annual
withdraws, but only withdraw when the market is UP.
jIM - 8*60=480K

This leaves 720K for 8 years worth of growth. With the warning about
"past performance, yada,yada" since 1920 the 8-yr annualized returns
average 10.9% with STD Dev of 6.0%.

To start will 40% sounds a bit high, I'm with Elizabeth on this, but
these conversations need to include a 'sleep factor' and your suggestion
would get one through most bad periods with little risk.

JOE
 
J

jIM

joetaxpayer said:
jIM - 8*60=480K

This leaves 720K for 8 years worth of growth. With the warning about
"past performance, yada,yada" since 1920 the 8-yr annualized returns
average 10.9% with STD Dev of 6.0%.

To start will 40% sounds a bit high, I'm with Elizabeth on this, but
these conversations need to include a 'sleep factor' and your suggestion
would get one through most bad periods with little risk.

JOE
If a large risk to assetts lasting for duration of retirement is a down
year early, I think hedging against this risk with cash is a wise
strategy. Maybe the assets do not get replaced until year 6 or 7 (so
withdraw 8 years income in cash to start, but overall plan might be
only 5-7 years of cash).

I am sure other strategies exist... maybe 8 years of income in bonds...
maybe 8 years of income in cash or inflation bonds, the rest in
equities...

The way I suggested above is the strategy I am looking to implement. 8
years cash the day I retire, with an equity/bond portfolio designed to
replace this one year at a time.

60k is 8% of 720k. If the 720k is around 70-80% in equities, I would
think it could generate the 60k without too much of an issue. There is
little need to sell in a down year because of the 8 year cash cushion.
 
F

FranksPlace2

Thank you all for your comments.

There seems to be a consensus that "selling stocks for income" is not a
good idea. If the FPA article and Fidelity include this in their
models, it does not represent good practice.

One alternative is to sell only bonds and rebalance once a year, say on
a fixed date. The results for this case may be better or worse than
the first case depending on whether the price on that day is higher or
lower than the average for the prior sales.

My alternative is to rebalance "when the market is up" sometime over a
3 to 5 year period. It is market timing in the sense that I might wait
to sell and the market goes down. But it seems better than selling on
a fixed schedule.

Going to 8 years cash is the opposite of my goal. I want more return,
not less risk. My strategy could result in a 100% stock portfolio in
the extreme case and I can live with that risk. (I wish I had been in
100% stocks in my younger years. I would be wealthier today.)

Dollar averaging is also the opposite of my goal. I don't want to sell
more shares at a low price, only less shares at a higher price.

I'll retire in about a year and see how this works out.

Frank
 
H

HW \Skip\ Weldon

I'll retire in about a year and see how this works out.
Frank one of the concerns I've had about these withdrawal and
rebalancing strategies has to do with increasing age. I've been
involved in investments for some time and don't recall any age 75+
investors who could do what's required - monitoring and making
decisions on the withdrawals, keeping current with tax rules, tracking
basis, following the markets, etc.

Since I frequently miss the obvious <grin>, I'd be interested in
comments from you and others on this subject.


-HW "Skip" Weldon
Columbia, SC
 
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D

Douglas Johnson

HW \"Skip\" Weldon said:
Frank one of the concerns I've had about these withdrawal and
rebalancing strategies has to do with increasing age. I've been
involved in investments for some time and don't recall any age 75+
investors who could do what's required - monitoring and making
decisions on the withdrawals, keeping current with tax rules, tracking
basis, following the markets, etc.
I certainly expect be able to do this at 75 -- my dad is 81, mom is 80 and
neither has any problem with this level of complexity. Grandma could whip me at
bridge into her late 90's. However, this is another reason immediate annuities
get interesting about this age.

My tentative plan (still 20 years away) is to buy an immediate annuity in my mid
70's. This, with social security, would be enough to cover my living expenses
in that year. It would become the fixed income portion of my portfolio with
most of the remainder in equities. At that age, an immediate annuity can return
7-8% guaranteed annually for the rest of my (I hope) long life.

The equities (probably more passively invested than now), along with social
security adjustments, would cover the inflation risk.

