Market Mini: How Astronomy Produces Sustainable Withdrawal Rates

Posted By on Nov 15, 2013|0 comments


Since 1994, the financial advising industry has used the 4% rule as its guiding light for determining how much to withdraw from a portfolio—it’s northern star of sorts. The 4% rule was advocated by William “Bill” Bengen in,  “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning, vol. 7, no. 4 (October):171–180.

In this Market Mini, we go back to his original research and provide you with a review of this sentinel piece. The whole premise being:

Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe.

While, many financial advisors I coach and consult with on sales training refer to the 4% calculation as the real rock, I found that the discussion on how to work with different types of clients was more valuable.

Bengen refers to three types of clients: Star, Asteroid and Black Hole (Bengen references astronomy, a favorite hobby of his, for labeling examples). Each of these clients reacts differently in varying stock markets.

  • The Stars experience great returns, well above average early in their retirement. They must be counseled not to take withdrawals greater than 4% plus the accumulated inflation.
  • Asteroids experience average returns over the first 10 or 15 years, and should stay on course.
  • Black Holes face a devastating loss in the first few years of retirement. They must maintain either the 50/50 or 75/25 allocation and lower their withdrawal rates below the inflation growth. Additionally they should be counseled to increase their asset allocation close to 100% in stocks at the low of the market, states Bengen.

As an aeronautical engineer graduate of MIT, Bengen is well versed in statistics and presenting numbers. He does a fine job showing how long retirement income would last at 4, 5, 6, and 7% withdrawal rates and at different asset allocations.

Bengen would do well to advise bank regulators today. He recommends not using averages to stretch test, but rather using deleterious times to stress test withdrawal rates. He specifically refers to three events: Big Bang, Big Dipper, and Little Dipper.

  •  The Big Bang includes the 1973-74 recession and impacted portfolios the greatest, not just because of the significant decline in the stock market, but also because of the huge inflation that occurred. This means that investors were taking much greater amounts of money from their portfolio just to sustain their quality of life.
  • The Big Dipper includes the stock market decline of 1937-41. However, bond interest rates were higher than in 1973 and inflation was moderate.
  • The Little Dipper occurred during the Depression, but due to deflation, an individual’s purchasing power was better due to the decline in the value of the dollar.

What is worth further consideration is how one’s portfolio or specifically the withdrawal rates would change if you did change the asset allocation mix based on the valuation of the stock market.

For now, based on Bengen’s work, financial advisors are advised to have focused conversations with clients at the start of retirement and as retirement progresses through the ups and downs of the market. The first step is to determine sustainable withdrawal rates. The second step is to maintain that withdrawal rate and asset allocation even if market fluctuations make it exceeding difficult to do so.

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