By Lorimer Wilson ——Bio and Archives--August 30, 2011
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The 4% rule starts with a 4% withdrawal in Year 1 and then adds 3% each year to the withdrawal amount to keep up with inflation. It turned out that the growth in the Mr. and Mrs. Growth Retiree’s retirement assets just could not keep up with the compounding effect of that 3% per year inflation increment. The Growth Retiree’s financial advisor had set them up with a conservative asset allocation to match their conservative risk profile whereby the return on their portfolio exactly matched the rate of inflation at 3% per year, and it just wasn’t enough.
The Growth Retiree’s advisor recommended an asset allocation and a withdrawal strategy to meet their goals. The advisor adjusted their asset allocations according to his understanding of Modern Portfolio Theory…believing that the best path to follow was a total return strategy.
Mr. and Mrs. Growth Retiree seemingly had already done the hard part by accumulating the $1,000,000. In a total return strategy, a withdrawal plan is mandatory. That is because the portfolio is not constructed to generate all the income needed. Rather, it is designed to have parts of the nest egg be sold off each year to obtain the cash needed for living expenses. The most common guideline is the 4% rule as described above, with 3% withdrawal increments each year to cover inflation.
Assumptions
In this article I am going… to revisit the situation and run other trials using different assumptions.
Other assumptions remain the same:
Discussion:
I lied. Running the return sequence forward and backward is not just for fun. It is, in fact, a main point of this article. I want to demonstrate the surprising impact that the sequence of returns has on the entire 30-year strategy…
Here’s the return series. The table below shows:
Year | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 |
Year# | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
Actual | -9% | -12 | -22 | 29 | 11 | 5 | 16 | 6 | -37 | 27 |
A | -6% | -8 | -15 | 19 | 7 | 3 | 11 | 4 | -25 | 18 |
B | -4% | -7 | -17 | 34 | 16 | 10 | 16 | 11 | -32 | 32 |
This will give us four shots at a successful 30-year retirement for the Growths: 1A, 2A, 1B, and 2B. Do you think any of them will work? Here are the trials:
Run 1A: Sequence Run Forward and Volatility Dampened to 2/3 of S&P 500’s Volatility
First Decade:
Year Number | BeginningBalance $ | Amount Withdrawn $ | Amount Remaining $ | Annual Return % | End Balance $ |
1 | 1,000,000 | 40,000 | 960,000 | -6 | 902,400 |
2 | 902,400 | 41,200 | 861,200 | -8 | 792,304 |
3 | 792,304 | 42,436 | 749,868 | -15 | 637,388 |
4 | 637,388 | 43,709 | 593,679 | 19 | 706,478 |
5 | 706,478 | 45,020 | 661,458 | 7 | 707,760 |
6 | 707.760 | 46,371 | 661,389 | 3 | 681,230 |
7 | 681,230 | 47,762 | 633,468 | 11 | 703,150 |
8 | 703,150 | 49,195 | 653,955 | 4 | 680,113 |
9 | 680,113 | 50,671 | 629,442 | -25 | 472,082 |
10 | 472,082 | 52,191 | 419,891 | 18 | 495,471 |
Second Decade:
11 | 495,471 | 53,757 | 441,714 | -6 | 415,211 |
12 | 415,211 | 55,370 | 359,841 | -8 | 331,054 |
13 | 331,054 | 57,031 | 274,023 | -15 | 232,919 |
14 | 232,919 | 58,742 | 174,177 | 19 | 207,271 |
15 | 207,271 | 60,504 | 146,767 | 7 | 157,041 |
16 | 157,041 | 62,319 | 94,722 | 3 | 97,563 |
17 | 97,563 | 64,189 | 33,374 | 11 | 37,045 |
18 | 37,045 | 66,115 | (29,609) | 0 | 0 |
19 | 0 | 0 | 0 | 0 | 0 |
20 | 0 | 0 | 0 | 0 | 0 |
Third Decade:
There is no third decade. The Growth Retirees ran out of money in Year 18 of their planned 30-year retirement.
