Continuing Withdrawal Rates (July 2009)

Today’s valuations are much more favorable than those of a year ago. P/E10=16 and 100E10/P=6.25%. Continuing Withdrawal Rates have improved dramatically.

Single Premium Immediate Annuities

Single Premium Immediate Annuities SPIA offer a 6.0% to 6.5% (plus inflation) continuing withdrawal rate for today’s traditional retirees.

Annuities are not nearly so good a choice for early retirees. They do not gain much from the insurance feature.

Traditional Liquidation Approach

The continuing withdrawal rate is 4.4% if you sell stocks for income using a stock and TIPS portfolio. You can see this using the Year 30 SWR Retirement Risk Evaluator [button on left]. I assumed 80% stocks (S&P500) and 2% interest rate TIPS. The Reasonably Safe rate for a final balance of 100% is 4.4%.

The downside risk is that the portfolio might fall to 50% of the original balance (plus inflation) at Year 30. This is the final balance at a Safe Withdrawal Rate of 4.4%.

Percentage of the Current Balance

This is a variant of the traditional liquidation approach. Instead of withdrawing a certain amount each year (plus inflation), you withdraw a constant percentage of the current balance each year, hoping that your income will keep up with inflation.

The continuing withdrawal rate at today’s valuations is 6% of the CURRENT balance of the portfolio. The downside risk is that the withdrawal amount (smoothed over four years) can fall to 4% of the original balance (plus inflation).

You can see this by looking at a plot of the Year 20 balances versus valuations. Year 20 is when the portfolio falls to its worst case condition before recovering and growing once again. Valuation Informed Indexing is best. The worst case withdrawal rate remains at 4% of the original balance (plus inflation), but its likelihood is much, much less.

Take 6%
Take 6% with Valuation Informed Indexing

Income Approach

ElLobo of the Morningstar Income & Dividend Investing discussion boards recently constructed a conservative income portfolio yielding 6.4%. He reports that a straight income approach can easily generate 7% to 8% with a minimum of 6% (plus inflation).

Assuming a portfolio with little growth, you reinvest about 3/4ths of the income stream to keep up with inflation.

Dividend Blend

I used my Retirement Practice portfolio. It is a 50%-50% combination of DVY, a broad based dividend oriented Exchange Traded index Fund, and PFF, a broad based preferred stock Exchange Traded index Fund. DVY is the growth component. It has disappointed recently. PFF is the high yield component. It has held up quite well.

I went to Yahoo Finance to characterize DVY and PFF. I used an initial yield of 6.08% and 5.5% per year growth in the dividend amount for DVY. I used an initial yield of 8.93% for PFF with zero growth. I put these numbers into my Simplified Automatic Allocator. I assumed 2% for the TIPS interest rate and 3% for the inflation rate.

The continuing withdrawal rate was 7.2%. Assuming a 25% downside risk to cover the risk of high inflation, the continuing withdrawal rate stays above 5.4% (plus inflation).

Summary

The drop in stock prices has improved the outlook for new retirees. They may find that they still have enough to generate a satisfactory income stream in spite of recent stock market losses.

The continuing withdrawal rates are:

1) Between 6.0% and 6.5% (plus inflation) for traditional retirees who use a traditional, low cost annuity.
2) About 4.4% of the original balance (plus inflation) using a traditional fixed allocation, liquidation approach, selling stocks for income and always withdrawing the same amount in terms of inflation adjusted dollars. The downside risk is that the Year 30 balance would be one-half of the original balance (plus inflation).
3) About 6% of the portfolio’s original balance (plus inflation) when withdrawing a constant percentage of the portfolio’s current balance, allowing withdrawals to vary in terms of buying power. The downside risk is that withdrawals could fall as much as one-third (to 4%) in terms of buying power at Year 20 before the portfolio recovers and grows once again.
4) About 7% to 8% of the original balance (plus inflation) with a straight income approach with a downside risk of 6% (plus inflation). A conservative selection with a very limited amount of risk produces 6.4% (plus inflation).
5) About 7.2% of the original balance (plus inflation) with a dividend blend. The downside risk is 5.4% (plus inflation) in the presence of high inflation.

Have fun.

John Walter Russell
July 2, 2009