The Spending Question

J. Andrew Concannon

J. Andrew
Concannon, CFA

Chief Investment Officer

4-1-18 -

"A realistic withdrawal rate paired with a properly managed portfolio can make a big difference to your financial wellbeing."

How much can I spend each year without depleting my portfolio? It’s a question we hear often from clients. While the question is simple, calculating the answer is not.

One conservative answer is to spend only the income your investment portfolio generates. Unfortunately, making this strategy work in today’s low-yield environment requires a very large portfolio relative to your annual spending. In fact, your portfolio needs to be over 43 times the size of your annual spending. That number is based upon the current 2.3% average yield for a portfolio balanced between stocks and high- quality bonds.1 Such a large multiple of annual spending is well beyond the size of most portfolios.

For most individuals and institutions, meeting annual spending needs requires withdrawing some combination of their portfolio’s income, appreciation, and principal. Many people approach this by withdrawing a predetermined percentage of their portfolio’s value. This sounds like a simple solution, right? Now all you need to do is determine a sustainable withdrawal rate. And that is where things get complicated.

Three factors determine whether your portfolio will be able to sustain your chosen withdrawal rate: inflation, the level of investment returns, and the variability of investment returns. A closer look at these factors will highlight the importance of having both a realistic withdrawal rate and a properly managed investment portfolio to avoid prematurely depleting your assets.

Inflation requires that your withdrawals grow over time to meet your expenses. For example, if you withdraw $50,000 in year one, inflation of 2.5% will raise your year-two withdrawal to $51,250, your year-three withdrawal to $52,531, and so on. If your portfolio’s investments do not provide an adequate return to cover both the current year’s withdrawal and inflation, its value will shrink at an ever-increasing rate.

Higher investment returns are generally better than lower returns when trying to sustain your portfolio. But higher returns typically come paired with higher return variability— often referred to as volatility. When you are withdrawing money from a portfolio, high return variability can be a negative as I will discuss below. On the other hand, a portfolio invested too conservatively will have little chance of providing the returns needed to meet your needs. Therefore, you should strive to structure your portfolio to provide an adequate return relative to your withdrawal rate, while avoiding excessive return variability.

When taking withdrawals from a portfolio, return variability can have a large effect on its value. For example, imagine two portfolios, A and B, each with starting values of $100,000. You withdraw $5,000 annually from each portfolio for three years. Both portfolios have the same three-year time-weighted average annual return of 5.2%, but the annual returns come in a different order. Portfolio A produces returns of +15% in year 1, +15% in year 2, and -12% in year 3. For Portfolio B, we reverse the order of the annual returns to -12%, +15%, and +15%. At the end of three years, Portfolio A’s value is $101,920, while Portfolio B’s value is just $99,018. Return variability, combined with withdrawals, caused the difference.

The process of applying these three factors- inflation, return levels, and return variability- to projecting the sustainability of a given withdrawal rate is complex. For that reason, we turn to a computer software tool known as Monte Carlo analysis. The software runs thousands of simulations based upon historic returns and correlations for stocks, bonds, and other investments while also accounting for the withdrawal rate entered. The software then calculates the probability of whether the portfolio will grow, shrink, or be completely depleted.

Table 1 shows the odds of depleting a $1 million portfolio within 25 years based upon various initial withdrawal rates and annual rates of return. Success means that at the end of 25 years the portfolio is worth at least one dollar. As you can see, withdrawal rates of 3% to 4% typically work out fine, while withdrawal rates of 7% or more greatly increase the odds of depleting the portfolio. The table further shows that a low return, most likely caused by investing too conservatively, also greatly increases the odds of depletion.

Note too that the odds of depleting a portfolio with a 7% return and a 7% withdraw rate are much higher than with a 5% return and 5% withdraw rate. The reason for this is return variability. As you increase the allocation to riskier assets in order to earn a higher return, you also increase the amount of return variability.

You might be thinking that cutting your portfolio down to one dollar remaining is a little too close for comfort. For that reason, we also calculated the odds that a portfolio would not fall below one-half of its initial value. Those odds are shown in Table 2. It should come as no surprise that this reduces the combinations of withdrawal rates and returns that are successful.

While there are never guarantees when predicting the future, having a plan based on a realistic withdrawal rate and a properly managed portfolio can make a big difference to your financial well-being. If you would like a customized projection based on upon your spending needs and portfolio, please contact your personal Goelzer advisor.

1Based on the March 29, 2018 yield for a 50/50 blend of the S&P 500 Index’s trailing 12-months dividend yield and the Bloomberg Barclays Intermediate Government/Credit Index’s yield to worst.

2 All calculations are from Zephyr Allocation Advisor’s Monte Carlo program based upon historical return and volatility data for U.S. equities, foreign equities, U.S. bonds, and liquid alternative assets using the following benchmarks and beginning dates: S&P 500® Index, Q4 1989; S&P 400® Mid Cap Index, Q3 1991; S&P 600® Small Cap Index, Q1 1995; MSCI EAFE Index, Q1 1970; USBIG Government/Credit 1-5 Year Index, Q1 1980; Goelzer Non-Traditional Assets Model Portfolio Q1 2009; and custom 3-month T-bill projections of 2.8%. The ending date for all benchmarks is 12/31/17. The Zephyr software calculates the asset allocations required to meet the stated annual rates of return and runs simulations based upon those asset allocations.

The information provided in this material should not be considered as a recommendation to buy, sell or hold any particular security. This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without notice. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. The information is not intended to provide and should not be relied on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.