Morningstar Advisor - October/November 2012 - (Page 68)
Gray Matters
Exhibit 1 Efficiency of Five Withdrawal Strategies
Withdrawal Rate Efficiency (WER) % Constant Dollar RMD Method Endowment Constant Failure
80 75 70 65 60 55 0
Equity Allocation %
Mortality Updating Failure
20
40
60
We assume a risk-aversion coefficient— gamma—of four to better reflect the riskaverse nature of the retirement planning where failure is penalized more heavily than success. The CEW is the constant payment amount that a retiree would accept such that its utility (their sum, to be precise) would equal the utility of the actual cash flows realized on a given simulation path. The sum of all the CEW payments is smaller than the sum of all the realized cash flows—by the nature of the CRRA utility function, a retiree would give up some of the potential cash flow amount to ensure a stream of unchanging cash flows. This process generates an equal-utility constant withdrawal amount for a given strategy (even if the strategy involves nonconstant cash flows), so the constant-amount equivalent of actual cash flows can be meaningfully compared against the constant cash flows achievable had the retiree had perfect information. Therefore, the per-path WER can be expressed as: WER CEW SSR
Exhibit 2 Comparison of WERs for Various Retirement Ages
Withdrawal Rate Efficiency (WER) % Constant Dollar Mortality Updating Failure
80 75 70 65 60 55 60
Age of Joint Couple
65
70
75
80
Exhibit 3 Initial Withdrawal Percentage for the Mortality Updating Failure Approach for a 40% Equity Portfolio
Withdrawal as a % of Portfolio Balance Male Female Joint
The metric we are going to use is the average of per-path WERs. The higher the average WER, the better the withdrawal strategy. We shall see that for plausible withdrawal strategies the average values of WER typically range between 50% and 80%.
Analyzing Five Withdrawal Strategies
9 8 7 6 5 60 65 70 75 80
Age
For the analysis, a Monte Carlo simulation is created where life expectancies and returns are randomized. Returns are based on a lognormal return distribution. The values are based on the historical returns of the Ibbotson Associates S&P 500 and U.S. Intermediate Government Inflation Adjusted Total Return indexes. For conservative forecasting purposes, the portfolio return was reduced by 50 basis points and the standard deviations were increased by 200 basis points. Four equity allocations were considered for the analysis: 0% equities, 20% equities, 40% equities, and
68 Morningstar Advisor October/November 2012
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?
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