Run 2A: Sequence Run Backward and Volatility Dampened to 2/3 of S&P 500’s Volatility
First Decade:
Year Number | BeginningBalance $ | Amount Withdrawn $ | Amount Remaining $ | Annual Return % | End Balance $ |
1 | 1,000,000 | 40,000 | 960,000 | 18 | 1,132,800 |
2 | 1,132,800 | 41,200 | 1,091,600 | -25 | 818,700 |
3 | 818,700 | 42,436 | 776,254 | 4 | 807,315 |
4 | 807,315 | 43,709 | 763,606 | 11 | 847,602 |
5 | 847,602 | 45,020 | 802,582 | 3 | 826,660 |
6 | 826,660 | 46,371 | 780289 | 7 | 834,909 |
7 | 834,909 | 47,762 | 787,147 | 19 | 936,705 |
8 | 936,705 | 49,195 | 887,510 | -15 | 754,383 |
9 | 754,383 | 50,671 | 703,712 | -8 | 647,415 |
10 | 647,415 | 52,191 | 595,224 | -6 | 559,511 |
Second Decade:
11 | 559,511 | 53,757 | 505,754 | 18 | 596,790 |
12 | 596,790 | 55,370 | 540949 | -25 | 405,711 |
13 | 405,711 | 57,031 | 348,680 | 4 | 362,628 |
14 | 362,628 | 58,742 | 303,886 | 11 | 337,313 |
15 | 337,313 | 60,504 | 276,809 | 3 | 285,113 |
16 | 285,113 | 62,319 | 222,794 | 7 | 238,390 |
17 | 238,390 | 64,189 | 174,201 | 19 | 207,299 |
18 | 207,299 | 66,115 | 141,184 | -15 | 120,006 |
19 | 120,006 | 68,098 | 51,908 | -8 | 47,755 |
20 | 47,755 | 70,141 | (22,386) | 0 | 0 |
Third Decade:
Once again, there is no third decade. The Growth Retirees ran out of money in Year 20 of their planned 30-year retirement. The resequencing of returns did get them an extra two years.
Run 2A: Sequence Run Forward and Returns 5% Better than S&P 500 Every Year
First Decade:
Year Number | BeginningBalance $ | Amount Withdrawn $ | Amount Remaining $ | Annual Return % | End Balance $ |
1 | 1,000,000 | 40,000 | 960,000 | -4 | 921,600 |
2 | 921,600 | 41,200 | 880,400 | -7 | 818,772 |
3 | 818,772 | 42,436 | 776,336 | -17 | 644,359 |
4 | 644,359 | 43,709 | 600,650 | 34 | 804,871 |
5 | 804,871 | 45,020 | 759,851 | 16 | 881,427 |
6 | 881,427 | 46,371 | 835,056 | 10 | 918,562 |
7 | 918,562 | 47,762 | 870,800 | 16 | 1,010,127 |
8 | 1,010,127 | 49,195 | 960,932 | 11 | 1,066,635 |
9 | 1,066,635 | 50,671 | 1,015,964 | -32 | 690,856 |
10 | 690,857 | 52,191 | 638,665 | 32 | 843,037 |
Second Decade:
11 | 843,037 | 53,757 | 789,280 | -4 | 757,709 |
12 | 757,709 | 55,370 | 702,339 | -7 | 653,175 |
13 | 653,175 | 57,031 | 596,144 | -17 | 494,800 |
14 | 494,800 | 58,742 | 436,058 | 34 | 584,317 |
15 | 584,317 | 60,504 | 523,813 | 16 | 607,623 |
16 | 607,623 | 62,319 | 545,303 | 10 | 599,835 |
17 | 599,835 | 64,189 | 535,646 | 16 | 621,349 |
18 | 621,349 | 66,115 | 555,234 | 11 | 616,310 |
19 | 616,310 | 68,098 | 548,212 | -32 | 372,784 |
20 | 372,784 | 70,141 | 302,643 | 32 | 399,489 |
Third Decade:
21 | 399,489 | 72,245 | 327,244 | -4 | 314,154 |
22 | 314,154 | 74,413 | 239,741 | -7 | 222,959 |
23 | 222,959 | 76,645 | 146,314 | -17 | 121,441 |
24 | 121,441 | 78,944 | 42,497 | 34 | 56,946 |
25 | 56,946 | 81,312 | (24,366) | 0 | 0 |
26 | 0 | 0 | 0 | 0 | 0 |
27 | 0 | 0 | 0 | 0 | 0 |
28 | 0 | 0 | 0 | 0 | 0 |
29 | 0 | 0 | 0 | 0 | 0 |
30 | 0 | 0 | 0 | 0 | 0 |
Once again, this withdrawal scheme fails, this time in Year 25.
