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You've entered the area of "Concepts" for Financial Planning strategies. Click on the links below to go to a topic of interest. Your Portfolio's Initial Withdrawal Rate Retirement Calculator Disasters including:
Constructing Tax Efficient Portfolios - This is an advanced discussion of the topic including: Your Portfolio's Initial Withdrawal Rate I first read about the initial draw-down study by Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz from Trinity University in Texas several years ago. They studied the "success" rates of various portfolio withdrawal rates over numerous historical time periods using differing mixes of stocks and long-term high-grade corporate bonds. ("Success" in this context meant whether a specific withdrawal rate avoided complete depletion of a portfolio during the owner's lifetime.) The initial withdrawal rate was simply the amount withdrawn from the portfolio as a percentage of the total portfolio. When adjusting the initial year's withdrawal for inflation and deflation, the study determined that only initial withdrawals rate of less than 5% had a reasonable chance of success. Inital withdrawal rates above 5% often result in total use of the investor's funds in the vast majority of cases. How this relates to your retirement calculator software is critical to identifying the liklihood of success. Some questions you might ask:
With Lifetime Planning Concepts' own proprietary software, we calculate projected draw-down for each of the first five years of retirement and every fifth year thereafter. If retirement calculator software does not quantify your initial draw-down rate, you miss an early warning sign of the importance of overshooting your targeted needs. You may also miss the early warning signs of a desired shift in portfolio allocations. Back to top of page Averages are used everywhere to explain key investment fundamentals. We have become so numb to the use of averages that financial projections often use average returns for asset classes in a portfolio without any question as to their likelihood of success. If your projections had a 50% chance of success, I expect you would suggest that's not good enough. Let me say this clearly: averages are for people with 2.2 children. The rest of us should plan for higher than projected accumulations in order to increase our success rates. We should also construct draw-down strategies to reduce retirement portfolio risks. You should use caution with averages when you estimate life expectancy - actuarial tables are generally not appropriate because they measure the age at which half of the population would not have survived. Your plan wouldn't work too well if you were in the 50% that outlived the life expectancy tables. We should use averages with caution when we choose rates of return as well. I did my own research. I started with data ending in 1973 and years forward to include the worst bear market and best bull market in recent history. The rolling period returns were of portfolios comprised of differing percentages of two asset classes: the S&P 500 and the Lehman Brothers Aggregate Bond Index. Eleven mixes ranging from 100% stock to 100% bond portfolios in 10% change increments were used. All rolling period returns were stratified to determine the likely failure of a portfolio using different rates of returns over different time periods. Starting with 1973 as the first rolling period end point, I looked at all 26 rolling period returns ending in years 1973 through 1998. My study included 5,10, 20, 30, and 40-year rolling period returns. What I found may shock and scare many investors whose plan rested on average returns. The failure of achieving average rates of returns included a high likelihood of failing to achieve a 10% return with a 100% stock portfolio. Few would expect that over a 20-year pay-out period the 100% stock portfolio has had a 55% likelihood of failing to achieve 10%. The research also suggests that an 80% stock - 20% bond portfolio would fail to achieve a 10% average return 61% of the 20-year periods, 76% of the 30-year periods and 46% of the 40-year periods. Consider further that these average returns are gross returns of the markets, prior to costs of acquiring and maintaining the funds used by most investors or the transaction costs incurred from the high turnover of those same funds. In spite of the evidence above, financial independence software routinely makes projections using average gross rates of return for major asset classes, leaving users blissfully unaware of the high probability of failure. For whatever reason, it seems to be human nature for all of us to assume that we can beat the average, when in reality that is impossible. If we all make up the average, then some will be above and some below. Investors using long-term average gross returns in their financial independence projections feel comfortable doing so because of recent stellar years' returns. The thought of below-average returns does not seem to enter most investor's minds. The Constant Rate Return Bombshell As bad as the use of averages is, another perhaps more sinister projection error is the use of constant rates of return. Yet most financial independence software assumes a constant rate of return throughout the plan projections. Some software allows the user to enter a different constant rate of return for before and after-retirement assumptions. In either case, like an insurance