Portfolio Lifetimes with Switching

Here is an early study into the switching of stock allocations. The required investments (which include 3% TIPS) are no longer available, today’s SAFE withdrawal rates are much lower and our procedures are better today. But the main point of this study is still true. Varying stock allocations in accordance with P/E10 dramatically decreases the sensitivity of portfolio lifetimes to withdrawal rates.

This is a brief study of the sensitivity of portfolio lifetimes to withdrawal rates when there is switching. The Historical Surviving Withdrawal Rates of portfolios with fixed stock allocations are extremely sensitive. A 0.2% increase in withdrawal rates reduced the portfolio duration by a decade (or worse) at high levels of safety (95% and above). This sensitivity disappears when we use portfolio switching.

Conditions

I looked at switching between 80% stocks and 20% stocks based on P/E10 at a threshold of 12. The higher stock allocation (80%) applied whenever the P/E10 was less than 12. The lower stock allocation (20%) applied when P/E10 was equal to or greater than 12. The alternative investment was TIPS with a 3% interest rate. The expense ratio was 0.20%, which is reasonable for an S&P 500 index fund, but which is high for TIPS.

I restricted my analysis to the years 1921-1980 to avoid a data anomaly.

Results

These are the number of failures on or before the number of years indicated for various withdrawal rates. Switching is between 80% stocks (below threshold) and 20% stocks (at or above the threshold). The P/E10 threshold is 12. The alternative investment is TIPS at a yield of 3%.

Rate....20....25....30....35....40
4.0%.....0.....0.....0......0.....0
4.2%.....0.....0.....0......0.....0
4.4%.....0.....0.....0......0.....0
4.6%.....0.....0.....0......0.....0
4.8%.....0.....0.....0......0.....1
5.0%.....0.....0.....0......2....10
5.2%.....0.....0.....0.....11....15
5.4%.....0.....0.....7.....14....16
5.6%.....0.....0....13....17....17
5.8%.....0.....5....16....18....19
6.0%.....0.....8....18....19....20

Conclusion

The combination of switching and TIPS eliminates the extreme sensitivity of portfolio lifetime to the withdrawal rate.

Have fun.

John Walter Russell
I wrote this originally on September 25, 2003.