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.
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.)
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.
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 cliché
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 (http://www.otpp.com/web/website.nsf/web/AssetMixPolicy)
and OMERS (http://www.omers.com/investments/assetmix.html).
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, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.