Tuesday, October 20, 2020

Variable Percentage Withdrawal: Garbage In, Garbage Out

The concept of Variable Percentage Withdrawal (VPW) for retirement spending is simple enough: you look up your age in a table that shows what percentage of your portfolio you can spend during the year.  The tricky part is calculating the percentages in the table.  Fortunately, a group of Bogleheads did the work for us.  Unfortunately, the assumptions built into their calculations make little sense.

If we knew our future portfolio returns and knew how long we’ll live, then calculating portfolio withdrawals would be as simple as calculating mortgage payments.  For example, if your returns will beat inflation by exactly 3% each year, and your $500,000 portfolio has to last 40 more years, the PMT function in a spreadsheet tells us that you can spend $21,000 per year (rising with inflation).

Instead of expressing the withdrawals in dollars, we could say to withdraw 4.2% of the portfolio in the first year.  If the remaining $479,000 in your portfolio really does earn 3% above inflation in the first year, then the next year’s inflation-adjusted $21,000 withdrawal would be 4.26% of your portfolio.  Working this way, we can build a table of withdrawal percentages each year.

Of course, market returns aren’t predictable.  Inevitably, your return will be something other than 3% above inflation.  You’ll have to decide whether to stick to the inflation-adjusted $21,000 or use the withdrawal percentages.  If you choose the percentages, then you have to be prepared for the possibility of having to cut spending.  If markets crash during your first year of retirement, and your portfolio drops 25%, your second year of spending will be only $15,300 (plus inflation), a painful cut.

A big advantage of using the percentages is that you can’t fully deplete your portfolio early.  If instead you just blindly spend $21,000 rising with inflation each year, disappointing market returns could cause you to run out of money early.

Choosing Withdrawal Percentages

One candidate for a set of retirement withdrawal percentages is the RRIF mandatory withdrawals.  These RRIF withdrawal percentages were designed to give payments that rise with inflation as long as your portfolio returns are 3% over inflation.

Unfortunately, the RRIF percentages would have a 65-year old spending only $20,000 out of a $500,000 portfolio.  Some retirees chafe at being forced to make RRIF withdrawals, but when it comes to the most we can safely spend in a year, most retirees want higher percentages.

A group of Bogleheads calculated portfolio withdrawal percentages for portfolios with different mixes of stocks and bonds.  Most people will just use the percentages they calculated, but they do provide a spreadsheet (with 16 tabs!) that shows how they came up with the percentages.

It turns out that they just assume a particular portfolio return and choose percentages that give annual retirement spending that rises exactly with inflation.  You may wonder why this takes such a large spreadsheet.  Most of the spreadsheet is for simulating their retirement plan using historical market returns.

The main assumptions behind the VPW tables are that you’ll live to 100, stocks will beat inflation by 5%, and bonds will beat inflation by 1.9%.  These figures are average global returns from 1900 to 2018 taken from the 2019 Credit Suisse Global Investment Returns Yearbook.  

So, as long as future stock and bond returns match historical averages, you’d be fine following the VPW percentages.  Of course, about half the time, returns were below these averages.  So, if you could jump randomly into the past to start your retirement, the odds that you’d face spending cuts over time is high.  

For anyone with the misfortune to jump back to 1966, portfolio spending would have dropped by half over the first 14 years of retirement.  More likely, this retiree wouldn’t have cut spending this much and would have seriously depleted the portfolio while markets were down.

The VPW percentages have no safety margin except for your presumed ability to spend far less if it becomes necessary.

Looking to the Future

But we don’t get to leap into the past to start our retirements.  We have to plan based on unknown future market returns.  How likely are returns in the next few decades to look like the average returns from the past?

30-year bonds in Canada pay less than 1.2%.  For them to beat inflation by 1.9%, we’d need to have 30 years of 0.7% deflation.  That’s not impossible, but I wouldn’t count on it.  It seems crazy to expect bonds to deliver 1.9% annual real returns in the coming decades.  Bond returns may get back to historical averages at some point, but retirees can’t expect much for some time.

Expecting 5% annual real returns from stocks may be sensible enough, as long as you have a high capacity for reducing retirement spending if it becomes necessary.  If your ability to reduce retirement spending is more limited, you need a safety margin in your assumed stock returns.  For my own retirement spending plans, I use inflation+4% for stocks (minus investment costs) and inflation+0% for bonds.

If we recalculate the VPW tables with these new assumptions, the annual withdrawal percentages drop by nearly a full percentage point.  This may not sound like much, but let’s look at an example of a 65-year old spending from a $500,000 portfolio invested 50% in stocks and 50% bonds.  The “official” VPW tables would have this retiree spending $25,000, but only $21,000 by my calculations.  It’s not hard to see who most retirees would rather believe.


This disagreement over reasonable assumptions makes a big difference for pre-retirees deciding how much money they need to retire.  For the 65-year old in the earlier example wanting to spend $25,000 per year, the Bogleheads say to save $500,000, and I say nearly $600,000.

