For retirees following a total-return-and-withdrawal strategy to fund retirement, establishing a sustainable or "safe" withdrawal rate is crucial. Standard information in the retirement-advice industry has been that a 4% withdrawal rate is safe (that is, will not run out of money for 30 years) for a 60%-40% mix of stocks and bonds.
Morningstar recently published a paper on this topic that has received surprisingly little attention considering its implications. The paper is entitled, "Low Bond Yields and Safe Withdrawal Rates," and it can be found here. The study's authors are David Blanchett (Head of Retirement Research at Morningstar Investment Management), Michael Finke (Professor and Ph.D. Coordinator at the Department of Personal Financial Planning at Texas Tech University), and Wade D. Pfau (Professor of Retirement Income at the American College). The paper is copyrighted by Morningstar. A video interview with Mr. Blanchett about the paper can be found here.
The paper's conclusions are startling. After constructing a model MPT-type portfolio and running Monte Carlo tests of return scenarios that begin with the actual low bond yields that we have today, the authors reached the following conclusions:
- Using this model, we find a significant reduction in "safe" initial withdrawal rates, with a 4% initial real withdrawal rate having approximately a 50% probability of success over a 30-year period.
- We find a retiree who wants a 90% probability of achieving a retirement income goal with a 30-year time horizon and a 40% equity portfolio would only have an initial withdrawal rate of 2.8%.
It is important to understand the main facts and presumptions behind the conclusions. First, the authors noted the current low interest rate environment, which is well below historical averages. They state that these low yields will have a significant effect on retirees, "who tend to invest heavily in bonds," because of sequence risk: Portfolio returns in the earliest years of retirement have a disproportionate impact on the overall success of a retirement funding plan. The fact that bonds' current yields are well below historical averages significantly affects the ability of a portfolio to kind of handle a 4% withdrawal for 30 or 40 years.
Second, the authors note that most research on sustainable withdrawal rates has used Monte Carlo simulations based on long-term historical average returns for each asset class in the portfolio. They note that approach may not make sense when markets are not near their long-term averages, "such as the current low bond yield market." As we all know, interest rates are at historical lows and have been for several years.
Third, to come up with a more realistic planning case, the authors constructed a model that utilizes current bond yields, allowing them to "drift" upward over time toward historical averages. They feel that this is a better model for those who are currently in or near retirement.
The paper provides an historical review of how "safe withdrawal rates" have been derived. (Note: Citations to all source materials are in the research paper itself):
For most practitioners, the methodology for generating a safe retirement income from an investment portfolio was first addressed in Bengen (1994), …which uses the probability of achieving a goal over some time period to define the optimal withdrawal amount from a portfolio. The term "initial withdrawal rate" is commonly used…to describe the initial percentage withdrawn from the portfolio. This withdrawal amount is assumed to increase thereafter by inflation. This inflation adjusted withdrawal [amount] is deducted from the portfolio balance [each year] until retirement assets are exhausted….
Bengen (1994) recommends a 4 percent initial withdrawal rate from a portfolio made up of 50 percent stocks and 50 percent intermediate-term treasuries, is sustainable for a minimum of 33 years for retirees age 60-65….Later research by Cooley, Hubbard, and Waltz (1998), often called the Trinity study, generally confirmed Bengen's findings but increased the scope to different period lengths, initial withdrawal rates and types, and asset allocations. …
Asset allocation can significantly affect a portfolio's ability to sustain a given cash flow during retirement. Research by [several papers listed] demonstrate[s] that portfolios with lower equity allocations tend to generate higher probabilities of ruin (in particular over retirement periods). These findings flow primarily from the use of historical market return averages in a Monte Carlo setting, since returns are generally assumed to be stationary and equities are assumed to have a higher return than bonds. Pfau (2011) used more forward-looking estimates when determining sustainable withdrawal rates and notes significant differences in the safety of different withdrawal rates.
In their new model, the authors used 2.5% as bonds' yield today, then allowed that yield to slowly revert back to its long-term historic average over time. They used 30-day Treasury Bills as a proxy for cash, the Ibbotson Intermediate-Term Government Bond Index as a proxy for bonds, and the S&P 500 Index as a proxy for stocks. They made a few additional adjustments that are described in the paper.