illustration, such projections are not realistic and do nothing to reinforce the notion of market risk. The constant rate of return assumes that the investor will receive a projected compound return over a period of time even though it is "understood" that returns may vary wildly along the way. Documentation supporting the projections, however, reflect constant returns year in and year out without real world variations. This projection of a constant rate of return is a graphic display that ignores the volatility of the markets in order to derive a "reasonably accurate answer". But is it reasonably accurate? You may be aware of market volatility and feel educated about the risks involved in your portfolio, but the graphic display of the retirement projection shows no volatility and thus understates the risk of the strategy. Constant rate of return projections can result in significant understatements of required investment funds. Draw-down creates a change in the way we view risk. The long range compound returns that are the basis for the software "averages" are less significant during draw-down because the terminal values may depend more on the withdrawal rate and year by year performance than the annual compound rate of return. In other words, the expected 40-year return of 11.3% is useless if you run out of money after 20 years. Losses that would recover during accumulation years are impacted significantly by draw-down. It is the combination of losses with draw-down that makes constant rate projections so useless. It is well known that a loss of 10% requires an 11% gain to breakeven. A loss of 25% requires a gain of 33% and a loss of 50% requires a gain of 100% to breakeven. This is simple math and works with amazing accuracy as long as draw-down doesn't exist. When we inject an 8% draw-down into a portfolio with a 12% loss, the return required to restore the portfolio to its beginning balance increases from 13.6% to 25%. Knowing a portfolio's draw-down rate will have more impact on a portfolio's fixed income allocation than any rule of thumb invented or any risk measurement system created for retirees. The ideal financial independence software would allow a variety of "real world" historical returns to be substituted for a constant rate of return over the life of the projection. Lifetime Planning Concepts' software allows me to present the impact of different portfolios over historical time periods each consisting of returns for up to 45 years. The different portfolios within our "Profile Builder" module allow me to inject the uncertainty of market returns on a client's projected portfolio. What was originally a single projection using a constant rate of return now is a multiple scenario presentation with wildly different results. We call our software "Financial Freedom Solutions". Our "Profile Builder" module uses actual returns from a variety of portfolio mixes over any time period starting in 1926 and later. Avoiding the Disaster - Strategies for the Future! The advantages of substituting "real world" historical returns in place of constant rates of return include: Using real world portfolios to illustrate financial freedom probability eliminates the use of "average" returns, by substituting multiple real world scenarios. By eliminating averages, the anesthesia that lulls investors into viewing retirement projections as fixed targets is removed. Rather, by substituting different scenarios, volatility of the markets becomes obvious and you can better prepare yourself to solve your cash flow needs without the adverse impact that draw-down can create. Projections that use average life expectancies or average constant rates of returns leaves the user with an impression of certainty that is not supported by the facts. Sensitivity analysis of the key assumptions used is essential to put projections in their proper perspective and to encourage adequate accumulations. As gains from the 1990's bull market piled up, investors became increasingly aware of the importance of tax efficiency in their taxable accounts. At the same time, the mutual fund industry engaged in active trading (some would say, excessive trading) of portfolios resulting in very high turnover of the stocks within the funds. In addition to the increased costs that trading incurs, the annual recognition of taxable income significantly impairs wealth accumulation. Investors need to understand the impact that tax efficiency can have on their portfolio and the underlying principles that make it work. Two age-old tools for tax efficiency still apply; conversion and deferral. Conversion is the process of changing or converting the character of income from ordinary to capital gain. The purpose of the conversion is to lower the tax rate from a high of 39.6% to 20% or lower. Rather than investing taxable funds in interest or dividend paying investments, conversion suggests a tilt towards growth. If held more than one year, an asset that increases in value 6% and is then sold would realize 4.8% after-tax. An alternative investment that paid 6% interest with no growth would result in only a 3.6% after-tax return because of the higher ordinary tax rates. Deferral is the concept of delaying tax payments until a future event. Tax deferrals can arise from two methods. The first is to create a "growth oriented" portfolio that controls or minimizes the selling of appreciated assets. The more common method is to use congressionally sanctioned "deferral devices". "Deferral