Clearly I could never make it as a financial advisor.  I’d be worried about protecting people from future spending cuts, and more “optimistic” advisors would scoop up all my clients by telling them what they want to hear.


Even when smart people develop good retirement spending tools, the results are only as good as the baked-in assumptions.  We can’t count on the high bond returns of the past, and it makes sense to have some safety margin in expected stock returns.  As with so many other calculators, if you input garbage assumptions, the results you get out will be garbage as well.

Tuesday, October 13, 2020

Financial Warning Signs

I recently saw the headline Five warning signs you are in over your head financially, by Pattie Lovett-Reid.  I saw it as an opportunity to learn more about how to help people avoid financial trouble.

Here is a summary of her list of warning signs:

  1. You are ignoring your finances.
  2. Your finances are giving you a lot of anxiety.
  3. As soon as you get paid, all of your money is spoken for, with the majority of it going to debt service.
  4. Your creditors are calling non-stop.
  5. You are borrowing from Peter to pay Paul.

I was expecting warning signs that you’re headed in a bad direction, but these seem to be signs that you’re already in serious trouble that will be difficult to fix.  In a similar vein, here are my warning signs that you’ve got health problems.

  1. Most of your blood is on the ground.
  2. You haven’t breathed in a few days.
  3. You’ve been cremated.

My point is that I was hoping for more subtle signs that your finances are heading in the wrong direction.  Catching the problem earlier makes it easier to fix.

Let’s go through some more early warning signs of potential financial problems.

You didn’t pay off all of your credit cards in full last month.

Does this mean all is lost?  Not at all.  It’s just a sign that you’re headed in the wrong direction.  If you’re on a trip and make a wrong turn, all you need to do is turn around; your trip isn’t ruined.

Suppose this is the first time you haven’t paid off your card in full.  The appropriate response is to make a plan to get it paid off.  Look for some way to reduce other spending until you’ve eliminated the credit card debt.

You don’t have any quick access to emergency funds without adding new debt.

If you don’t have an emergency fund, you’ll be fine as long as nothing bad ever happens.  Of course, bad things do happen, such as cars needing repairs, health expenses, etc.  Going further into debt for each of these problems is a formula for eventual bankruptcy.

Don’t despair if you have no emergency savings.  Just start saving a little at a time.  When you have enough of a cushion, stop adding to it.  If you ever have to dip into it, start adding to it a little at a time again.

You are about to sign a many year commitment to big payments.

This is most common when buying cars or houses that are too expensive, but there are other cases.  For example, an insurance salesperson might try to sell you on some complicated mix of life insurance and investments.  As long as you make the big monthly payments for decades, you’ll get millions in your retirement.  But what happens if you can’t make the payments at some point?  The answer is that you’ll lose the car, house, or retirement.  Make sure the payments you commit to are reasonable, even if you end up facing big changes in your life.

I’d be interested to hear about more early warning signs of personal financial trouble.  The idea is that the warning should come early enough to be able to solve the problem without too much pain.

Friday, October 9, 2020

Short Takes: Revisiting the 4% Rule, Vanguard’s new Monthly Income Fund, and more

Sharp-eyed readers might have noticed that I removed ads from my blog.  The income has been dismal for some time, and I was never really doing this for the blog income.  The deciding factor was that so many of the ads I saw on my blog were at odds with my messages.

I started writing because I wanted to learn more about investing and about personal finance in general.  With the help of readers I've made great strides, and I've been pleased to educate others while learning myself.

I wrote one post in the past two weeks:

Rebalancing When There are No Trading Fees

Here are some short takes and some weekend reading:

William Bengen
, author of the original “4% rule,” revisits his work on safe retirement withdrawal rates.  This paper is quite interesting, although it travels significantly into data-mining territory.  Here are a few things I wish he would consider in his analysis: longer retirements than 30 years, investment costs, and flexibility to reduce spending somewhat if necessary.

Canadian Couch Potato answers questions about Vanguard Canada’s new monthly income ETF with the ticker symbol VRIF.  His analysis of VRIF continues in a second post, and in the third he explains the ways VRIF is different from problematic monthly income funds.  In the last post of this series, Canadian Couch Potato explains which types of portfolios are suitable for VRIF.

John Robertson finds some problems with a proposal to try to save money unbundling all-in-one ETFs.

Justin Bender compares the gold ETFs IAU and GLD.  My favourite part came in an example with two hypothetical traders: “immediately after purchasing their shares, Wayne and Garth realize they just bought a hunk of metal that doesn’t do anything.”  I keep waiting for the world to figure out that gold’s price makes no sense compared to its value as a metal, and that the world’s major currencies are no longer backed by gold.  It’s like a huge game of hot potato where whoever is holding the gold when we all wake up loses.

The latest Rational Reminder podcast includes Jordan Tarasoff describing in detail how badly clients were treated at his previous financial advice firm.  The bad advice of the week that follows is entertaining as well.

The Blunt Bean Counter describes how to gift money to grandchildren through RESPs, TFSAs, RRSPs, and your will.

