My friend Chris from Growing your Tree of Prosperity alerted me that there is a pretty good article on a particular slant of retirement spending down strategy.
Since he is working on his materials for his upcoming talk at Investors Exchange and subsequent talks on financial independence and related topic, this would be especially relevant.
If you been reading the content on InvestmentMoats.com, you would know that this is a topic that I am interested in.
The article is titled The 5% rule to retirement planning by Eric Kong and its a premium article so its only available to subscribers.
When I heard its written by Eric Kong, who is from Aggregate Asset Management, I knew I got to read it.
While I have not met Eric, he comes across as real thoughtful in the subjects that he is interested in.
So given a topic such as retirement planning, I am sure he probably have read extensively on the subject to offer his point of view. Of course, since he is managing a fund, there is an incentive for him to be bias towards what they are doing.
Aggregate Asset Management charges zero-management fee. This is unconventional in that there is no base fee that usually sustain the cost of running the fund. Simply put, if their funds do not perform, they do not eat.
The Conventional 4% Safe Withdrawal Rate
Eric went into a discussion on Aggregate’s target audience, which is higher net worth individuals:
- Millionaires also have cost worries if they live to 100 years old, given the higher overall life expectancy due to greater quality of healthcare
- They are worried their wealth cannot sustain them due to rising healthcare cost and cost of living
- When surveyed, equities and real estate was favored by Singapore richest
- But close to 40% of the high net worth individuals in Singapore and over 52% of the same group in Asia prefer to hold cash
Eric brings up the question on their mind, how much of your wealth should you take out each year?
The 4% withdrawal rule should not come as a surprise to readers here, since we talked about it enough.
The 4% Rule is also called the constant inflation adjustment spending rule. This means you define a constant inflation rate (e.g. 2% or 3%), and you adjust your initial withdrawal $X upwards every year.
Thus the 4% is the initial withdrawal rate. If you start with this initial amount, based on the rule, your money should last you.
However there are assumptions in Bengen’s study, as well as the subsequent Trinity Study on the subject:
- 50% equities and 50% bonds
- Time duration 30 years
- Based on USA rolling data
The study is robust because USA have a long history of equity and bonds, going through many bulls and some wicked bears, high inflation period, deflationary period.
Eric believes that we can do better.
He believes we can step up that initial withdrawal rate to 5%.
1% might not seem like a lot but think about this. Suppose you estimate that your annual expense is $36,000/yr.
Based on the 4% rule, you will need $36,000/0.04 = $900,000.
If we can improve it to 5%, you will need $36,000/0.05 = $720,000.
That is like $180,000 less or 20% less!
It moves you closer to your goal.
Eric also believes that instead of this lasting only 30 years (the assumptions in Bengen’s study), doing things in a structured way can ensure your wealth last in perpetuity.
To me, this shows the level of detail they pay attention to because many in this field would just say “oh if you have build up $X due to 4% rule you are ready” without taking into consideration the study has a 30 years duration.
Suppose you are a highly functional property agent and take in $200,000/yr and your spending is just $36,000/yr, you could probably be there in 4-5 years. However, instead of 30 years you probably live for like 70 years.
Various study that I have read shown that if you extend the duration and put it through that rolling USA stock market test, the safe withdrawal rate goes down from 4% to even close to 2%.
Using the Value Approach to Wealth Withdrawal
Eric’s suggestion is to actively invest in a portfolio of value stocks. This would require active management on your part, or through delegation to someone else.
A portfolio of value stocks have a higher probability of providing above market returns.
He highlights the common implementation which is to invest through actively managed unit trust. The high fees and expenses would eat into the return, thus making it not possible to hit the 5% withdrawal rate.
While low cost exchange traded funds (ETF) have reduced the cost problems of unit trust, Eric contends that by virtue of value stocks out performing the index means you have a greater probability that your wealth will last longer and meet your expenses.
He cites an example that if you are going through a time period where your $1 mil portfolio is cut by half, because you invested before the 1984 recession, you would still be able to withdraw $4k/yr and every year increase that amount by a 2% inflation rate.
The Drag of Bonds and Cash
Eric emphasize that the reason money doesn’t last was because the returns of cash and bonds were too low.
He calls this a penalty, which is the opportunity cost that you could have earned versus putting that amount of money in the stock market.
In other words, to enjoy a long sustain withdrawal rate, your rate of return of your overall wealth needs to be adequate.
Some Thoughts on the Suggestions
1. Long Term High Returns Definitely Helps. Whether if its bonds, equity, or cash, Eric’s suggestions work because he believes that this approach generally provides higher returns. When your returns are higher in the long run, and you keep the withdrawal rate conservative, it will definitely work. For example, if your withdrawal rate is 7% but in the long run you can put your money in an arbitrary wealth machine that generates 15% rate of return, a 7% withdrawal rate is conservative.
