Safe withdrawal rates: The new math

How much Canadian retirees can afford to spend without going broke.

Morningstar Canada 3 March, 2017 | 6:00PM
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Editor's note: The following article is based on a new Morningstar research paper: Safe Withdrawal Rates for Retirees in Canada Today. The paper's co-authors are David Blanchett, Morningstar's head of retirement research; Paul Kaplan, Morningstar Canada's director of research; and Tom Teder, a researcher and business analyst with Morningstar Canada.

Given the heavy reliance by most Canadians on government plans and personal savings to meet their financial needs during retirement, it's important for retirees to have a reasonable expectation of the proportion of their assets they can withdraw safely each year. Commonly known as the "safe withdrawal rate," this is the amount that ensures sufficient capital remains to deliver a similar level of future income.

There are three primary findings from our research. First, while the historical performance of stock and bond markets in Canada has been relatively similar to the global average, future expected returns in Canada, especially in the near term, are likely to be considerably lower. Second, given these lower returns, safe withdrawal rates are relatively low, and may decrease further when incorporating longer life spans and the impact of fees. Finally, a balanced portfolio is likely to be the best asset allocation for Canadian retirees.

Safe withdrawal rates for Canadians are lower today than what would be implied by the frequently cited 4% rule. This rule holds that an initial safe withdrawal rate from a portfolio is 4% of the assets, where the initial withdrawal amount would subsequently be increased annually by inflation and assumed to last for 30 years. While individual circumstances will vary widely, our findings serve as a useful starting point for retirees and their financial advisors.

Our estimations for a a safe initial withdrawal rate rely heavily on return assumptions, and these can vary significantly by country and target success rate. (For the purpose of this study, we define "success" as not running out of money over a 30-year retirement period.)

For example, using the historical returns in Japan, a 95% target success rate would yield an initial withdrawal rate of a mere 0.2%, while for the United Kingdom a 95% target success rate would yield an initial withdrawal rate of 2.8%. U.S. returns have yielded the highest initial safe withdrawal rates across the 20 countries historically, closely followed by Canada. This suggests safe withdrawal rates based on historical U.S. returns may be overly optimistic on a global basis.

While investors are likely to exhibit a home bias when building their portfolios, the impact of the variance in historic returns across countries is likely to be reduced by diversifying internationally.

Another important risk when considering safe withdrawal rates is longevity risk -- the risk of outliving your money. Mortality rates are likely to improve in the future, as they have historically. Consequently, estimates of life expectancy that are based on longer-term historical data are likely to underestimate the number of years someone could expect to live.

As for expected returns, it's impossible to predict the future. What we can do, however, is create a series of long-term returns based on the current prices of assets. While historical returns are sometimes viewed as a simpler path than attempting to forecast returns, we believe using forward-looking returns is the best approach since it incorporates today's market conditions.

Long-term returns for most capital markets are generally estimated to be lower than observed in the last century. This is particularly the case with equities, since above-average valuations in many markets have lowered return expectations. Interest-generating assets are also being affected by lower prevailing market yields.

Portfolios with higher allocations to equities have higher initial withdrawal rates but also tend to have higher risk. Therefore, it's important to balance the potential for a lower initial required savings amount (i.e., higher initial withdrawal rate) with the additional risk incurred during retirement. Most retirees are uncomfortable taking excessive risk in their portfolios. Therefore, it's important to strike a good balance between the two.

Longer retirement periods, higher probabilities of success and more conservative portfolios tend to yield lower initial sustainable withdrawal rates. The actual level of required savings to fund retirement is a very personalized and complex decision where a financial adviser has the potential to add significant value.

How should retirees and financial advisers use this research? First, the assumed retirement period should vary by client. For instance, a 30-year time horizon is ideal for a hypothetical 65-year old retiree who dies at age 95. But based on the actuarial tables, remaining life expectancy at age 65 is less than 30 years (approximately 21 years), so many will die with money unspent. Our simulations with retirement lasting over 30 years resulted in some safe initial withdrawal rates that are relatively low. However, it may be possible to hedge this longevity risk through annuitization.

Most retirees will also not need to spend the same amount every year. For couples, the amount needed per person will be less than for a single-person household. Retirees generally decrease spending as they experience physical and mental limitations throughout retirement, although spending may rise later in life due to medical costs. In addition, most retirees are willing to cut spending a little when markets don't do as well as they'd hoped.

Incorporating variability into spending can increase the safe initial withdrawal rate significantly. The probability of success is only one way to measure outcomes for a retiree. It fails to show the magnitude of the failures early in retirement, and it doesn't consider the security of retirees who live well beyond the 30-year timeframe. By neglecting to consider the magnitude of failure, portfolio risk is increased, leaving retirees vulnerable to adverse market events, particularly those early in retirement.

The results of this analysis suggest that a safe initial withdrawal rate for a heterosexual couple, both age 65, who invest in a balanced portfolio (with 40% equities) with a reasonably high target probability of success (80%), is approximately 3.3% (assuming retirement lasts 30 years).

A 3.3% initial withdrawal rate means retirees need approximately 30.3 times the portfolio income goal. (1/3.3%=30.3). For example, if the retirees wanted $10,000 of income per year during retirement, increased annually by inflation, the required initial balance would be approximately $303,000.

The lower end of the safe-withdrawal range is 2.5% to 3%. The generous capital-market returns of the prior century that bolstered a comfortable and long-lasting retirement portfolio may give 21st-century retirees a false sense of security.

Our paper also highlights how the probability of success can be used to understand potential outcomes. While expected returns are a mid-point operating at the 50% probability of success, our definition of "safe withdrawal" has been calculated in the range of 70% to 99% success. Helping retirees understand the certainty of retirement incomes in this context is an important step to better meeting expectations.

While this analysis provides a useful framework to consider the question of retirement spending, it also highlights the importance of understanding the specific needs and preferences of a retiree in framing investment objectives.

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