devices" include IRAs, 401(k)s, employer retirement plans and tax-deferred annuities. These devices allow tax deferral, even when income is paid or an appreciated asset is sold. "Deferral devices" however, carry negative baggage that must be understood in order to create the most tax efficient portfolio. Those negative issues are discussed at Deferral Device Demons. Tax deferral can also be achieved in taxable funds with a well planned tax strategy that considers turnover of investments. Since tax deferral is an important factor in greater wealth accumulation, a discussion as to which assets are best suited to be held inside "deferral devices" and which are best held outside "deferral devices" is important. One viewpoint suggests that because common stocks provide higher returns, they should be held within "deferral devices". This so called, "excess return advantage" is called the "equity risk premium". The argument suggests that if deferral of 6% returns is good, deferral of 10% returns is better. In a sense, this theory suggests by exposing the lower return asset classes to taxes, the result is lower taxes and larger accumulations. Thus the easy argument is to put lower return fixed income assets in taxable accounts and higher return stock investments in "deferral devices". This viewpoint is most likely true for investors who make little or no effort to create tax efficiency in their taxable accounts. Nevertheless, "deferral devices" demon's must be considered before they are used without first considering other tax efficient strategies. When Congress granted tax deferred status to IRAs, employer provided retirement plans, 401(k)s and tax-deferred annuities they added some profoundly negative factors. Effective tax rates Go to Effective Tax Rate Table
Assumed 7% Discount Rate After forty years of 5% annual gain recognition, the effective tax rate is reduced to 17.38%, only 69% of the converted rate alone. The benefits of deferral can be fleeting however, with slight increases in the gain recognition rate. By the time 25% of gains are recognized annually, little additional tax rate advantage exists after 20 years (22.84% after 20 years compared to 22.34% after 40 years.) An 80% gain recognition rate offers little deferral benefit at all. It is clear that in order to create a tax efficient portfolio, low turnover is a must. This means that typical mutual funds are not tax efficient and should be used inside the "deferral devices" whenever possible. Individual managed accounts or the use of index funds is the only way to create a tax efficient portfolio for taxable accounts. The following two tables look at a portfolio of 50% stocks and 50% bonds. The stock portion is held in taxable accounts and the bond portion is held inside "deferral devices". The first table reflects the impact on returns during the build-up years while the second table reflects the same portfolio during draw down. The two differ because draw down triggers gain recognition on the cash withdrawn, reducing after-tax returns. The results of these tables can be compared to the reverse mix, that is the stocks inside the "deferral devices" and bonds held in taxable accounts. In that case, the build-up returns totaled 7.9% after-tax and during draw down 5.93% after-tax.
For purposes on my study, the estimated average after-tax return when stocks are included inside "deferral devices" and bonds in taxable accounts is 7.9%. That structure suggests conservative portfolios benefit more from stocks held inside retirement accounts or other deferral devices during the accumulation years. During draw down, however, the same portfolio performs lower at 5.93% when stocks are held inside the deferral devices. This is because of the reverse conversion rules that penalize deferral devices by taxing all withdrawals including long-term gains as ordinary income. This assumes that withdrawals are required and actually taken. From this I conclude that a 50/50 stock/bond portfolio would most likely be better off with the stock portion in taxable accounts and the bonds in "deferral devices". I then looked at a more aggressive portfolio (70% stocks/ 30%bonds) that had an estimated average after-tax return of 9.34% when stocks were held inside "deferral devices and bonds in taxable accounts.
My conclusions are summarized in the following table where I isolate the impact of five different variables.
In addition to the broad general rules in the table above, I suggest the following be included in "deferral devices" when available: Conclusions In my opinion, real world portfolios require more flexibility than academic studies allow for. For example, if one took the position that all stocks should be held outside of deferral devices, annual rebalancing would likely result in gain recognition faster than the 25% maximum turnover rate since there are no stocks in tax-deferred accounts to sell. Similarly, if all stocks were held inside "deferral devices" the allocation would be incompatible with a portfolio nearing the required minimum distribution date, since stable liquidity is required. It seems to me, any allocation should strive to minimize tax impacts from annual rebalancing because that's the pain we currently feel. During build up years this can be accomplished with new money, but during drawdown years rebalancing requires selling something. Any conclusions can be affected by the following possible change in circumstances. |
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