-- Doug
 
E

Elle

FranksPlace2 said:
There seems to be a consensus that "selling stocks for
income" is not a
good idea.
It is certainly not a bad notion, either, though. The now
famous 1998 "Trinity Study" demonstrates that, using
historic returns, regularly drawing down on stocks (and
bonds) in retirement is an effective strategy.

See http://home.earthlink.net/~elle_navorski/id4.html for
links to various retirement withdrawal calculators and
discussions.

I mean, assuming one does not care to will one's estate to
children, grandchildren, a charity etc., and assuming one is
not filthy rich, what is the point of accumulating a fortune
if one is just going to live off its income?

I say be open to cashing in principal in one's twilight
years.
 
T

TB

FranksPlace2 said:
There seems to be a consensus that "selling stocks for income" is not a
good idea. If the FPA article and Fidelity include this in their
models, it does not represent good practice.
Frank,
I wouldn't call that the consensus at all, and selling stocks is an
important part of portfolio management, even if that's not viewed
specifically as selling stocks for income. Total return - the
combination of dividends and gains - should be the focus when looking at
any equity asset class, whether US stocks, international stocks or
REITs. If you focus on higher-yielding stocks (so you aren't forced to
'sell stocks for income') you could end up with a basket of stocks with
a lower total return. And if nothing else, not-selling will leave you
with too much invested in stocks when the market runs up -- missing out
on one benefit of diversification.

I think you're on the right track with your original post...asset
allocation models aside, a cash & bond buffer really helps things, by
giving you something to dip into when the market tanks. Implicitly
though you also have to be willing to stare down those drops and not
sell stocks again until things recover (an 8-year buffer in the past has
been more than adequate most of the time; even 3 or 5 years has been
enough much of the time). And of course, there's the flip side...you
need to sell periodically to replenish your cash/bonds, or when stocks
rise so much that your investment mix is far off target. Once again...is
this selling stocks for income? Maybe not specifically but it amounts to
the same thing. Someone who lives off dividends and doesn't sell stocks
ever -- and chooses stocks with that approach in mind -- is probably
leaving money on the table.

My alternative is to rebalance "when the market is up" sometime over a
3 to 5 year period. It is market timing in the sense that I might wait
to sell and the market goes down. But it seems better than selling on
a fixed schedule.
If you want to reduce the subjectiveness of it you could rebalance any
asset class when it's a certain percentage off-target. That's what I do,
that's what a lot of professional advisors do. I agree that
calendar-based rebalancing makes no sense, practically speaking. What if
stocks rise 15% suddenly and your portfolio is well off-target but it's
not your scheduled date? I think those calendar-based illustrations are
the result of lazy modeling as much as anything (calendar-based data is
easy to find and easy to simulate).

I think Evensky did an article in Financial Planning some time ago - 04
or 05? - supporting the "bonds first" withdrawal strategy. I've seen it
several other places but can't think of where off the top of my head. It
makes intuitive sense, if nothing else.

Some other things to consider...those 4-5% models presume spending that
blindly ramps up at the inflation rate (often, a fixed inflation rate).
That doesn't describe everyone's spending during retirement, not by a
long shot. And the models don't allow for simply putting off spending in
a truly dismal year. If your fixed expenses, excluding all discretionary
purchases, could be covered by Social Security alone (which actually
isn't uncommon) you could have a 0% withdrawal rate in during a bad
spell which would do wonders for the long-term prospects for the
portfolio. Point being that with some flexibility assumed, the Monte
Carlo simulations are overly pessimistic, and might just leave you with
a pile of money for heirs at the expense of a more-enjoyable early
retirement.

-Tad
 
K

kastnna

Frank,

Whether you like the answer or not, $1.2MM is pretty close to the
"risk-free" answer. Given 3% inflation and a 4% "risk free" investment
(i.e. gov't bonds) your principle would be gone be the end of the 23rd
year.

Obviously, the amount of risk you are willing to take on is entirely
based on your risk tolerance. If you opted for riskier investments (for
ex: 8% return) you could accomplish the same financial goals with only
$850k.

Many of the answers given here could be correct. they are the proper
answer given the level of acceptable risk they assumed into the
situation.

