After a strong 2017, financial markets took investors on a turbulent ride during the first quarter of 2018. Following its first correction since 2016, the S&P 500 index of large U.S. stocks quickly recouped losses and finished the quarter only slightly negative on a total return basis (‐0.8%). Most major market indices were a bit lower, with the real estate securities index experiencing the largest decline (‐5.8%). The increased volatility was attributed to several economic and geopolitical developments, including the President’s proposed tariffs on China and other U.S. trading partners, concerns about inflation, and lingering uncertainty over the Federal Reserveʹs plan for interest rates. Although the uptick in market volatility has dominated financial media headlines, the fundamental macroeconomic backdrop has not changed materially and remains quite positive. Almost all of the world’s large economies are growing simultaneously for the first time in many years. In the U.S., corporate earnings are growing at a healthy pace, inflation is still historically low, and tax reform is generally viewed as favorable for corporations and many individuals.

Asset class returns for the quarter were as follows:

 

Index

Asset Class

First Quarter 2018

Barclays U.S. Govt./Credit—Intermediate

Fixed Income

‐1.0%

S&P 500

Large U.S. Stock

‐0.8%

Russell 2000

Small U.S. Stock

‐0.1%

MSCI ACWI ex‐USA

Foreign Stock

‐1.2%

S&P Global REIT

Real Estate Securities

‐5.8%

 

Of course, risk and volatility are omnipresent in financial markets, and changing asset prices affect all of our portfolios on a daily basis. This can lead to a great deal of uncertainty as to how much one’s portfolio will appreciate in the future. With our many clients who are retired or are nearing retirement, we have conversations every day about appropriate and sustainable levels of spending from their portfolios. Not surprisingly, we have observed that spending — in the form of portfolio withdrawals — seems to creep higher when the stock market is rising and less turbulent. But what level of portfolio spending is truly sustainable and practical over the long term, given good and bad market conditions?  We would like to use this quarter’s letter to give a brief overview of the concept of safe withdrawal rates, as well as to review some of the important factors to consider when developing a long‐term spending plan.

What is a Safe Withdrawal Rate?

In financial planning circles, the “4% Rule” is a well‐known approximation of the amount investors can safely withdraw over a 30‐year time horizon and still have a very high likelihood of not outliving their portfolio. The seminal research behind this rule‐of‐thumb was published in 1994 by a now‐retired San Diego‐area financial planner and researcher, William Bengen.

Bengen’s study concluded that an investor can withdraw 4% of a well‐balanced portfolio (split between high‐quality stocks and bonds) each year, adjusted annually for inflation, with a very high probability of not running out of money. An example of the 4% Rule in the context of a portfolio is outlined below:

If an investor begins retirement with a $2 million portfolio at the age of 65, he or she can safely withdraw $80,000 in the first year (4% x $2 million), $81,600 in year two, $83,232 in year three, etc., increasing each year with inflation (assumed to be 2% in this example). The investor would have a constant withdrawal stream of $80,000, adjusted for inflation, at least until the age of 95, with the potential for the portfolio to continue growing.

The 4% Rule is a very good starting point. At Dowling & Yahnke, we have used it for many years as an initial “back‐of‐the‐envelope” way of evaluating whether a client or prospective client’s spending ambitions were realistic given the dollar value of the resources at his/her disposal. However, it is important to realize that the backtesting and validation of the 4% Rule were done in an era of generally attractive stock and bond market returns. There are numerous variables to consider when using the 4% Rule as a guide for long‐term retirement spending.

A 30‐year retirement period may not be long enough for early retirees or those with greater longevity. Bengen’s study estimated retirement as a 30‐year period, which probably seemed like a reasonably conservative assumption at the time. With improvements in health care, however, life expectancies have continued to lengthen, particularly for those with higher levels of education and income.  Consider that for a 65-year‐old couple, there is a 49% chance that one will live to age 90, and a 20% chance that one person lives beyond age 95. (Sources: JPMorgan Guide to Retirement, Social Security Administration Period Life Table, 2014.) Centenarians (those living to 100) are becoming more common.

Retiring early can also extend your planning horizon significantly. If you retire in your 50s, you may have 45‐plus year retirement period for the portfolio to provide for your spending goals.

What does this imply? The longer the anticipated retirement timeframe, the more serious consideration should be given to a lower initial withdrawal rate. An early retiree may want to err on the conservative side of the safe withdrawal rate scale, with 3.0% or 3.5% being more appropriate than the traditional 4.0%.

