The Current Annuity Factor and Safe Withdrawal Rates

[Kevin K.]

There's a very interesting discussion of this article in Bloomberg over on Bogleheads right now that was started by a guy who knows the world of pension and liability matching investing really well. Here's he link to the article that's the basis for the discussion:

https://www.bloomberg.com/opinion/articles/2021-05-14/retirement-savings-may-not-go-as-far-as-you-think

The key points here that I think should be of particular interest to those in or planning on ER has to do with approaches like the 4% SWR and other strategies (up to and including McClung's Prime Harvesting approach, which was discussed recently on this board) not taking into account negative real returns on safe bonds of all durations.

It's all-too-easy to be either optimistic about or overly concerned by the run-up in equities since last March's brief but severe meltdown while missing the fact that interest rates since then have declined to unprecedented levels and may well stay there for years.

Another take-away which is discussed in more detail on the Bogleheads post (see link below) is that in retirement it's having the assets to match your liabilities that matters, not stability vs. volatility of the portfolio or even growth rate. And matching liabilities with risk-free assets means owning a boatload of TIPs - not an easy pill to stomach given their current negative nominal and real rates of return.

If nothing else good food for thought and a useful bookend to the "100% VTSAX and forget it" stuff that still has a lot of adherents.

https://www.bogleheads.org/forum/viewtopic.php?f=10&t=349648&sid=1c984f89a64ada695966cb1aed3d31a6

[bacchi]

How can TIPS have a negative real return? They're literally tied to CPI and were set to 3.54% last month. At worst, without any fixed rate, they would hold their value and equal inflation.

Edit: I was thinking of I-bonds. Nm.

[windytrail]

How about just piling up cash so that you have a few years' worth before pulling the retirement trigger, with the rest in equities?

Then if we face a prolonged downturn, you can (a) spend only 4% of the current value of your portfolio annually and take up part-time work to cover the rest, first drawing down cash before selling any stock; and/or (b) lower expenses as much as possible

Why exactly does the early retiree need to invest in a lot of bonds or TIPs?

[bacchi]

The key points here that I think should be of particular interest to those in or planning on ER has to do with approaches like the 4% SWR and other strategies (up to and including McClung's Prime Harvesting approach, which was discussed recently on this board) not taking into account negative real returns on safe bonds of all durations.

FYI: Prime Harvesting is about the withdrawal strategy and not about the percentage withdrawn. That is, it's about what and when to sell and when to rebalance.

One could use an inflation-adjusted SWR with Prime Harvesting as easily as a VPW (variable percentage withdrawal).

[BicycleB]

How about just piling up cash so that you have a few years' worth before pulling the retirement trigger, with the rest in equities?

Then if we face a prolonged downturn, you can (a) spend only 4% of the current value of your portfolio annually and take up part-time work to cover the rest, first drawing down cash before selling any stock; and/or (b) lower expenses as much as possible

Why exactly does the early retiree need to invest in a lot of bonds or TIPs?

Inflation. Cash loses buying power due to inflation.

So there's a tradeoff. TIPS at rates negative compared to inflation might strongly outperform cash for "a few years".

Example: 2% inflation x 3 years = 6% lost value in cash. TIPS that got nominal 1.5% annually during the same time would lose 1.5% of buying power value (half a percent times three years) but beat cash by 4.5%.

Regular bonds might also beat cash, but the details are different. TIPS vary based on inflation, giving shelter to that factor - in exchange for rates that are usually lower than regular bonds. Regular bonds often beat TIPS, therefore beating cash even more.

That said, bonds (including TIPS) also can gain or lose value due to changes in interest rates. Depending on events, this could mean that bonds and TIPS perform better or worse than cash during a specific period. Cash avoids this uncertainty, but at the expense of most often losing value due to inflation.

Holding cash could be viable, but often is non-optimal. Tradeoffs!

[Kevin K.]

The key points here that I think should be of particular interest to those in or planning on ER has to do with approaches like the 4% SWR and other strategies (up to and including McClung's Prime Harvesting approach, which was discussed recently on this board) not taking into account negative real returns on safe bonds of all durations.

FYI: Prime Harvesting is about the withdrawal strategy and not about the percentage withdrawn. That is, it's about what and when to sell and when to rebalance.

One could use an inflation-adjusted SWR with Prime Harvesting as easily as a VPW (variable percentage withdrawal).