As you stated it is a good idea to hold a percentage of bonds in your
portfolio to hedge against a market downturn. 25% is a common
allocation to be found in a moderately aggressive to conservative
portfolio.

As for the selling stocks or bonds comments. Ideally you should be
taking income from the bonds in your portfolio as they generate
interest and never divest your principle. However, if by sell you mean
to liquidate principle (whether stocks or bonds) then why would you
only want to sell bonds and never equities as was mentioned here
earlier? Furthermore, if the 5% withdrawal rule you mentioned earlier
does not sit well with you, then I am assuming that you will be forced
to liquidate principle.

By selling only bonds, you are selling at a discount in an upmarket and
premium in a bear. Even if you replace the bonds in a bull (like now)
as long as the market continues to rise, the value of the bonds will
decline (bonds and equities inversely related blah blah blah).
Given that the market has had almost twice as many up years as down,
you are almost certainly asking for trouble.

Look into fee based accounts (non commission based) that use an asset
allocation strategy and allow free trades and automatic rebalancing.
ETFs are also more tax advantageous and usually lower in fees than
mutual funds.
 
E

Elizabeth Richardson

TB said:
And of course, there's the flip side...you
need to sell periodically to replenish your cash/bonds, or when stocks
rise so much that your investment mix is far off target. Once again...is
this selling stocks for income? Maybe not specifically but it amounts to
the same thing. Someone who lives off dividends
I think this is more what I had in mind. When Frank said selling stocks for
income, I pictured a monthly (or maybe quarterly) selling to provide that
monthly (or maybe quarterly) necessary income. When you allocate your assets
among different classes - at least some stocks and some bonds/cash - then in
order to keep the bonds/cash component providing sufficient income you
probably have to sell some equities. This doesn't feel to me like selling
stocks for income. I will have to sell equities, of course, but I don't
anticipate it feeling like I'm selling them for income, and it certainly
won't be as often as monthly or quarterly.

Elizabeth Richardson
 
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M

Mark Freeland

HW "Skip" Weldon said:
Frank one of the concerns I've had about these withdrawal and
rebalancing strategies has to do with increasing age. I've been
involved in investments for some time and don't recall any age 75+
investors who could do what's required - monitoring and making
decisions on the withdrawals, keeping current with tax rules, tracking
basis, following the markets, etc.
Our family accountant, a CPA, was not only doing this at age 75, but was
still teaching accounting at the university level (as an adjunct).

I'm not saying that this may be common, but certainly possible.

Mark Freeland
(e-mail address removed)
 
F

FranksPlace2

A couple of Clarifications...

When I said "sell stocks for income" I meant what Elizabeth meant,
periodically selling stocks and bonds in porportion to my portfolio,
e.g. 75/25, without regard to market conditions. I think that's what
some of the models do. The alternative I plan to use is sell bonds
periodically and sell stocks to rebalance "when the market is up."

I plan to "live rich and die broke," frittering away my principal and
earnings on travel and entertainment with my wife. That is probably an
overstatement of reality but it's a guide.

Skip, when I' m too old to manage my portfolio, I'll probably be too
old to fritter any more so my income needs will be down.

Most of the models I have seen tend to be pass or fail, either you have
plenty money at the end or you go broke in 15 years. Reality is you
adjust your lifestyle based on where you are.

I'd like to have as much income when I retire as I have now. I will
have more time to spend money when I am retired.

I may start at 6% and see what happens.

Frank
 
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E

Elizabeth Richardson

FranksPlace2 said:
A couple of Clarifications...

When I said "sell stocks for income" I meant what Elizabeth meant,
periodically selling stocks and bonds in porportion to my portfolio,
e.g. 75/25, without regard to market conditions.
Well, a couple of clarifications . . . Without regard to market conditions
is not exactly what I meant. I have several years income in lower-risk
income producing bond mutual funds and cash. However, the income they
produce isn't enough to satisfy my income needs and I will have to sell some
bit by bit. I am one of the lucky ones for whom the market isn't tanking the
first year of retirement. Still, I have enough to disregard market
conditions if necessary and replenish my bond/cash position when prices are
attractive to do so.

Elizabeth Richardson
 

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