New science for retirement withdrawals

During retirement, what is the best strategy to assure that you will not run out of money?

Mar 1st, 2012

By Brian Hufford, CPA, CFP®

During retirement, what is the best strategy to assure that you will not run out of money? Of course, there is no assurance that any strategy can ultimately protect a retiree from running out of money during a long retirement. Still, mathematical science can greatly improve the probability of success.

Let me illustrate the challenge of the mathematical/statistical problem with this question: Which is better as a retirement portfolio, all bonds or all stocks?

If you will allow me extremes for a moment, I will explore the nature of the retirement withdrawal problem. For a long retirement of 30 years, with a 2% inflation assumption, the low volatility cash/bonds portfolio preferred by many retirees has a zero percentage probability of successfully providing a constant stream of income for more than 30 years. The all-stock portfolio has nearly an 80% probability of success, and on a median basis, will yield a remaining sum at the end of 30 years that is 3 times the original starting amount of savings.

In other words, the median outcome of an all-stock portfolio for a retiree that entered retirement with $3 million in savings, withdrawing a starting amount of $150,000 per year, would be an 80% probability of success and a median outcome of having approximately $9 million remaining after 30 years of retirement. This compares to the all-bond portfolio, which runs out of money in 21 years and has 0% remaining on a median basis.

Should you change your retirement portfolio to all stocks?

Retirees intuitively understand that starting retirement in a severe bear market with an all-stock portfolio can sabotage any hope of success. This can be illustrated mathematically by looking at the worst 5% of all outcomes with the all-bond versus all-stock portfolios discussed.

This worst-case comparison is as opposed to the “median” case mentioned in the previous paragraph. With 95% of hypothetical outcomes better, the all-bond portfolio lasts for 21 years. The all-stock portfolio runs out of money in only 15 years.

This is the challenge of an all-stock portfolio for retirees. The peculiar nature of human loss-aversion, which drives the emotional tendency for all of us to make poor mathematical choices, causes us to flee from stocks during retirement, when having stocks in a portfolio can be critical for success.

The new science for retirement withdrawals that attempts to solve this problem mathematically was proposed in a paper by authors John J. Spitzer, PhD, and Sandeep Singh, PhD, titled, Is Rebalancing a Portfolio During Retirement Necessary?

The authors approached the problem with a unique method. Instead of focusing only on retirement withdrawal rates or portfolio allocation among stocks and bonds, they explore how to best withdraw retirement dollars from investments in a portfolio. The authors look at five different withdrawal strategies during each year of retirement, which they call Rebalancing, High First, Low First, Bonds First, and Stocks First.

In practice, Rebalancing would take withdrawals proportionately from all investments; High First would take withdrawals from the best performing sectors; Low First would take withdrawing from the worst performing sectors; and Bonds First and Stocks First are self-explanatory.

What the authors discovered from their statistical analysis is that withdrawing from bond investments first created a significant improvement in the probability of success for retirement withdrawals, compared to any other method. This makes sense with the historical tendency of stocks to provide larger expected returns over longer periods of time.

By withdrawing from bonds first, a retiree would mitigate the early-retirement loss problem of holding stocks in a retirement portfolio during a bear market. The stock portfolio would be given time to recover. It also would appear to solve some of the problems of my starting example for the all-bonds vs. all-stocks portfolio, in which a retiree either chooses assured failure with all bonds or frightening risk in a worst-case bear market for all-stocks at the start of a long retirement.

What is counterintuitive with this methodology is the fact that a retirement portfolio would become more heavily invested in stocks during retirement. By selling bonds first, the holdings of stocks would increase dramatically over time. The portfolio would become more aggressive during retirement. To most retirees, this would be unacceptable, yet illustrates how human emotion can sabotage logical mathematical outcomes.

More than anything, this new science proves that investment outcomes can be counterintuitive, and that emotion and herd psychology are powerful forces that must be overcome for ultimate success when pursuing an important goal such as retirement.

Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064 or bhufford@huffordfinancial.com.

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