Portfolio Survivability: Will Your Assets Outlast You?

In the depths of the market panic earlier this spring, one of my clients called up and requested that I rebalance his account.

He was nearing retirement and determined that he could cover his current income needs with coupon interest if 80% of his assets were invested in bonds, leaving 20% in stocks for growth. His account had grown very nicely over the past five years invested 75% in equities and 25% in fixed income, but the volatility of the markets was very frightening to him and he wanted to protect his nest egg.

So, as a financial adviser, I had to decide whether I should follow his instructions.

Many baby boomers will face these questions over the next decade: What is the appropriate mix of investments in retirement, and at what rate can assets be drawn out of a portfolio without running it down to zero?

One area to look for guidance is in endowments, which are pools of assets held by colleges, universities and foundations to provide support for operating budgets. According to the National Association of College and University Business Officers' annual Endowment Study, on average, U.S. universities invested 58.4% of their assets in equities (U.S., non-U.S., private and venture), 21.2% in fixed income and cash instruments, and the remaining 20.6% in hedge funds, real estate and commodities (for more details, see this table of asset allocation.) Drawdown rates ranged from 4% to 6.5% of market value, with an average drawdown rate of 4.5%.

Should individuals follow these guidelines? Well, there are some critical differences. Most individuals do not have access to special investment products like hedge funds, but an allocation of 70% equities and 30% fixed income would probably represent a comparable exposure. Also, endowments are perpetuities; therefore trustees must set the drawdown rate at lower levels so that endowment returns are available to future generations. Individuals, on the other hand, are concerned mostly with the next 10 to 35 years. Leaving an estate is nice, but always having money is critical.

What if we set the drawdown rate assuming that the long-term returns from stocks and bonds match their historical averages? Ibbotson Associates provided these average returns from 1926 to 2000:

S&P 500	11.0%
Long-Term Corporate Bonds	5.7
Long-Term Government Bonds	5.3
30-Day T-Bills	3.8
Inflation	3.1
Source: Ibbotson Associates.

So if we took 70% stocks, 15% corporate bonds and 15% government bonds, could we set the drawdown rate at 0.70*11%+0.15*5.7%+0.15*5.3%, or 9.35% a year? That drawdown rate would have been fine over the five years ending January 2000, when the S&P 500 gained 22% a year. But from 1972 through 1980, returns on the S&P 500 averaged 4% from dividend income and 0% from price appreciation. A drawdown rate of 9.35% in that environment would have reduced the nominal value of a portfolio by 40%, and even more in inflation-adjusted terms.

Professors Phillip Cooley, Carl Hubbard and Daniel Walz of Trinity University in San Antonio, Texas, prepared a probabilistic study of portfolio survivability that appeared in the February 1998 AAII Journal (members of AAII can read the full report at the AAII Web site).

Using returns data from Ibbotson, they prepared a simulation of the likelihood that portfolios would be depleted using asset mixes ranging from 100% stocks to 100% bonds, withdrawal rates ranging from 3% to 12% and payout periods ranging from 15 to 30 years. With permission, I've reproduced two tables from that study.

Portfolio Success Rates: 1926 to 1995 (Percentage of all past payout periods supported by the portfolio) Withdrawal Rate as a % of Initial Portfolio Value:
Payout Period	3%	4%	5%	6%	7%	8%	9%	10%	11%	12%
100% Stocks
15 Years	100	100	98	98	93	91	88	77	63	55
20 Years	100	98	96	94	92	84	73	61	47	43
25 Years	100	98	96	91	87	78	70	50	43	35
30 Years	100	98	95	90	85	78	68	54	49	34
75% Stocks/25% Bonds
15 Years	100	100	100	100	96	95	91	79	63	46
20 Years	100	100	100	96	94	88	71	51	41	33
25 Years	100	100	98	96	91	78	57	46	33	26
30 Years	100	100	98	95	88	73	54	46	37	24
50% Stocks/50% Bonds
15 Years	100	100	100	100	100	98	91	71	50	36
20 Years	100	100	100	100	96	88	61	41	25	10
25 Years	100	100	100	98	96	70	43T	22	7	0
30 Years	100	100	100	98	90	51	37	15	0	0
25% Stocks/75% Bonds
15 Years	100	100	100	100	100	100	91	50	21	14
20 Years	100	100	100	100	100	71	24	12	4	2
25 Years	100	100	100	100	78	22	9	0	0	0
30 Years	100	100	100	100	32	5	0	0	0	0
100% Bonds
15 Years	100	100	100	100	100	79	43	38	14	7
20 Years	100	100	100	96	47	35	16	6	0	0
25 Years	100	100	98	52	26	7	2	0	0	0
30 Years	100	100	51	27	0	0	0	0	0	0
Note: Numbers are rounded to the nearest whole percentage. The number of overlapping 15-year payout periods from 1946-95, inclusively, is 36; 20-year periods, 31; 25-year periods, 26; 30-year periods, 21. Stocks are represented by the S&P 500 index, and bonds are represented by long-term, high-grade corporates.
Source: Ibbotson Associates.

