Recently I conducted a study of the safe amount a retiree can withdraw from their portfolio each year without running out of money and also leaving at least half of the initial portfolio value to their heirs (after inflation). My goal is to publish this analysis in one of the financial planning research journals, but here’s your sneak peek into some of the key findings.
Financial planners, including me and my colleagues at Abacus, generally prescribe a healthy dose of bonds in a retirement portfolio to accompany the stock allocation. Although we believe that equities (stocks and real estate) are the key to keeping pace with the rising cost of living and preserving one’s quality of living, we protect portfolio withdrawals in the short- and medium-term from drops in equities by using high quality bonds, because history and logic tell us that they don’t drop as significantly as equities, even though the drops of equities have historically always been temporary. The financial planning profession may well have been getting this wrong for decades. My study finds that based on the history of the S&P 500 since the end of World War II (the “post-industrial” era that began nearly 72 years ago), retirement portfolios have been designed more conservatively (meaning, with more bonds) than they needed to be.
The “worst time to retire” is right before a market crash. Crashes that occur mid-way through a retirement have not posed as much of a challenge for the retiree if there was no crash in the beginning, because if a well-designed retirement portfolio has several years to accumulate without an initial crash then it will have built up a sufficient surplus to absorb the eventual and inevitable crashes. To a large extent, we use bonds in a retirement portfolio to manage exactly that specific risk: that a crash happens shortly after retirement begins. Having bonds available to sell to generate retirement cash flow during a stock market drop could give equities time to recover; in other words, without a sufficient allocation to bonds, equities might need to be sold during a stock market crash to generate retirement cash flow, potentially creating a downward spiral in the value of the portfolio. For this reason, I expected to find in this study that a reasonably balanced mix of 60% stocks and 40% bonds should have allowed for higher withdraws during a retirement that started at these worst times, than a portfolio invested 100% in stocks.
I focused on what would have happened to a 35-year retirement that started just before the 14 bear markets (defined as a 20% drop or more in the S&P 500[1]) since WWII, as illustrated in the exhibit above. The result surprised me: In every one of the 14 bear markets, the portfolio invested 100% in the S&P 500 allowed a higher withdrawal over the 35-year retirement (subject to our criteria of having half of the initial portfolio value, increased with inflation, available at the end of retirement). The average maximum initial withdrawal rate possible for the 14 retirements starting at the worst times invested 100% in the S&P 500 was 4.4% (plus an additional assumed 1% that is withdrawn for fees, for a total of 5.4% withdrawn when fees are included). This means that the initial annual withdrawal for living expenses from a $1 million portfolio would have been $44,000; this withdrawal amount is adjusted for inflation each month thereafter. This (4.4%) is generally considered by planners to be a good withdrawal rate. The average maximum initial withdrawal rate for the 60/40 portfolio over the same 14 difficult retirement periods was 3.5%, somewhat lower (but still in the acceptable range for many financial planners). It is important to note (since many of your portfolios are likely closer to 60/40 than 100% equities) that if one includes the other 775 starting months (in addition to the 14 most difficult) since WWII then the 60/40 portfolio would have allowed a 4.2% withdrawal rate on average.
The single worst time to retire since WWII was at the top of dot.com bubble[2], because on an inflation-adjusted basis, the bottom was not reached until March of 2009, when the Financial Crisis reached its bottom (in other words, the period 2000-2009 can be thought of as one long bear market). The most a retiree can withdraw in a 35-year retirement starting in 2000 is 2.4% (initially, and then adjusted for inflation) for the S&P portfolio and 2.1% for the 60/40 portfolio.