Run 2B: Sequence Run Backward and Annual Returns 5% Better than S&P 500
First Decade:
Year Number | BeginningBalance $ | Amount Withdrawn $ | Amount Remaining $ | Annual Return % | End Balance $ |
1 | 1,000,000 | 40,000 | 960,000 | 32 | 1,267,200 |
2 | 1,267,200 | 41,200 | 1,226,000 | -32 | 833,680 |
3 | 833,680 | 42,436 | 791,244 | 11 | 878,281 |
4 | 878,281 | 43,709 | 834,572 | 16 | 968,103 |
5 | 968,103 | 45,020 | 923,083 | 10 | 1,015,392 |
6 | 1,015,392 | 46,371 | 969,021 | 16 | 1,124,064 |
7 | 1,124,064 | 47,762 | 1,076,302 | 34 | 1,442,244 |
8 | 1,442,244 | 49,195 | 1,393.049 | -17 | 1,156,231 |
9 | 1,156,231 | 50,671 | 1,105,560 | -7 | 1,028,171 |
10 | 1,028,171 | 52,191 | 975,980 | -4 | 936,941 |
Second Decade:
11 | 936,941 | 53,757 | 883,184 | 32 | 1,165,802 |
12 | 1,165,802 | 55,370 | 1,110,432 | -32 | 755,094 |
13 | 755,094 | 57,031 | 698,063 | 11 | 774,850 |
14 | 774,850 | 58,742 | 716,108 | 16 | 830,685 |
15 | 830,685 | 60,504 | 770,181 | 10 | 847,199 |
16 | 847,199 | 62,319 | 784,880 | 16 | 910,461 |
17 | 910,461 | 64,189 | 846,272 | 34 | 1,134,005 |
18 | 1,134,005 | 66,115 | 1,067,890 | -17 | 886,349 |
19 | 886,349 | 68,098 | 818,251 | -7 | 760,973 |
20 | 760,973 | 70,141 | 690,832 | -4 | 663,199 |
Third Decade:
21 | 663,199 | 72,245 | 590,954 | 32 | 780,059 |
22 | 780,059 | 74,413 | 705,646 | -32 | 479,839 |
23 | 479,839 | 76,645 | 403,194 | 11 | 447,546 |
24 | 447,546 | 78,944 | 368,602 | 16 | 427,578 |
25 | 427,578 | 81,312 | 346,266 | 10 | 380,893 |
26 | 380,893 | 83,751 | 297,142 | 16 | 344,684 |
27 | 344,684 | 86,264 | 258,420 | 34 | 346,283 |
28 | 346,283 | 88,852 | 257,431 | -17 | 213,668 |
29 | 213,668 | 91,517 | 122,151 | -7 | 113,600 |
30 | 113,600 | 94,264 | 19,336 | -4 | 18,563 |
Finally, a Total Return plan that squeaks through, barely. If taxes were counted, this would have failed too. It will fail in Year 31.
More Discussion:
As with the previous article, I had no preconceived notions of how any trial would end up. I simply wanted to illustrate the importance of return sequencing on total returns. I was aware that using 2000-2009 as a starting decade would provide a severe stress test on the 4% strategy. That’s what a stress test should do.
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[While] sequencing by itself [does not] make a difference in compounded returns…sequencing [is] important when you are making withdrawals because the withdrawals go relentlessly up (the result of the 3% annual increment), and sometimes an increased withdrawal coincides with a particularly bad annual return year. The combination can be lethal. In each run, the backwards sequence did better than the forward sequence. That’s because the smallest withdrawals coincide with the best returns in each decade when you run the sequence backward.
Here are some other takeaways:
Conclusion
For me personally, this is my takeaway:
How this method has gained dominance in the retirement industry is a mystery to me. The risks of failure, and fear of failure, are just so great.
Links to Related Articles by Van Knapp as Posted at Seeking Alpha:
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