Looking at the table, we see that a portfolio of 100% stocks has a 91% chance of lasting 15 years at an 8% drawdown rate. Change the mix to 25%stocks/75% bonds and the portfolio has a 100% chance of lasting the same period at the same drawdown rate.

Based on this information, I should do what my client says, right?

Well, this first simulation doesn't take into account the effects of inflation. A fixed-income investment (excluding inflation-adjusted Treasuries) has the same nominal return whether inflation is high or low. So if inflation picks up to levels last seen in the 1970s, the asset disbursement rate would have to increase to offset the loss in purchasing power, and a bond-heavy portfolio would do poorly. Stocks offer some inflation protection in the sense that companies can boost prices as costs rise. If operating margins remain the same, the rate of increase in earnings rises in line with inflation.

A second simulation takes inflation into account:

Inflation-Adjusted Portfolio Success Rates: 1926 to 1995 (Percentage of all past payout periods supported by the portfolio after adjusting withdrawals for inflation) Withdrawal Rate as a % of Initial Portfolio Value:
Payout Period	3%	4%	5%	6%	7%	8%	9%	10%	11%	12%
100% Stocks
15 Years	100	100	100	91	79	70	63	55	43	34
20 Years	100	100	88	75	63	53	43	33	29	24
25 Years	100	100	87	70	59	46	35	30	26	20
30 Years	100	95	85	68	59	41	34	34	27	15
75% Stocks/25% Bonds
15 Years	100	100	100	95	82	68	64	46	36	27
20 Years	100	100	90	75	61	51	37	27	20	12
25 Years	100	100	85	65	50	37	30	22	7	2
30 Years	100	98	83	68	49	34	22	7	2	0
50% Stocks/50% Bonds
15 Years	100	100	100	93	79	64	50	32	23	13
20 Years	100	100	90	75	55	33	22	10	0	0
25 Years	100	100	80	57	37	20	7	0	0	0
30 Years	100	95	76	51	17	5	0	0	0	0
25% Stocks/75% Bonds
15 Years	100	100	100	89	70	50	32	18	13	7
20 Years	100	100	82	47	31	16	8	4	0	0
25 Years	100	93	48	24	15	4	2	0	0	0
30 Years	100	71	27	20	5	0	0	0	0	0
100% Bonds
15 Years	100	100	100	71	39	21	18	16	14	9
20 Years	100	90	47	20	14	12	10	2	0	0
25 Years	100	46	17	15	11	2	0	0	0	0
30 Years	80	20	17	12	0	0	0	0	0	0
Note: Numbers are rounded to the nearest whole percentage. The number of overlapping 15-year payout periods from 1926-95, inclusively, is 56; 20-year periods, 51; 25-year periods, 46; 30-year periods, 41. Stocks are represented by the S&P 500 index, and bonds are represented by long-term, high-grade corporates, and inflation (deflation) rates are based on the Consumer Price Index (CPI).
Source: Ibbotson Associates.

In this study, we see that an 8% withdrawal rate is pretty aggressive, with survivability rates being the worst for the portfolios with high bond exposure. The sweet spot is the 75% stock/25% bond portfolio, which had the highest survivability rate over multiple drawdown rates and time frames.

After I faxed a copy of this study to my client; we talked over the ramifications of different asset mixes and drawdown rates, and in the end he left his allocations unchanged.

In general, I feel comfortable recommending that my clients assume drawdown rates of 5%-8% of their total assets when they retire, and I remind them that this draw includes living and medical expenses and taxes. Many retirement planners assume that postretirement expenses will be 70% of preretirement expenses (house paid off, lower spending rates on furniture, clothing, etc.). I find that my clients generally maintain their preretirement spending levels as they travel more, buy vacation homes or give money away. So I have a very simple worksheet for helping my clients visualize how much money they need to have on hand before they can quit working.

Here's an example of a single individual, 45 years old, who's vested in a pension:

Current annual income	$120,000
Current annual expenses	$100,000
Annual savings	$20,000
Estimate of future expenses	$100,000
Social Security	($15,000)
Defined benefits	($5,000)
Gap	$80,000

The minimum asset base to cover this gap is $80,000/8% or $1,000,000. The preferred asset base is $80,000/5% or $1,600,000. Bottom line: This individual had better make the most of that $20,000 in annual savings.

This worksheet obviously doesn't extrapolate inflation, but because inflation affects different people in different ways (home owners suffer less from inflation than renters, for example), it helps our clients easily model whether or not they are on track, based on their particular situation (clients currently covering children's expenses in college can remove that component from their expense estimations in retirement). Also, if a client's income rises (because of a promotion, for example) and he or she starts spending more (joining a country club, for example), that client can quickly see that retirement savings must also rise.

In summary:

A retirement portfolio should still invest 60% to 80% in equities, 20% to 40% in fixed income.

During your peak earning years, tilt your asset mix more toward equities to maximize returns, even at the risk of higher volatility.

An 8% drawdown rate is the maximum you can assume, but 5% is preferable.

Estimate your minimum and preferred asset base using the worksheet above; if current assets are substantially below the minimum, act now to lower your expenses and increase your savings rate.