What do we conclude from this? It should be clear that stocks have been a great investment for retirement portfolios. However, I would not interpret this study as saying one should not hold bonds in a retirement portfolio. In fact, when I studied the same 35-year retirement starting the day before the 1929 stock market crash associated with the Great Depression, I was finally able to find a period where a balanced mix of stocks and bonds allowed a higher withdrawal than 100% stocks (2.3% for 100% stocks, 2.7% for the 60/40 portfolio). And we have no guarantee that there will not be an even worse crash than 1929 in our lifetimes. Your Abacus advisor can and will help you decide what level of risk (of a historically rare, severe market crash early in retirement) you should manage against by using bonds, weighed against the increased lifestyle and inheritance that increased stock allocations have afforded (in the vast majority of historical retirement periods). If clients stay committed to their retirement allocation (which likely will prove to have more bonds than will be needed) but use this study — and its message of the resilience of the stock market — to remain patient and disciplined, if not to find some level of comfort and peace during the next inevitable stock market crash, then the study will have been a success.
[1] The S&P 500 price only dropped by 19.3 to 19.4% in three of the bear markets, but they each led to a climate of investor anxiety of the type associated with a bear market.
[2] Some readers will notice that a 35-year retirement starting with the October, 1987 bear market (“Black Monday”) and later, will require some assumption for futures returns beyond the date of this study, namely May, 2017. I assumed a repeat of the historical cycle of a 30% bear market drop in the S&P 500 every five years, starting with the first future crash happening immediately in the future (June, 2017). I assume the compounded annual return in the future for the S&P 500 is 9% from peak to peak of each bear market cycle (which is a bit below its historical average).
Disclosure: Abacus Wealth Partners, LLC (Abacus) is an SEC registered investment adviser with its principal place of business in the State of California. Abacus may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. This brochure is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Abacus with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Abacus, please contact us or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).
This is not an offer to sell any type of security, and there is no investment currently available through Abacus. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell this security. This newsletter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Information was based on sources we deem to be reliable, but we make no representations as to its accuracy. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.
For additional information about Abacus, including fees and services, send for our disclosure brochure as set forth on Form ADV from us using the contact information herein. Please read the disclosure brochure carefully before you invest or send money.
Note from the CIO: A Study of the Worst Times to Retire
The Abacus Investment Committee
Recently I conducted a study of the safe amount a retiree can withdraw from their portfolio each year without running out of money and also leaving at least half of the initial portfolio value to their heirs (after inflation). My goal is to publish this analysis in one of the financial planning research journals, but here’s your sneak peek into some of the key findings.
Financial planners, including me and my colleagues at Abacus, generally prescribe a healthy dose of bonds in a retirement portfolio to accompany the stock allocation. Although we believe that equities (stocks and real estate) are the key to keeping pace with the rising cost of living and preserving one’s quality of living, we protect portfolio withdrawals in the short- and medium-term from drops in equities by using high quality bonds, because history and logic tell us that they don’t drop as significantly as equities, even though the drops of equities have historically always been temporary. The financial planning profession may well have been getting this wrong for decades. My study finds that based on the history of the S&P 500 since the end of World War II (the “post-industrial” era that began nearly 72 years ago), retirement portfolios have been designed more conservatively (meaning, with more bonds) than they needed to be.
The “worst time to retire” is right before a market crash. Crashes that occur mid-way through a retirement have not posed as much of a challenge for the retiree if there was no crash in the beginning, because if a well-designed retirement portfolio has several years to accumulate without an initial crash then it will have built up a sufficient surplus to absorb the eventual and inevitable crashes. To a large extent, we use bonds in a retirement portfolio to manage exactly that specific risk: that a crash happens shortly after retirement begins. Having bonds available to sell to generate retirement cash flow during a stock market drop could give equities time to recover; in other words, without a sufficient allocation to bonds, equities might need to be sold during a stock market crash to generate retirement cash flow, potentially creating a downward spiral in the value of the portfolio. For this reason, I expected to find in this study that a reasonably balanced mix of 60% stocks and 40% bonds should have allowed for higher withdraws during a retirement that started at these worst times, than a portfolio invested 100% in stocks.
