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All Withdrawal Strategies are Risky

One of the central topics in the personal finance community is withdrawal strategies, that is, how should a retiree convert assets into income. It's a very important topic as the ability to use one's portfolio to pay for spending needs is likely the preeminent reason that investors spent many years accumulating the assets in the portfolio.

Until about 30 years ago, many very intelligent people thought that since U.S. stocks had returned about 7% annually, after inflation (i.e., '7% real'), that retirees could safely withdraw 7% of their portfolio each year without much concern about depleting their funds. But all this changed in 1994 when Bill Bengen discovered that if retirees withdrew a fixed dollar amount, adjusted for inflation, from a portfolio comprised of U.S. stocks and bonds, they could have only withdrawn about 4% of their portfolio in the first year and not run out of money in fewer than 30 years.

It should be kept in mind that virtually no one would even consider determining how much they would withdraw from their portfolio in inflation-adjusted dollars every year without any regard for the performance of their portfolio, and for very good reason. Portfolio performance has a tremendous impact on how much can be safely withdrawn from the portfolio, and there is nearly always substantial uncertainty in how a portfolio will perform going forward.

Nonetheless, Bengen's work, which has been reexamined countless times by others, is still quite helpful as the safe withdrawal rates (SWRs) that he studied represent a good, though imperfect, measure of how much income a portfolio could have generated over a given historic period. Withdrawing less when a portfolio is suffering and more when it is flourishing, while decreasing the likelihood of prematurely depleting the portfolio, does not substantially increase the total amount that can be safely withdrawn from the portfolio. And such flexible withdrawals necessitate that retirees have some degree of flexibility in their spending. If the amount withdrawn is strictly a percentage of the portfolio's balance on an recurring basis, then the withdrawals will be as volatile as the portfolio itself.

Inspiration Point, Grand Teton National Park

For instance, let's consider the performance of two withdrawal strategies starting in the year 2000 with a portfolio of 60% U.S. stocks and 40% U.S. bonds. Had 4% of the portfolio's balance at the end of each year been withdrawn (i.e., a fixed percentage of the portfolio), the amount withdrawn at the end of 2003 would have decreased to only 3.18% of the portfolio's starting balance (e.g., $31,800 from a starting portfolio of $1 million). In fact, such an approach would have resulted in the amount withdrawn from the portfolio being less than the amount withdrawn using a 4% SWR approach in every subsequent year except the three years of 2019-2021!

Due to the interplay between both returns risk and sequence of returns risk, purely flexible withdrawal methods simply move the impact of these risks from premature portfolio depletion to withdrawals that are insufficient to cover one's spending needs.

There are certainly ways that retirees can reduce the impact of returns risk and sequence of returns risk (e.g., lower withdrawal rate, larger starting portfolio, portfolio construction, dynamic withdrawal strategies, delaying Social Security benefits), but these and other risks are always present. And of key importance is the reality that reducing exposure to one risk very often increases one's exposure to another risk. In this context, reducing the risk of premature portfolio depletion may increase the risk of inadequate portfolio withdrawals. Accumulating a larger portfolio to reduce both these risks increases the 'risk' of working significantly longer than needed. And on it goes.

The bottom line is that we live in a world that is literally filled with uncertainty. But Christians know that God is still in control, and, one way or the other, He will take care of His people.

"Therefore humble yourselves under the mighty hand of God, so that He may exalt you at the proper time, having cast all your anxiety on Him, because He cares about you."

1 Peter 5:6-7

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