Living off your investments when you retire


If you don’t have time to read through the whole article, you can check out our short version below:

There are various strategies to draw down on our retirement funds. We discuss two such strategies:

The systematic withdrawal strategy involves selling off portions of your investment portfolio regularly to generate funds for retirement expenses.

The floor-to-ceiling approach links your annual retirement expenses—and hence, portfolio withdrawals—to market conditions. The “ceiling” caps expenses, while the “floor” supports them.

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Against a backdrop of longer life expectancy, rising standards of living and inflation driving up costs of good, services and particularly medical care, whatever nest egg we have prepared for retirement needs to continue working for us.

In Singapore, with the current retirement age in the early 60s, we need to plan for financial adequacy for two decades or more. And that does not factor in the growing number of people who intend to retire before 60 years of age.

The systematic withdrawal strategy involves selling off portions of your investment portfolio regularly to generate funds for retirement expenses. This is a very broad approach and particular care must be taken to address how retirees ensure they do not run out of assets during their lifetime.

How much do you systematically withdraw per year? Introducing the “4% rule” of decumulation. This so-called “rule of thumb” can be used to implement a systematic withdrawal strategy to lower the risk of running out of assets during a retiree’s lifetime.

It argues that based on US historical data, an investor is likely to be able to withdraw 4% of his portfolio in the first year, with the absolute dollar amount per year adjusted by the inflation rate each subsequent year, without exhausting his nest egg in his lifetime.

The 1994 study, by financial advisor William Bengen, stress-tested the longevity of portfolios through:

The study found that no portfolio was depleted in less than 33 years using the “4% method”.

Bengen wrote that, on the basis of a 50-50 stocks-bonds asset allocation, the “safe withdrawal” limit (that is, the withdrawal limit at which the retiree is unlikely to outlive his portfolio) for an investor aged 60-65 “will usually be about 4%”.

But don’t get too hung up on the actual figure. The 4% figure was derived from the US experience and long-term US market data. Because stock and bond returns today are lower than what they were during the period considered by Bengen, we should treat the 4% figure as only a guide for implementation of a systematic withdrawal strategy.

What is important about the “4% rule” is the idea of continued investment and prudent withdrawals during retirement. Note that Bengen’s 4% a year plus inflation withdrawal recommendation was based on a portfolio that continued to be invested in stocks even in retirement.

His base case calculations for the 4% rule was a 50-50 portfolio, evenly divided between stocks and US government bonds. In fact, he recommended a stock allocation “as close to 75% as possible, and in no case less than 50%.” A 0% allocation to stocks produced the lowest minimum number of years that 4% plus inflation withdrawals lasted. In short, the supposedly safest approach of government bonds only produced the worst outcome for retirees.

The floor and ceiling approach involves adjusting withdrawals from your investment portfolio to take into account how your portfolio performs. This strategy, popularised by investment manager Vanguard Investments, links your annual retirement expenditure—and hence, your portfolio withdrawals—more closely to market conditions.

You start by deciding on a percentage of your portfolio to withdraw each year for your retirement spending. That would be a figure that balances your desired retirement lifestyle and how long you would want your assets/portfolio to last. All other things being equal, the larger the percentage of the annual withdrawal, the shorter the likely life span of the portfolio, and vice-versa.

This percentage of portfolio withdrawal is also called your “spending rate”. And it is calculated on the inflation-adjusted, ending balance of your portfolio in the previous year.

So, if you have an inflation-adjusted portfolio balance of $1 million at the end of the year, and you have a 4% spending rate, your withdrawal/spending for the following year will be $1 million x 4% = $40,000.

Then you decide on your floor and ceiling percentages. These are the ranges which your spending can vary, depending on how your portfolio performs in the market. Figures frequently used by Vanguard are a floor percentage of -2.5% and a ceiling percentage of +5%. These floor and ceilings are calculated respectively as downward and upward variations of your annual withdrawal/spending the previous year.

Finally, you compare the withdrawal/spending based on the percentage of portfolio withdrawal method versus figures for the floor and ceiling. If it exceeds the ceiling, you limit spending to the ceiling amount; if it is below the floor, you increase spending to the floor amount.

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