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You are here: Home / Investments / Improving the success rate of the retirement portfolio

Improving the success rate of the retirement portfolio

13, May 2014 by Wilfred Ling 3 Comments

Because you wouldn’t want to sell tissue

This is a follow-up article from the previous article I wrote on "Retirees, here is an example of converting capital gains to an income stream".

Professional financial planners have been debating ways to improve the success rate of the retirement portfolio. ‘Success’ is defined as the retiree not outliving his or her resources.

The success rate of the retirement portfolio depends very much on the following factors:

  1. Expected returns of the retirement portfolio;
  2. Expected withdrawal rate;
  3. Volatility of the retirement portfolio;
  4. Expected Inflation;
  5. Expected expenditure and where the retirement portfolio is required to fund ‘long-tail’ expenses such as medical and disabilities; and
  6. Risk tolerance of the retiree.

Among all the factors above, I have found that most retirees find it hard to understand the impact of volatility. Without understanding the impact of volatility, the success rate of the retirement portfolio is in jeopardy.

Most of my clients say that volatility is not important as long as the expected return is good. This misconception arises due to the common notion that it does not matter how you travel as long as you reach your destination. Unfortunately, volatility (how you travel) is as important as the expected returns (the destination). The jargon that is often used by professional investment advisers is ‘path dependent’.

Consider two investments. One is a risk-free with returns of 4.5%pa over a 14 years period. Another is a more volatile investment also with 4.5%pa returns over a 14 years period. I used MSCI AC Asia ex Japan as a proxy for this volatile investment. Below is a chart to illustrate that over 14 years, both gives the same returns from end of April 2000 to end of April 2014:

blog-2014-05-05-chart1

Click to enlarge image

Let’s say you invested $1,000,000 of your money into a retirement portfolio and you withdraw $7500 every month for 14 years. How would each of these two investments perform? The chart below shows that the risk free investment would still have some money left (to be precise it is $113,242) at the end of 14 years. However, the volatile investment runs out of money at the end of 12 years. To the retiree, he could end up outliving his resources due to volatility. Imagine at such an old age, you have to go back to selling tissues because you run out of money before you are called to paradise. By the way, you need to pay an annual licensing fee to sell tissues. If you do not wish to sell tissue and pay a licensing fee to do so, make sure you improve the success rate of the retirement portfolio by watching the volatility.

Click to enlarge image

Click to enlarge image

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Filed Under: Investments, Retirement Planning

Comments

  1. xyz says

    17, May 2014 at 1:34 pm

    This topic has already been researched for many years (30+ years) and by many economists (at least hundreds) liao.

    Hence the lazy rule of thumb of not drawing more than 4% of the initial portfolio each year. The “4% rule”.

    For $1M retirement portfolio that means not more than $10K each year i.e. $833 per month, adjusted for inflation each year.

    The 4% rule won’t guarantee you will outlive your nestegg. But based on monte carlo simulation probably within 2.5-sigma events, 98%-99% of the time.

    If a person were to retire on Oct 2007 just before the 3-sigma event of GFC, will his portfolio survive for 30-40 years? Who knows…

    Also for retirement funds to be holistically “successful”, not only must survive lifetime of retiree, but also must provide “adequate” living expenses for the desired lifestyle.

    A person used to $10K a month lifestyle can probably downgrade to $500 a month lifestyle if life & death depended on it. But after 10 years like that, he probably rather kill himself.

    Reply
    • Wilfred Ling says

      17, May 2014 at 8:28 pm

      The ‘4%’ withdrawal rule is not used by professional planner. Probably not even in US. This is due to two issues (1) The ‘4%’ withdrawal rule is based on a poorly diversified portfolio consist mainly in US bonds and equities. and (2) but more importantly there is no consideration given to the willingness and ability of the retiree to take risk. Also, a retiree’s mental capacity tends to degrade over the years to a point in which the willingness to take risk is no longer even mentally possible.

      That is why there is a vast difference between academic and practice.

      Reply
  2. JOHN says

    5, July 2014 at 4:12 pm

    Your example also highlights the dangers of withdrawing too much from your nest egg.

    Even with the risk-free constant 4.5% portfolio, you will run out of money by the 17th year if you simply withdraw $7,500 monthly from a starting nest egg of $1M. This is a withdrawal rate of fixed 9% of starting portfolio (7500X12 / 1000000). Research has shown that fixed 9% is just too damn high. And your drawdown graph above illustrates this.

    Also there is no inflation adjustment. You will be happy at the start of your retirement with $7500 worth of creature comforts. But after 10 years, those creature comforts will be much lesser. Not to mention the increasing amount of healthcare spending required, compounded by high healthcare inflation (both insurance premiums as well as the expenses, bills, costs).

    For a fixed % withdrawal, many studies show sustainable withdrawal rates not more than 4% of initial portfolio (often less, around 3.5%), together with yearly inflation adjustment.

    For variable % withdrawal, at most up to 5% of ongoing portfolio. Also with annual inflation adjustment.

    No 2 ways about it. You can slice & dice with all sorts of uncorrelated assets from all corners of the universe, but if you cannot psycho the retiree to accept certain level of risk and limit on amount of withdrawal, you are guaranteeing that the retiree will run out of cash before he dies, and asking him to sign on this contract.

    Reply

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