Tuesday, September 29, 2020

Rebalancing When There are No Trading Fees

Index investors usually choose some target allocation percentages for the different asset classes of stocks and bonds in their portfolios.  As markets move, these percentages can wander, so investors need to make trades to get back to their target percentages, a process called rebalancing.  Long-time reader JC asked how rebalancing changes when there are no trading fees.

Younger people with smaller portfolios typically rebalance only when they add new money to their portfolios.  This can be as simple as buying more of whichever asset class is furthest below its target percentage.  Those with larger portfolios can’t always keep balanced with new money; sometimes they have to sell an ETF that’s been rising to buy another that’s fallen behind.  One way to do this is to rebalance based on the calendar, perhaps once per year.  With this approach, having no trading fees makes little difference in how investors rebalance.

More ambitious investors may try “threshold rebalancing,” which means rebalancing whenever asset classes get too far from their target percentages.  This is best done in some automated way, such as with a spreadsheet.  Doing a bunch of calculations by hand every day to see if rebalancing is necessary isn’t my idea of a fun way to live.  In fact, I’ve set up my spreadsheet to email me if I need to rebalance, so I don’t even have to look at the spreadsheet.

Earlier this year, I wrote a post and an associated paper describing a set of rules for choosing rebalancing thresholds.  It’s somewhat complicated, but once coded into a spreadsheet, the complexity is hidden.  However, this work assumes investors pay trading commissions.  What happens when there are no trading commissions?

The first thing to understand is that commissions aren’t the only trading costs.  Traders also have the implicit cost of the bid-ask spread.  If there is a 2-cent difference between the bid price and ask price on a stock or ETF, then, on average, trading costs 1 cent per share.  For large trades, spreads effectively become wider due to the market impact of these big transactions.  The definition of a “large trade” depends on the liquidity of the ETFs you own.

For investors with sub-million-dollar portfolios who stick to popular broad-market ETFs, spread costs can be quite low.  So, if you plug in zero for the commission cost in my formulas, rebalancing thresholds will be narrow, leading to lots of rebalancing trading.

To decide whether this is a good idea, imagine that your spreadsheet tells you to rebalance three times a day.  Right away it’s clear that your time has value.  You might find rebalancing exciting for a little while, but it would feel like a job quickly.  It’s clear that you need to place some value on your time.  Once you get good at rebalancing, perhaps $5 or $10 per trade makes sense.

Another concern with frequent trading is uncertainty in the prices you’re getting.  Markets today are very efficient, but with some markets selling trade data to high-frequency traders or selling the right to make the market for the trade, it’s hard for individual investors to know if they’re getting good prices down to the penny.  If you trade infrequently, this isn’t much of a concern, but these imperceptibly small losses to market sharks add up if you trade too often.  For this reason it makes sense to be conservative in choosing a value for the typical spread on your favourite ETFs to plug into my formulas.

When I did my original rebalancing analysis, I included a factor f, which we might as well call a fudge factor.  I decided that I didn’t want to rebalance unless the expected profit from rebalancing was at least 20 times the trading costs (commissions plus spreads).  In part this is to make sure that I get to keep most of the profits instead of losing them all to costs.  But other reasons to make this factor as high as 20 are to place some value on your time, and to handle some uncertainty in the trading prices you’re getting.

So, in my formulas, you could replace the commission c with c+v, where v is the value of your time for each of the required trades.  You could also choose spread values on the high side for safety.  Then you could reduce the profit factor f to, say, 10.  This wouldn’t make much difference in the original case I envisioned where trading commissions are about $10, but these changes give better threshold levels when commissions are zero.

Something else to keep in mind is that your thresholds are most likely to get triggered in volatile markets, such as the ones we had earlier this year.  During this volatility markets remained orderly, so I went ahead and rebalanced a few times.  But if bid-ask spreads ever get very large, it’s a sign that markets aren’t orderly, and you should be cautious about trading for any reason.

It might seem like a lot of work to understand and implement threshold rebalancing, but it has a positive side effect for me beyond capturing profits during market volatility.  I mechanically follow my spreadsheet’s orders when it tells me to rebalance.  This means buying stocks after they’ve crashed or selling stocks after they’ve been on a tear.  Many investors can’t bring themselves to rebalance at these times, but my spreadsheet’s daily reminders to rebalance are hard to ignore.

Thursday, September 24, 2020

Short Takes: Foreign Withholding Taxes, Financial Happiness, and more

I wrote one post in the past two weeks:

Fortress Fiasco

Here are some short takes and some weekend reading:

Justin Bender brings us his ultimate guide to foreign withholding taxes on ETFs.  Unlike other so-called “ultimate guides” I’ve seen from other financial writers, this one really is comprehensive and useful.

Morgan Housel says being happy financially requires managing your expectations as much as making more money.

Alexandra Macqueen explains what goes into calculating official inflation figures and the controversies surrounding what is and is not included.

Jason Heath
is a Certified Financial Planner who refers to his practice as “advice-only” to try to distinguish his services from those paid by commissions or percentage of assets.

The Blunt Bean Counter explains how large gifts to grandchildren can have some unpleasant tax implications if you’re not careful.