Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress of changing markets and spending levels. The resulting models estimate portfolio survival in terms of statistical probabilities. While the technical details are beyond the scope of this article, the general conclusions are more intuitive.
Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly consider them.
Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium reflects the higher risk of owning stocks. Consequently, the larger the equity allocation, the greater a portfolio’s expected return — and risk.
Portfolio withdrawal is typically described in terms of a specified dollar amount (i.e. $50,000 per year) or a per cent of annual portfolio value (i.e. five per cent of assets each year). For different reasons, neither method is ideal, however.
Briefly consider each one:
• Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value. One academic study quantified this amount. It found that a retiree with at least a 60-per-cent stock allocation can withdraw up to four per cent of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of money. Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.
• Per cent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.
Investment time frame
Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well.
Planning involves assumptions about the future — assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected.
For instance, you may assume an average return based on historical performance. But there is no certainty that future portfolio returns will resemble the past, regardless of the time frame. Moreover, short-term results may vary drastically, which could force hard financial choices. Investors should think in terms of probability, not history.
Managing asset mix, payout, and time horizon inevitably involves trade-offs. For example, a bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a longtime horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Retirees who take this route must be able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to market downturns. In fact, investor flexibility plays a role in all of the trade-offs.
Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio.
Alan Acton is a financial adviser in Ottawa and can be reached at [email protected]. The opinions expressed are those of Alan Acton and not necessarily those of Raymond James Ltd. Statistics, data, and other information are from sources believed to be reliable but their accuracy cannot be guaranteed. This document has been prepared to assist individuals with financial concepts and is for informational purposes only.