Then they conducted 10,000-run Monte Carlo analyses on different withdrawal rates from 3% to 6%. The results are dismal. The probability of success (defined as "the percentage of runs that are able to successfully achieve the target cash flow for the respective period") for a 3% initial withdrawal rate was about 60% after 40 years. The probabilities of success for higher withdrawal rates, of course, were worse:
- 4% initial withdrawal rate: 60% at about 28 years; 40% at 40 years
- 5% initial withdrawal rate: 60% at about 22 years; about 4% at 40 years
- 6% initial withdrawal rate: 60% at about 17 years; near zero at 40 years
For the more commonly used retirement period of 30 years, the probability of success for even the 4% initial withdrawal rate was just 48%, or as the authors note, "…just slightly less than a coin flip."
The authors focus on the difference between their results and past research, where that latter probability of success has tended to be above 80%. Here are their observations:
This result stems from three key differences in this study versus past studies (especially those that have used purely historical data). First, we use a model that incorporates the actual yields available to retirees today (that converges towards the long run expectation, on average). Second, we reduce the expected arithmetic return on equities by 2.0% (to 9.77%) to reflect a more realistic forecast for U.S. equities. Third, we assume a fee of 1.0% as a proxy for the asset management fees that are likely to be paid by an investor.
So what is a safe initial withdrawal amount given the assumptions in the study? There is a table in the paper showing a variety of scenarios. "Safe" can be defined by different probabilities of success, and equity allocations can be adjusted. For a common scenario - 20% equity allocation, 90% probability of success, and 30-year period - the safe initial withdrawal rate is just 2.7%. If the equity allocation is increased to 60% and the acceptable probability of success is lowered to 80% but still called "safe," that increases the initial withdrawal rate to 3.2%.
The implications are significant. The reciprocal of the initial withdrawal rate is the amount that the individual must have saved to achieve his or her income goal. (That amount would be "The Number" shown in the retirement commercials.) So if your income goal in Year 1 is $40,000, you need a nest egg of $1,000,000 using a withdrawal rate of 4%. But at an initial withdrawal rate of 3.0%, for example, your nest egg would have to be $1,333,333 to be considered "safe."
Another way to look at it is to hold the nest egg constant and determine what "income" different withdrawal rates provide. If you have a $1,000,000 nest egg, a 4% initial withdrawal rate will produce $40,000 in Year 1 of retirement. A 3% withdrawal rate will produce just $30,000. The income, obviously, is directly proportional to the withdrawal rate.
There is no mention of dividends or dividend growth investing in the study. In my experience, Morningstar is generally an MPT shop. Most of its advice about retirement funding is based on MPT asset allocations and withdrawals such as those discussed in this new study. In traditional MPT, dividend stocks are not singled out for their income-generating qualities, and they are not considered to be a separate asset class.
However, Morningstar did publish one article recently that displayed dividend stocks - well, dividend stock ETFs - as if they comprised an asset class. In "The Young Investor s Model Portfolio: Getting Started with ETFs," analyst and author Abby Woodham recommends a 10 percent allocation to dividend stocks.
We've included these dividend-focused ETFs because the rationale behind dividend investing is rigorously supported by research. From 1900 to 2010, almost 70% of the U.S. stock market's real growth came from dividends, and there's a strong correlation between high dividend payouts and future earnings growth.
This recommendation is made for individuals in their 20s. No commenters to the article at the time I accessed it focused on the dividend stock allocation, although a couple questioned why there was a 5% recommended allocation to bonds.
For me, this is the first time that I have come across an MPT-type asset allocation model that treats dividend stocks as if they are an asset class. As a dividend growth investor myself, dividend growth stocks are the only kinds of stocks I buy. But in the asset-allocation world, dividend stocks simply are not recognized as worthy of special attention.
For example, in the popular 7-Twelve investing model, the so-called old-school 65/35 basic allocation is shown here.
Under 7Twelve, that model is modernized and "utilizes multiple asset classes to enhance performance and reduce risk."
Notice that none of the stock allocations are specifically dividend stocks. Instead there are allocations to familiar stock categories that are often encountered in asset allocation schemes: large U.S. stocks, mid U.S. stocks, small U.S. stocks, emerging market stocks, and so on.
Of course, a lot of the stocks in those categories pay dividends. But the fundamental distinction - that in dividend growth investing, the dividends are the point of the investing strategy - is never mentioned.