Friday, July 11, 2008

"Determining Withdrawal Rates Using Historical Data" - My Opinion

I recently stumbled upon this article from William P. Bengen DETERMINING WITHDRAWAL RATES USING HISTORICAL DATA”. The basic idea behind this research is that year over year fluctuations in annual returns could drastically change the standard of living of retired individuals, who rely on their investments for income. That’s why “safe” withdrawal rates need to be determined and a proper asset allocation needs to be applied. William Bengen does look into a very basic allocation of stocks and bonds, and then adjusts those target allocations annually.

He builds on the idea that market cataclysms like the 1929-1932 and 1972-1974 bear markets could have long-term effects on ones portfolio which can overwhelm the average returns for stocks and bonds, that have been commonly advertised. William Bengen then tries to calculate the longevity of portfolios using a variety of target allocations between stocks and bonds, assuming that he had clients retiring each year from 1926 to 1976. He uses several initial withdrawal percentages in order to determine the safe withdrawal rate.

In the end his research showed that having 25%-50% allocation to bonds actually increases portfolio longevity at safe withdrawal rates of 3%-4% annually, adjusted for inflation. An investor, who was 100%, invested in stocks, who planned on withdrawing 4% from the initial balance and then adjusts for inflation, and who retired in 1929 would have been able to enjoy his retirement for only 24 years.

One thing that I would like to see from William Bengen is a possible dividend strategy where retirees will be withdrawing only dividend income. Even if our investor used only dividends as a source of income, the Great Depression would have presented them with a major challenge, when the dividend payments on the S&P 500 fell by 55% from 1929 to 1932. (This back tested data for the index, which could be accessed from here). Deflation was the only “positive” thing at the time. Price decreased by 25% on average during the great depression, which decreased the actual purchasing power income of our dividend retiree by only 30%.

This paper got me thinking that having an allocation in bonds in retirement will actually smooth fluctuations in annual returns and decrease overall risk, while enhancing portfolio longevity. What I am basically thinking about is that I would keep 100% invested in stocks while I am still working, in order to take full advantage of the stock price and dividends appreciation. When my actual retirement date is 10 years and less away I would start contributing bond investments to my portfolio.

This article originally appeared on The Div-Net one week ago.

What is your opinion on this article?

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