I focused on what would have happened to a 35-year retirement that started just before the 14 bear markets (defined as a 20% drop or more in the S&P 500[1]) since WWII, as illustrated in the exhibit above. The result surprised me: In every one of the 14 bear markets, the portfolio invested 100% in the S&P 500 allowed a higher withdrawal over the 35-year retirement (subject to our criteria of having half of the initial portfolio value, increased with inflation, available at the end of retirement). The average maximum initial withdrawal rate possible for the 14 retirements starting at the worst times invested 100% in the S&P 500 was 4.4% (plus an additional assumed 1% that is withdrawn for fees, for a total of 5.4% withdrawn when fees are included). This means that the initial annual withdrawal for living expenses from a $1 million portfolio would have been $44,000; this withdrawal amount is adjusted for inflation each month thereafter. This (4.4%) is generally considered by planners to be a good withdrawal rate. The average maximum initial withdrawal rate for the 60/40 portfolio over the same 14 difficult retirement periods was 3.5%, somewhat lower (but still in the acceptable range for many financial planners). It is important to note (since many of your portfolios are likely closer to 60/40 than 100% equities) that if one includes the other 775 starting months (in addition to the 14 most difficult) since WWII then the 60/40 portfolio would have allowed a 4.2% withdrawal rate on average.
The single worst time to retire since WWII was at the top of dot.com bubble[2], because on an inflation-adjusted basis, the bottom was not reached until March of 2009, when the Financial Crisis reached its bottom (in other words, the period 2000-2009 can be thought of as one long bear market). The most a retiree can withdraw in a 35-year retirement starting in 2000 is 2.4% (initially, and then adjusted for inflation) for the S&P portfolio and 2.1% for the 60/40 portfolio.
What do we conclude from this? It should be clear that stocks have been a great investment for retirement portfolios. However, I would not interpret this study as saying one should not hold bonds in a retirement portfolio. In fact, when I studied the same 35-year retirement starting the day before the 1929 stock market crash associated with the Great Depression, I was finally able to find a period where a balanced mix of stocks and bonds allowed a higher withdrawal than 100% stocks (2.3% for 100% stocks, 2.7% for the 60/40 portfolio). And we have no guarantee that there will not be an even worse crash than 1929 in our lifetimes. Your Abacus advisor can and will help you decide what level of risk (of a historically rare, severe market crash early in retirement) you should manage against by using bonds, weighed against the increased lifestyle and inheritance that increased stock allocations have afforded (in the vast majority of historical retirement periods). If clients stay committed to their retirement allocation (which likely will prove to have more bonds than will be needed) but use this study — and its message of the resilience of the stock market — to remain patient and disciplined, if not to find some level of comfort and peace during the next inevitable stock market crash, then the study will have been a success.
[1] The S&P 500 price only dropped by 19.3 to 19.4% in three of the bear markets, but they each led to a climate of investor anxiety of the type associated with a bear market.
[2] Some readers will notice that a 35-year retirement starting with the October, 1987 bear market (“Black Monday”) and later, will require some assumption for futures returns beyond the date of this study, namely May, 2017. I assumed a repeat of the historical cycle of a 30% bear market drop in the S&P 500 every five years, starting with the first future crash happening immediately in the future (June, 2017). I assume the compounded annual return in the future for the S&P 500 is 9% from peak to peak of each bear market cycle (which is a bit below its historical average).
Disclosure: Abacus Wealth Partners, LLC (Abacus) is an SEC registered investment adviser with its principal place of business in the State of California. Abacus may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. This brochure is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Abacus with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Abacus, please contact us or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).
This is not an offer to sell any type of security, and there is no investment currently available through Abacus. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell this security. This newsletter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Information was based on sources we deem to be reliable, but we make no representations as to its accuracy. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.
For additional information about Abacus, including fees and services, send for our disclosure brochure as set forth on Form ADV from us using the contact information herein. Please read the disclosure brochure carefully before you invest or send money.
For more information about Abacus and this article, please read these important disclosures.
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