Future portfolio returns may be lower than historic norms. As we discussed in our first quarter 2017 letter, we believe future returns on both stocks and bonds are likely to be lower than historical averages, and almost certainly lower than the outsized market returns of the past several decades. In fact, when the original 4% Rule study was completed in the mid‐1990s, the assumed returns were approximately 10% for stocks and 5% for bonds. Many experts are predicting annual returns over the next 10 to 20 years to be 2% to 3% lower for both stocks and bonds. Today, with the benchmark 10‐year U.S. Treasury bond yielding just 2.7% and the S&P 500 trading above its historical average price‐to‐earnings multiple, investors should be wary of overly optimistic portfolio return assumptions over the coming decades.

Portfolio asset allocation (the mix of stocks and bonds) matters. In Bengen’s study, a 50% to 75% allocation to stocks was assumed for the duration of the 30‐year period. A higher allocation to stocks might increase the longevity of the portfolio and the future portfolio value but would likely produce a bumpier ride with more volatility along the way. Conversely, a bond‐oriented portfolio with less than 50% allocation to stocks may be tempting because of the lessened volatility but could shorten the longevity of the portfolio given the potential for spending and inflation to outpace the portfolio’s lower expected returns.

Taxes must be taken into consideration when contemplating safe withdrawal rates and managing portfolios. For the sake of simplicity, Bengen’s original 4% Rule ignored income taxes, as investors do not have homogeneous portfolios. In other words, under the 4% Rule’s logic, an investor would need to cover any taxes due out of their 4% withdrawal each year. In reality, the higher an investor’s income tax rate, when taking out taxable dollars (i.e., withdrawing from tax‐deferred IRA accounts), the greater the portion of the annual withdrawal that will go to pay taxes rather than retirement expenses. Additionally, large unrealized capital gains in taxable accounts create a similar drag when withdrawals are needed from the portfolio, and gains must be realized to create cash for those withdrawals.

Required Minimum Distributions (RMDs) further complicate a retiree’s spending rate since a percentage of tax‐deferred accounts must be taken out each year. These tax issues can create a vicious cycle in which investors withdraw their targeted “spending” money, then need to take out additional dollars to pay the taxes due on the original withdrawal, then need to pay additional taxes on the incremental withdrawals, and so on. The end result is that total portfolio withdrawals far exceed the targeted spending rate and may be much greater than what is considered sustainable over the long run.

Spending is almost never constant in retirement. It is unrealistic to expect retirees to calculate exactly 4% of their initial portfolio value and make consistent withdrawals each year for 30 years. It is more likely that withdrawal rates will be dynamic in nature, as an individual’s or couple’s spending changes. A very high spending rate in the early years of retirement can have a detrimental effect on portfolio longevity, especially when coupled with a bad sequence of market returns. Conversely, a low initial spending rate coupled with a good sequence of stock market returns can allow for higher spending in later retirement years (e.g., an investor who retired in 2009, then benefitted from eight‐plus years of healthy stock market returns). It is worth noting that one of these key success factors (spending rate) is very much under the investor’s control, while the other (sequence of market returns) is unequivocally not.

Legacy goals may change spending and allocation. If creating a legacy for heirs or leaving a bequest for charity is the primary goal of the portfolio, then the withdrawal rate will likely need to be lower to allow for long‐term growth in the portfolio. For example, a married couple who takes just a small amount of portfolio income and wants to leave a large bequest to their children will have a different withdrawal rate and portfolio allocation than a couple who is entirely reliant on their portfolio for income.

So, what is the appropriate safe withdrawal rate for you and your portfolio? As with most financial planning topics — it depends. Your goals and the unique aspects of your portfolio (The mix of taxable and tax‐deferred assets) will affect the sustainable withdrawal rate. A 4% withdrawal rate is a good, practical starting point, but may not be ideal or realistic for every investor. Other sources of income, such as Social Security, pensions, or business income, will factor into how much one is able to spend in retirement. In the end, no two situations are exactly alike, and every retirement discussion benefits from a tailored investment plan that can be followed in both strong and weak market environments. Please feel free to contact us to discuss your unique situation.

Finally, the Securities and Exchange Commission (SEC) requires all registered investment advisors under its supervision, including Dowling & Yahnke, to provide clients with an annual summary of specific and significant changes that have occurred within the past year. As such, we are enclosing with this letter our ADV Part 2A, Item 2: Material Changes. A complete copy of our most recent ADV is available upon request or may be obtained by visiting our website at www.dywealth.com.

We thank our clients for their continued trust and support. We hope your year is off to a great start and welcome you to contact our team with any questions or concerns regarding your finances.