One of the difficulties a financial advisor has in helping a client is that there is no way of knowing in advance what the market will do in the future or how long a portfolio will need to last.
As a result of this uncertainty, Morningstar’s David Blanchett, CFA; Maciej Kowara PhD, CFA; and Peng Chen, PhD, CFA, have written a review of retirement strategies titled “Optimal Withdrawal Strategy for Retirement-Income Portfolios,” in Retirement Management Journal, Volume 2, Number 3, Fall 2012.
The authors conducted the research to determine what the efficiency of any particular retirement withdrawal strategy may be.
To fully understand this, they created a new measure, Withdrawal Efficiency Rate (WER). WER measures the efficiency of a withdrawal strategy against perfect information and includes questions such as: What if you knew the returns in advance and what would the glide path of returns be given your year of death?
Using this approach of WER, an advisor can compare the efficiency of an individual’s withdrawal rate strategy.
Comparing Withdrawal Rate Strategies
The authors compared five withdrawal rate strategies:
- Constant Dollar Amount – The same amount is withdrawn and adjusted for inflation in each year of retirement.
- Endowment Approach – A fixed percentage of the portfolio is withdrawn annually.
- Probability of Failure with Fixed Retirement Period – The amount withdrawn is consistent with the same probability of failure for a predetermined number of years. If the value of the account declines, then the size of the withdrawal also declines in order to reduce the probability of failing.
- RMD Method – The withdrawal rated is updated based on survivorship using survivor rates similar to required minimum distributions for IRA accounts.
- Probability of Failure Mortality Updating – The account value is adjusted based on probability of failure (reduce withdrawal rate with a decline in the stock market) and according to the probability of mortality.
Of all the strategies compared, the most inefficient was to make withdrawals based on a constant rate adjusted for inflation. The authors found that the best strategies were, in order: 1. Probability of Failure Mortality Updating; 2.Probability of Failure with Fixed Retirement Period; 3. RMD Method.
Withdrawals Increase with Age
Further, by incorporating a 25% mortality probability, one could increase the starting withdrawal percentage. Unlike common perception, stock exposure increases WER, indicating that a person should increase stock exposure as he gets older. This creates the common rule of 100, whereby an individual decreases stock exposure as he ages, or begin with 100 and subtract one’s age to get the stock percentage obsolete.
These strategies indicate the need to account for inflation, probability of mortality and the change in one’s account value. However, in this study, consideration for stock valuations was not included. One might see the probabilities of failure change not due to age, but rather stock valuations, and as a result, further research should be conducted on how valuations affect WER and the probability of failure.
Blanchett, Kowara and Peng Chen have brought to light that looking at withdrawal strategies based on WER is helpful for advisors to create a foundation for determining retirement income strategy. Though their research indicated that the most common retirement income strategies are inefficient, adjusting according to the probability of mortality and identifying one’s probability of running out of money can help to improve the amount a client can safely withdraw from her portfolio.