Eric shows the progression how we can improve. By going from a less than 100% equity allocation to a higher equity allocation. Then you improve it by going to an approach that shows consistent out-performance (in this case a basket of value stocks)
2. Cash is a Drag. Cash will provide us with some psychological safe guard. However, having too much cash will also lower the overall rate of return. There is an opportunity cost to it.
In one of my article, I highlighted a research done that shows having a cash buffer does not increase how long your wealth lasts.
However, the jury is still out. Early Retirement Now have some of the best articles in this area. In part 25 of his ultimate guide to safe withdrawal rates, his testing do show that having a cash bucket to cushion the early sequence of return risk does help.
When the cash bucket is empty you do not refill it. This cash bucket thus, is really meant to tackle the adverse sequence of return risk you faced, if you get hit with something like Eric’s 1984 example.
A Few challenges to Eric’s 5% Withdrawal Strategy
1. 100% Equity Plans are Volatile. There is a reason people add cash and bonds to the portfolio, whether retired or in the wealth accumulation. The cash is non volatile, the bonds are lower in volatility. This brings down the volatility of your portfolio.
When your portfolio falling is lesser, you have a higher chance to stick to the plan.
100% equity is volatile.
The value approach have shown to give you higher expected rate of return but that doesn’t mean it is less volatile.
Warren Buffett and many value investors have 50% draw downs in their funds.
A lot of their investors stuck with them because they understand that these draw downs is part and parcel of their approach. Those that failed to understand would exit the funds. Overall the quality of fund investors improves.
Finance is not just a numbers discipline. It is proven again and again that while the returns can be 10%, the average investor’s returns is lower because of the actions they carried out due to being emotional.
Suppose we go back to the example that your portfolio gets cut in half in 1984.
The decline would have affected your psychology.
- You would withdraw less.
- You might consider going back to work.
If you do the 2 above, you are not trusting that the strategy 100% will work.
If it does work, we do not need to build in flexibility like these.
2. The Effect of a Negative Sequence of Return at the Start. I do wonder if the higher rate of return, will offset a negative sequence of return.
To recap, the sequence of your returns matters, when you are drawing down money, instead of accumulating money. This is known also as reverse dollar cost averaging.
In portfolio A, the first 10 years is punctuated with more negative return. In portfolio B, the first 10 years have more positive return.
Yet if you multiply the 20 year returns of portfolio A and B, the returns are the same. If no withdrawals, $100,000 grow to $658,148 after 20 years. This is a 658% total growth or 9.88% annualized return.
But you will run out of money using the constant inflation adjusting withdrawal rate.
In the above example is a 7% initial withdrawal rate!
The gap is almost similar to using a portfolio of 7% return and withdrawing 4%.
Suffice to say the sequence of your returns matters.
While Eric’s example shows a very crazy 50% draw down, the 30 year rolling return starting in 1982 happens to be a period where the bull run is one of the greatest.
A better example would be to test his strategy in 2 periods in USA history:
- the period starting in 1937
- the period starting in 1969
These 2 are the brutal periods.
In a previous article of mine explaining David Zolt’s Target Percentage Adjustment, Zolt presented his variable adjustment method over these 2 testing periods with an initial withdrawal rate of 6% (!!)
The dark green and red lines denote the portfolio value and annual withdrawal amount of a constant inflation adjusting 6%. By 1955, you would have ran out of money. If you start at 6% but adjust with the target percentage adjustment amount, it will last the period. However, if you see the thin red line, your withdrawal amount does not keep up with inflation.
The 1969 period is brutal as well punctuated by a crazy draw down in 1974 and some high inflation period.
Eric’s case may eventually work out.
But I wonder how high does my rate of return needs to be to necessitate 5%. 5% means confirm plus chop it will work out without all the going back to work, spend less kind of adjustment.
3. The Challenge of Performing Well i.e. Getting a High Rate of Return. Eric lays out how to achieve the better rate of return. And this would give hope to many who have less money but would hope that they can retire sooner. However, I do find it challenging to get that kind of high rate of return. To do it consistently over a long period, that is even more challenging.
There is a reason why researchers use bonds and equity index returns. This is because it removes the subjective nature of individual wealth building performance.
It presents a good working model that they can advice people to implement.
It is an easy sell to ask someone to implement a 50% equity and 50% bond allocation.
For this kind of value approach, you have to build up that competency, prove to yourself that it works, gain confidence that you are able to do it consistently.
And hope that you do not suffer cognitive decline in retirement.
There is a easy way out.
That is to find that arbitrary 10% rate of return wealth machine. Buy that and rid yourself of the work.
But its damn challenging to find one. Perhaps its easier if you are high net worth, where you have access to funds like Aggregate Asset Management.
