In this classic Retirement Researcher article, originally published in June of 2011, Wade Pfau considers the contributions of the groundbreaking 2001 article, “Making Retirement Income Last a Lifetime.”
I’m now in the process of re-reading some of the classic studies on retirement planning. As I am more involved in the research side of it now, doing this allows me to see points that I missed before or otherwise had just forgotten about. Yesterday I discussed the Terry (2003) article and found that it contained a computation error that works to invalidate the whole premise of the article. I was reading that one yesterday, because it is critical of John Ameriks, Robert Veres, and Mark J. Warshawsky’s December 2001 article from the Journal of Financial Planning, “Making Retirement Income Last a Lifetime.” Actually, this is a really excellent article that deserves lots of accolades. It is quite innovative. At the end of my review process, I might like to try to put together a top 10 list of the most important articles about sustainable withdrawal rates, and this one is certainly going to be a contender.
Let me highlight a few things about the article:
Contributions of the Article
1. I hadn’t realized it, but this article makes a comparison between Monte Carlo simulations and historical simulations. It considers the results with both cases. I thought Cooley, Hubbard, and Walz (2003) were the first to do it, but I should change my past citations to this article instead.
2. This paper also investigates how partial annuitization can affect safe withdrawal rates. This is really important. Annuities don’t have to be an all-or-nothing proposition. The authors don’t try to find an optimal annuity amount, but they do show about annuitizing 25% or 50% of one’s savings can help improve the success rates for a 4.5% withdrawal rate. The chances for success increase, and the tradeoff is a reduced amount of leftover remaining wealth in many cases.
3. The article incorporates a 1% fee.
4. The article also addresses retirement durations of 35 and 40 years, in addition to the usual 30 years (and also, there are 20 and 25 years too).
Findings of the article
1. The authors consider 4 portfolios with different combinations of stocks, bonds and bills, and they find that over rolling periods and with Monte Carlo simulations that the most aggressive portfolio provides higher withdrawal rates on average, with very little downside risk. In the rare case that the aggressive portfolio provides a lower maximum sustainable withdrawal rate than a less aggressive portfolio, the difference is very small. Actually, I am well aware of this type of finding. As this is a 2001 article, it is quite possible that they were one of the first to note it. With US historical data, it is very hard to beat a 100% stocks portfolio. The authors suggest caution about using this result in a forward-looking manner.
2. The annuities part is very important. Partial annuitization, even with fixed annuities that do not adjust for inflation, can help improve the sustainable withdrawal rate. They can also allow the remaining portfolio to be invested more aggressively, as the annuities can substitute for bonds in the portfolio.
3. The authors find that less aggressive portfolios work better for shorter retirement durations, but that more aggressive portfolios perform better for the longer retirement durations.
Concerns / Suggestions for Improvement
1. This article is based on data between 1946 and 1999, which may portray bonds in too negative of a light. In other words, this time period may be too much “pro-stocks.” I discuss this type of issue more extensively in the section “Bias Against Bonds in Historical Simulations” of my paper, “Retirement Withdrawal Rates and Portfolio Success Rates: What Can the Historical Record Teach Us?”
2. As the authors note, the historical simulations are hampered by the short data period. For the 35-year case, the simulations will be cut off at 1965, which happens just before some of the worst withdrawal rates in history.
3. The authors include Treasury bills in their less aggressive portfolios, but this may just serve to drag down the performance of the bonds component. Just including intermediate-term government bonds may be the best way to represent bonds in the portfolio.
4. This is a more minor quibble, but the authors track negative wealth as a way to consider how far into debt people may go with a 4.5% withdrawal rate. But in this case, depending on their programs, any negative portfolio returns might have actual served to bring their wealth closer to zero rather than farther away from zero. If they stopped incorporating asset returns once the portfolio ran out of wealth, then there is no problem. But they don’t clarify how they treated this, and I suspect the problem may be there.
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