Brush. Rinse? Repeat. – Part 2

The big idea and why it matters: The 4% rule for retirement income withdrawal rates is mathematically reasonable, but it also implies a significant equity representation in one’s portfolio. If implementing a retirement income strategy with a yield that is less than the income need – as is often the case with passive indexing – then other tradeoffs are introduced (e.g., the need to hold excessive cash reserves and fixed income).

“Live as if you were to die tomorrow. Learn as if you were to live forever.” -Mahatma Gandhi

Picking up where we left off in Part 1, today we will continue to look for areas of opportunity within commonly accepted investment management practices. In the spirit of Gandhi’s quote, a lifetime of learning may force us to rethink or even undo approaches we previously took for granted as being advisable. And if we build portfolios as if we will live forever, it should increase robustness and provide added peace of mind. Here we go!

4 percent descent

This Forbes article offers a perspective on withdrawal rates and what is widely known as “the 4% rule,” based on William Bengen’s 1994 paper, “Determining Withdrawal Rates Using Historical Data.” Bengen found that limiting withdrawals to 4% of the initial portfolio value (and then adjusting for inflation and rebalancing annually) resulted in portfolios that mostly lasted at least 50 years. However, beginning retirement in 10 of the years he analyzed resulted in portfolios lasting at least 35 years (but less than 50 years); we refer to this as “sequence of returns risk,” which essentially means poor timing for starting retirement withdrawals. As Investopedia succinctly phrases it: “Account withdrawals during a bear market are more costly than the same withdrawals in a bull market.”

Given the worst case of 35 years, which is a reasonable retirement lifespan for most retirees, the 4% rule became a thing. The Forbes article also points out why 4% is the tipping point:

5% withdrawal rate: More than half of the portfolios were exhausted in less than 50 years, with the worst portfolios lasting no more than about 20 years.

6% withdrawal rate: Only seven portfolios lasted 50 years, with about 10 lasting fewer than 20 years.

Another powerful takeaway from Bengen’s work that relates to Part 1 of this series is the importance of maintaining equity exposure during retirement, as “portfolios with 0 to 25% allocated to equities saw their longevity severely compromised.” The ultimate takeaway was that a portfolio with a mix of somewhere between 50% and 75% equities was ideal for balancing portfolio longevity with wealth generation. 60/40 portfolio, anyone?

Falling Water

Through my network of financial advisor friends and charitable endeavors, I regularly gain insight into approaches for generating a livable wage from a portfolio. In the non-profit world, institutional organizations and private foundations typically have an annual spending requirement in the 4-5% range. In private wealth, a similar percentage often marks the crossroads where funding lifestyle without permanently impairing one’s nest egg occurs. Given the 4% rule, none of that is surprising.

However, as we discussed earlier, sequence risk remains a concern. While retirement may not last 50 years, clients often prefer not to destroy their nest eggs, and institutions are typically intended to exist in perpetuity – so 50 years of portfolio longevity simply doesn’t cut it. What’s one potential, common solution? Buckets and waterfalls.

By holding multiple years’ worth of expenses in cash and cash alternatives (even very short-term fixed income), along with several more years in fixed income, the goal is to create a buffer that helps avoid selling equities during extended downturns. And when times are good for the stock market, gains can be trimmed to replenish the fixed income and cash buckets – hence the “waterfall” nomenclature.

Where’s the opportunity for improvement? Aligned with water naturally finding its way to the lowest point, this waterfall consistently directs capital to its poorest long-term use (i.e., cash), and the significant cash levels involved result in a drag on portfolio returns. If only there were a way to create a reliable and growing income stream from a portfolio, such that the need for this waterfall were greatly diminished…

Low cost can be pricey.

The equity bucket of the aforementioned waterfall is often implemented using passive indexing. And why not save the cost, since it’s challenging to beat the market, anyway? The answer is because equities don’t exist in a vacuum, so to speak. While inexpensive equity exposure sounds appealing in theory, we have to make accommodations for reality, just like we have to adjust physics equations for factors like friction and wind resistance when we leave a perfect vacuum and enter the real world. [Remember, a feather and a rock fall at the same rate in a vacuum, but you’ll find that they hit the ground at different times in a classroom experiment].

If we use a typical S&P 500 ETF, it will provide a yield that is slightly over 1%. I could then combine this with other equities, such as International and some higher-dividend stocks, so I will give the benefit of the doubt and say the equity yield gets up to 2%. With the 4-5% spending need we’ve discussed, the other 2-3% needs to come from equity price appreciation or other parts of the portfolio, and the exposure needs to be balanced (now keeping in mind both the 4% rule and waterfall approach) with a significant amount of cash and fixed income to help insulate from downturns that can last longer than we expect. Using a 60/40 portfolio mix, quick math tells us that we’d need to generate a yield of 7% or more on the non-equity portion of the portfolio to compensate for the equity yield of only 2%, ignoring any price appreciation.

The inconvenient truth, then, is that lower-yielding equities (whether index or actively managed strategies) within an income-focused portfolio require the ballast of cash and bonds; however, this point is almost always overlooked during discussions of equity returns. Thus, the added utility of an equity strategy that pays a livable, growing income is that it may allow less cash and fixed income to be held, avoiding a substantial amount of that oft-ignored “cash drag.”

Is the point of this to “talk TBG’s book,” given our core philosophy of higher-yielding Dividend Growth? Not at all (but you can see how we’ve arrived at this philosophy). It is more so to encourage readers to consider the broader, pragmatic, and very real implications of their investment selection decisions in the context of a financial plan – forest for the trees and all that jazz.

As my trusted colleague (and Director of our Private Wealth Advisor Group), Trevor Cummings, succinctly put it in a recent edition of Thoughts on Money, regarding retirement income generation: “The consistent, reliable, and growing cash flows of a dividend growth strategy create planning clarity that you just don’t get for most other investment strategies…the only riddle to solve is to create enough income to match the withdrawal expectations, which a simple indexed portfolio (low yield) won’t typically accomplish.”

I promise that this topic will end with perspective on where Alts fit into all of this, but this edition is too long already, so please bear with me, and we will cover that in Part 3.

Until next time, this is the end of alt.Blend.

Thanks for reading,

Steve

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About the Author

Steve Tresnan, CAIA®, CFP®

Private Wealth Advisor

Steve is a Certified Financial Planner as well as a Chartered Alternative Investment Analyst®. He is also an Accredited Investment Fiduciary, which helps him offer guidance to clients with fiduciary responsibilities, such as board members of trusts, foundations, and endowments. Steve earned a Bachelor of Science degree in Industrial Engineering from Penn State University.

Steve serves on the board and finance committee of New Music USA – a national nonprofit devoted to the development and appreciation of new music in the U.S.

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