Why Your Withdrawal Rate Matters More Than Your Asset Allocation In Retirement

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By Walter Updegrave, RealDealRetirement @RealDealRetire

Achieving the right balance between stocks and bonds is a key concern for retirees wary of exhausting their retirement savings, especially in a rocky market like this one. But if you really want to make sure you don’t outlive your nest egg, you’ll want to focus even more on choosing an appropriate withdrawal rate.

One of the most frequent questions I get for my Ask RealDealRetirement column from people who are retired or nearing retirement is how much of their savings they should devote to stocks vs. bonds. That’s understandable. After all, if you load up too aggressively on stocks, your nest egg could get whacked with big losses from which it may be difficult to recover. Err too much on the side of caution, and the lower returns you’ll earn could make it harder to maintain your standard of living in the face of inflation.

Setting the right stocks-bonds mix is certainly important. But if you’re looking to ensure that your nest egg supports you the rest of your life, choosing a sustainable withdrawal rate is even more critical. To demonstrate why that’s the case, I ran a number of scenarios on the T. Rowe Price Retirement Income Calculator to see how the chances of a retirement nest egg lasting throughout a long retirement varied with different asset allocations and withdrawal rates.

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Let’s say, for example, you’re 65, have a $1 million nest egg and plan to follow the  4% rule—that is, start with a withdrawal of 4%, or$40,000, and then increase that dollar amount for inflation each year to maintain your purchasing power. If you invest 50% of your savings in stocks and 50% in bonds, the calculator estimates there’s an 80% chance that your nest egg will last at least 30 years.

You might think that investing more aggressively would significantly increase the probability of your nest egg lasting 30 or more more years at the same withdrawal rate, and that a more conservative mix would dramatically reduce the chances. But that’s not the case. In fact, when I plugged in stock allocations ranging from as low as 30% to as high as 90%, the chances of this hypothetical 65-year-old’s nest egg lasting at least 30 years didn’t change all that much, falling between 77% and 79%. Pretty close to a wash.

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Eliminating stocks entirely did reduce the chances significantly—a 100% bond portfolio had less than 60% chance of lasting at least 30 years, and an all-cash portfolio pushed the probability down even further, to 30%. But really loading up on stocks, say, going to 90% in equities, didn’t boost the chances any more than more modest stock allocations of 30% to 60%. That’s largely because increasing stock exposure can be a double-edged sword, helping you when the market is doing well but penalizing much more than more conservative allocations when markets suffer severe setbacks.

In short, even a relatively small dollop of stocks seems to be enough to provide decent assurance against running through one’s savings too soon, while ratcheting up one’s stock exposure doesn’t appear to add a whole lot of additional protection against outliving your nest egg. And, in fact, if you go to a lower initial withdrawal rate, say, 3.5% or 3%, you see much the same effect—that is, very high stock allocations don’t boost the probability that your savings will last and may even slightly reduce the odds (although, of course, the chances of one’s nest egg lasting at least 30 years are higher all around at lower withdrawal rates).

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Higher stock allocations can, however, significantly improve the chances of your money lasting a long time, if you go with a higher withdrawal rate, say 4.5% or 5%. The reason is that bonds have a hard time generating the returns necessary to sustain high inflation-adjusted withdrawal rates. But while higher stock allocations help on that score, there’s a limit to what they can do. For example, a 50% stocks-50% bonds portfolio has about a 50-50 chance of lasting at least 30 years at a 5% withdrawal rate, according to the calculator. Increasing stock exposure to 80% boosts the success rate to nearly 60%—a definite improvement. But a 60% success rate—or, 40% chance of running out of dough— probably doesn’t provide the sort of comfort most retirees seek.

A couple of caveats. The scenarios I’ve outlined above look only at survival rates, or how long a portfolio is likely to last. But that’s just one side of the coin. There’s also the issue of how much of one’s savings will remain if assets aren’t depleted early on. And in cases where portfolios survive, the ones with more stock exposure will generally have much higher balances late in retirement than more conservative ones. If you’re looking to leave money to heirs or would just like a larger cushion later in life, it could make sense to boost your stock allocation, although the more you rely on stocks, the more your portfolio (and probably you) will suffer during inevitable downturns and bear markets. And if you happen to get hit with big losses early in retirement, your nest egg could have trouble recovering from the combination of withdrawals and investment losses.

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Keep in mind too that given the many uncertainties and unknowns involved in any forecast—future investment returns, the timing and severity of market setbacks, inflation rates, levels of volatility, etc.—no person or financial tool has a clear view of the future. So consider the figures above estimates of what might happen, not predictions of what will. You should also stay flexible about adjusting withdrawals up or down throughout retirement based on market conditions and your spending needs. (And if you would like extra assurance that you’ll have spending cash coming in regardless of how the markets perform, you can always invest a portion of your savings in an immediate annuity or longevity annuity.)

That said, there’s an important takeaway here. As long as you adopt a reasonable initial withdrawal rate—say, 3% to 4%—you should have plenty of leeway for choosing a stocks-bonds mix you’ll feel comfortable with throughout retirement. I suspect that an acceptable stock allocation, at least in the early stages of retirement, will fall somewhere between 40% and 60% for most retirees, but you can get a sense of what’s right for you by completing a risk tolerance-asset allocation questionnaire like the free version Vanguard offers online.

So when you’re creating your retirement income plan, remember: the rate at which you draw spending cash from your savings will have a bigger effect on how long your nest egg will support you than how you invest it. (1/31/16)

Walter Updegrave is the editor of RealDealRetirement.comIf you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com. You can tweet Walter at @RealDealRetire.

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