Safe Withdrawal Rate Risks
and the Implications for Asset Allocation
By Adam Butler, Mike Philbrick, Rodrigo Gordillo and Michael Guan
March 13, 2013
Retirees face longevity risk, or the risk of living longer (or less long) than expected; market risk, or the risk of poor investment returns over the retirement horizon, and finally; failure risk, or the risk of running out of money before death. The authors examine the sensitivity of these three risks to asset allocation and Safe Withdrawal Rates, and offer a model to optimize these factors in order to minimize the three primary risks in the context of personal preferences. Finally, a forecast model is proposed to link Safe Withdrawal Rates to contemporaneous stock market valuations and interest rates, with strong statistical significance.
Note from dshort: The chart below is the first illustration of several from the complete article. Below the chart, I've included the final section of the article.
The complete article is available from the SSRN website here.
Summary and Thoughts
There is a great deal of contention about how to calculate safe withdrawal rates for the tsunami of retiring Boomers that will hit developed economies over the next 15 to 20 years. Many high quality studies have been conducted using Monte Carlo analysis, others through more sophisticated empirical methods, and still more through a purely analytical lens. The most comprehensive studies attempt to model the cointegration between interest rates, stock market returns and inflation, and it was our ambition to add more colour to this particular area of study.
We investigated the three primary sources of risk in retirement, and described a framework for quantifying these risks in a way that allows retirees to take control of their own risk/reward equation. Retirees face longevity risk, which is the risk of living longer (or less long) than expected; failure risk, or the risk of running out of money before death, and; market risk, which is the risk of poor investment returns over the retirement horizon.
We demonstrated how these risks are sensitive to the asset allocation between stocks and bonds, and proposed a model to quantify the optimal allocation given specified withdrawal rates and tolerance for failure. We also offered a model linking retirement age with longevity risk tolerance and tolerance for failure given specified asset allocations and withdrawal rates.
Unfortunately, most retirement planning is conducted under the potentially dangerous assumption of long-term average returns. Such assumptions manifest in amplified risk of plan failure as markets and interest rates often deviate from long-term average valuations for extended periods of time.
We examined the relationship between ex ante safe withdrawal rates, and contemporaneous stock market valuations and long-term interest rates. A model was then proposed to estimate a statistically significant range of safe withdrawal rates given stock market valuations and interest rates at the month of plan inception, and it was determined that the model explained over 70% of changes to safe withdrawal rates over the 112 year study.
Investors that look to the above models for guidance must take account of the fact that fees and taxes may substantially reduce SWRs under all assumptions. As such, investors should speak to a qualified Advisor or planner who is well versed in actuarial retirement planning to see how the topics covered above affect their own personal situation. Further, given the sensitivity of safe withdrawal rates to initial valuation conditions, we are of the strong opinion that as markets approach high levels of valuation (e.g. high CAPE, low interest rates), investors would benefit from exploring alternative sources of return to complement, or perhaps even replace traditional investment approaches.
Finally, given that SWRs are especially vulnerable to periods of large or extended portfolio drawdowns, and that these types of drawdowns are much more likely to occur during periods of high market valuations. For these reasons investors might consider allocating to 'tactical alpha' strategies, which have historically managed to deliver stable returns across market regimes. Examples of this type of approach include dynamic absolute valuation approaches (Butler, Philbrick, Gordillo, 2012), trend following (AQR, 2012), tactical asset allocation (Faber, 2009), robust risk parity, factor risk parity (AQR, 2012), generalized momentum (Keller, 2012), or adaptive asset allocation (Butler, Philbrick, Gordillo, 2012).
Note: Here are some additional Advisor Perspectives articles by the Butler-Philbrick team:
- The Full Montier: Absolute vs. Relative Value
- Don't Take Our Word For It
- Tactical Alpha: The Case for Active Asset Allocation
- Equity Portfolio Optimization with Factor Tilts
- Permanent Portfolio Shakedown Part 1
- Permanent Portfolio Shakedown Part 2
- The Permanent Portfolio Turns Japanese
- Estimating Future Returns: New Update
- Retirement's Volatility Bogeyman
- 2277 Stocks and Still Not Diversified?
- How to Beat the Market, and Why Most Investors Don't
- Volatility Management for Better Absolute and Risk-Adjusted Performance
- Diversification: Still the Only Free Lunch
- Adaptive Asset Allocation: A True Revolution in Portfolio Management
- Adaptive Risk Parity for a Better 'Balanced Fund'
- Risk Parity: Past Its Prime
- Track Records are Rubbish (or Why Managers are Factors in Drag)
- Predicting Markets, or Marketing Predictions
- Balanced Portfolios: Keeping it Real
Adam Butler and Mike Philbrick are Portfolio Managers with Butler|Philbrick|Gordillo & Associates at Macquarie Private Wealth in Toronto, Canada.
(c) Butler|Philbrick|Gordillo & Associates, 2011