Morningstar Advisor - October/November 2012 - (Page 67)

that dynamically adjust for changes in both market and mortality uncertainties outperform the more traditional approaches to retirement. Building the New Framework Most research on retirement-portfolio-withdrawal strategies has centered on the ability of a portfolio to maintain a constant withdrawal rate or constant dollar amount (either in real or in nominal terms) for some fixed period, such as 30 years. The annual withdrawal is commonly assumed to increase annually for inflation. Bengen (1994) is widely regarded as the first person to study the sustainable real withdrawal rates from a financial-planning perspective. He found that a “first-year withdrawal rate of 4%, followed by inflation adjusted withdrawals in subsequent years, should be safe.” This is commonly referred to as the “4% rule.” Many experts and practitioners think that the 4% rule is rather naïve, as it ignores the dynamic nature of market and portfolio returns. More-recent research has sought to determine the optimal withdrawal strategy by dynamically adjusting to market and portfolio conditions. These approaches can offer a more realistic path for retirees to follow because they continually “adapt” to the returns of the portfolio. Up until this point, however, there has been no measure to evaluate the effectiveness of these withdrawal strategies (other than probability of failure, which has significant limitations). Another common assumption in retirement research is the notion of a fixed retirement period, which is typically based on some life-expectancy percentile. For example, if we have a male and female couple, both age 65, the probability of either (or both) member of the couple living 35 more years, past age 100, is roughly 14%, based on the 2000 Annuity Mortality Table. If 14% was determined to be an acceptable probability of outliving the retirement period for modeling purposes, 35 years would be selected as the retirement duration. The fixed-period approach essentially assumes retirees will live through the period without dying. In other words, this approach ignores another important dynamic a retiree faces: the mortality probability. Assuming a fixed retirement period and then selecting a withdrawal rate based on that period is an incomplete methodology because this approach ignores the dynamic nature of mortality. Possessing Perfect Information Retirees face two unknowns when determining the best strategy to withdraw from a retirement portfolio to fund retirement: the future returns of their portfolio and the duration of the retirement period. If retirees knew their future returns and the years they will live—if they had “perfect information”—they would be able to determine the precise amount of income that could be generated from the portfolio for life, eliminating any uncertainty about a shortfall (running out of money before death) or surplus (not spending all the money during the lifetime). As we mentioned, both a constant-withdrawalrate approach and fixed horizon planning— the most common approaches to assessing retirement withdrawal—leave out important aspects of what is relevant to a real failure or success of the retirement-spending decision. In general, determining the optimal withdrawal strategy is complicated because there are two unknown random variables—life expectancy and portfolio returns—that will have a dramatic effect on how much retirement income will be available. Because of this, no single comparison metric has emerged to compare the competing methodologies of the different strategies. This puts the retiree and financial planner in a quandary because there are a number of strategies retirees can choose among to draw retirement income. Common rules include “draw X% of your initial savings pool,” or “draw Y% of your current, and constantly changing, account balance,” or “draw the inverse of your life expectancy.” The new WER measure can be used to evaluate different withdrawal strategies and thus determine the optimal income maximizing strategy for a retiree. The main idea behind WER is the calculation of how well, on average, a given withdrawal strategy compares with what the retiree could have withdrawn if he or she possessed perfect information on both the portfolio’s market returns and the precise time of death. It is intuitively clear that, given a choice between two withdrawal strategies, the one that on average captures a higher percentage of what was feasible in a perfect-foresight world should be preferred. How We Calculate WER To calculate the WER, we first need to calculate the Sustainable Spending Rate under perfect information of market returns and life expectancy. (We use Monte Carlo simulations to generate both portfolio returns and the times of death.) For each simulation path, the SSR is the maximum constant income a retiree could have realized from the portfolio had he or she known the duration of the retirement period and annual returns as they were to be experienced in retirement, such that it depletes the portfolio to zero at time of death. The SSR is the denominator for the WER equation; it is the constant amount that is feasible to withdraw for a given combination of market returns and death scenarios. (We disregard the bequest motive, which is secondary for most retirees.) To calculate the numerator for the WER equation, we first need to address the problem that most strategies will produce cash flows that fluctuate over time. Even a constant-withdrawal-rate approach may be subject to one dramatic fluctuation when a retiree happens to outlive his or her assets. Therefore, for each series of changing cash flows, we calculate the Certainty Equivalent Withdrawal, based on a standard Constant Relative Risk Aversion utility function: u (C )   C   MorningstarAdvisor.com 67 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2012

Morningstar Advisor - October/November 2012
Contents
Contributors
Letter From the Editor
Ill Communication
Do You Use Factor-Investing Strategies?
Practicing What She Preaches
How to Determine the True Price of ETFs
The Quant Factor
Managers Dispute the Death of Equities
Investments á la Carte
Investment Briefs
Five Inconvenient Truths of Manager Research
Health Care’s Outlook Clarifies
Exploring the World of Factors
Uncloaking the Alpha Machine
Factor Strategies Gain Footholds in Practices
Big Mo
Fitting Factors Into the Formula
Clients Have a Friend in Luther King
Less-Liquid Holdings Mean More-Solid Results
Retirement-Withdrawal Strategies Quantified
Amid Turmoil, Don’t Discount Foreign Equities
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Should I Stay or Should I Go?

Morningstar Advisor - October/November 2012