Sorry I should have been clearer about what I was referring to in McClung's excellent book. Prime Harvesting is an innovative (albeit somewhat complicated) withdrawal method but the book itself is entirely based on historical asset returns - including a lot of data for specialized assets (e.g. small-cap value, emerging markets and other "tilts") which haven't been investable assets long enough for the data to mean much. Meanwhile he also fails to even address gold, despite that fact that including 5-15% of it in most of the portfolios he features greatly improves SWR's while mitigating sequence-of-returns risks (but at least you can play with that on Portfolio Charts).

Specifically though his recommendations and return estimates fully reflect the 40+ year bull market for bonds which is now over, and his baseline recommendation is a full 50% in bonds: 50% TIPS, 25% each short-term and intermediate Treasuries. The current yields on those bonss are -.85%, .04% and .81% respectively. So - getting back to the article I posted - all of the return for his portfolios going forward have to come from equities, and as we know with valuations (especially in the U.S.) being very rich it'd be unrealistic to plan on much more than 2-4% real from them.

The clear take-away from the article for those still working is save more and work longer, and for those in retirement or contemplating it to be able to do so with much lower withdrawal rates - perhaps 3% (not adjusted for inflation) max, until and unless bonds start offering a real return.

[ChpBstrd]

From the Bloomberg article:

People nearing retirement typically have about 40% of their retirement savings in the stock market.

A 40/60 portfolio?!

I think people nearing retirement should consider not allocating 60% of their portfolios to asset classes like treasuries that will, with near certainty, yield lower than the rate of inflation. The old advice about 60/40 portfolios came along in a time when one could earn about a +2% real return on risk-free bonds, and more like +4-5% on corporates. Those real returns went a long way toward supporting a 4% WR back in the 20th century when the Trinity study was done. The 60/40 doesn't even look all that attractive in historical simulations like portfoliocharts.com, using data from more favorable times for bonds.

https://www.multpl.com/10-year-real-interest-rate
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=realyield

We're just going to have to accept that the world is different now, and a bond-heavy FIRE portfolio is not going to last 30 or 40 years under current conditions. In fact, such a portfolio will, with certainty, blow up if interest rates revert back to normal levels, because of bond convexity.

There are a lot of ways to deal with Sequence of Returns Risk (SORR) without the dead weight and duration risk of bonds. One such strategy is the "collar". Another is the "protective put". Either of these will underperform a rising stock market to some extent, but they also will prevent large and sudden drawdowns of a stock-heavy or all-stock portfolio.

https://www.optionseducation.org/strategies/all-strategies/collar-protective-collar
https://www.optionseducation.org/strategies/all-strategies/protective-put-married-put?source=3127f1e6-8969-41c7-a0eb-50a711cc9195

Avoiding significant damage during a risk event like 2000 or 2008 is the key to portfolio durability, not loading up on TIPS yielding 1% and then withdrawing at 4%+inflation. The strategies above can make a 100% stock portfolio have the volatility of a 50/50, and with a firm floor on potential losses.

[ericrugiero]

There are a lot of ways to deal with Sequence of Returns Risk (SORR) without the dead weight and duration risk of bonds. One such strategy is the "collar". Another is the "protective put". Either of these will underperform a rising stock market to some extent, but they also will prevent large and sudden drawdowns of a stock-heavy or all-stock portfolio.

https://www.optionseducation.org/strategies/all-strategies/collar-protective-collar
https://www.optionseducation.org/strategies/all-strategies/protective-put-married-put?source=3127f1e6-8969-41c7-a0eb-50a711cc9195

Avoiding significant damage during a risk event like 2000 or 2008 is the key to portfolio durability, not loading up on TIPS yielding 1% and then withdrawing at 4%+inflation. The strategies above can make a 100% stock portfolio have the volatility of a 50/50, and with a firm floor on potential losses.

I'm not really familiar with the protective put option but it makes sense.  As I understand the article, you pay a fee to gain the option of selling when the shares drop to certain point.  This limits the loss you can experience.  The fee is a drain on your gains and you could lock in some losses but they are limited.  The upside is that you can keep more money invested in stocks so your long term gains "should" be higher.  Am I understanding that right?  Can this be done on funds like VTSAX or just on individual stocks? 

This protective put option doesn't make any sense for me right now in the accumulation phase (I'm trying to maximize gains and I'm not worried about short term dips because I won't sell) but I could see the benefit of using it to limit SORR risk.