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.

Pre-Retirees


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.

Conclusion

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.