However, if you are not high net worth, you got to really hunt high and low for such a fund.
If not you stick with lower return, or you choose to take it up and invest yourself.
Some Things to Think About
I wonder without Eric would Business Times be able to put out such a piece that challenges the retirement paradigm.
The 4% withdrawal rule is mentioned more but in local context still not prevalent.
If we start hearing this from our advisers, then perhaps its getting more prevalent.
This piece is inline with a lot of the research out there.
Here are some parting advice to augment the piece:
1. Find a reliable fund that generates high return. I think I laid out that high returns helps in preserving the wealth, but its difficult to do it by ourselves over time. You need to delegate this job. The difficulty is that you will only know something is good when you look back. Past performance does not mean the future will measure up.
2. Would Forex Trading Bots and Quantitative ETFs be the future. In recent months, I been hearing more and more about trading bots that helps you to trade based on some methodology. Since forex trading is high return, you can see why it will appeal to people if you can create trading systems for this.
This would be an area with many fraudsters and con artist if it takes off. That does not mean that there won’t be good ones.
Another area that could breach the gap of having above market returns, and low effort are those exchange traded funds based on some fundamental factors. I can see the appeal of putting all my money in 3 to 4 ETF and just selling units annually to fund my retirement.
My concern here is that whether it is trading bots or quantitative ETF, if too many people are doing it, it will become ineffective.
There might be some alpha to certain factors, but if it becomes popular, and wide scale, would the factor be reduced? Some of the research from Alpha Architects seems to show that this is happening.
3. Accept there is flaw in that plan, incorporate contingency processes into the plan. Unless you have adequate buffer wealth, you got to accept that there are periods where performance fall short.
It is more realistic to consider whether you can find compensation in some of the work that you do in retirement or to withdraw less if you do not have a need to.
4. Avoid volatility at the start of the period you need to withdraw from your portfolio. If you can avoid the periods where sequence of return is negative, you preserve more of your wealth, your wealth last longer.
Focus on the purpose and if the purpose is for semi retirement or full retirement, structure your wealth accordingly for that purpose.
Do note that if you anticipate a negative sequence, but in reality, the market went
5. Lower the Withdrawal Rate, if you are more Conservative. If you really do not like to work then extend your working career to build up more money. It would be better if you don’t hate your job more. If you need $36,000/yr and you wish to be conservative at 3%, then you will need $1.2 mil.
To have so much you need to lengthen your career. If you are more risk seeking, you can work with less than $1.2 mil. However, you might need to go back to work. The math is like that. You cannot run away from it.
Sunday 17th of June 2018
Hmmm, I used the Portfolio Backtesting excel from Boggleheads to try try...
Put 1/3 each into US Large Value, US Mid Value & US Small Value. For these 3 asset classes, they have annual returns data from 1927.
Safe withdrawal rate over 30-year cycles: 5.86% "Perpetual" withdrawal rate: 5.22%
I tried putting 100% into EAFE Value (annual returns data only from 1970). But the returns not so good. Hence safe withdrawal rate over 30-yr cycles is 4.86% "Perpetual" withdrawal rate is only 3.59%
So to replicate, can just use ETFs for US Value stocks. Simplest is just 1 ETF. Else can use 2 or 3 to increase the mid- & small-cap value stocks, which will also increase the volatility & returns of the portfolio.
To avoid the negative sequence of returns risk, some conservative US financial planners will advocate building up 8 years' worth of living expenses in cash & short-term T-bills prior to retirement. Retirees to draw down from this cash pile 1st, before touching their main portfolio.
Why 8 years? Coz that's the time taken for 100% stocks portfolio to get back to breakeven if invested right before the Great Depression in Oct 1929 (with dividends re-invested).
Of course it's a kiasu thing. If 8 years cash pile is too much, or if you're not that pessimistic / more flexible, then maybe 5 yrs or 3 yrs cash pile is enough.
Sunday 17th of June 2018
Thanks for the research. Thanks for doing it with the EAFE. It seems that doing a pure equity ETF really increases the withdrawal rate. That gives hope. However, keeping 8 years worth of living expenses is....
Sunday 17th of June 2018
I had read the book "Lifecycle Investing" by Ian Ayres as recommended by Chris of Prosperity Tree. Incidentally they mentioned that it is safer to have a 200% portfolio cash allocation to equities (either via options on indices or less preferably margin). And this outperformed the 50/50 approach in terms of return and reduced risk.
They ran their theory through a period of different times (60 years) and even through randomised returns and noted that there is reduced risk and higher returns using a leveraged approach.
What are your views on this ?
Sunday 17th of June 2018
Hi Alan, I did not read that book, but what is the 200% portfolio? is it a 66% debt to asset portfolio?