Were you expecting an article about a particularly frugal birth-control method? Sorry to disappoint you, but today we’re going to be looking at how much you can safely spend in retirement – the safe withdrawal rate. And in particular I’ve not seen anything on the special secret techniques that Actuaries use to evaluate this.
Last week I saw a tweet that basically said that a popular personal finance blogger was approaching early retirement and confident that a 2% withdrawal rate would be safe. Let’s use some super-secret actuary techniques to tease out whether this really could be safe.
There is an enormous amount of commentary around the FIRE community about the 4% rule of thumb. This is the idea that if you withdraw 4% of your nest egg each year, then you should be able to enjoy that annual income for the remainder of your life. So withdrawing only half that amount of 2%, should be super-duper safe right?
Well here at Actuary Towers we like to put things under the microscope and… hang on, stop! Here we like to do things differently. We should use the microscope backwards, or even throw the microscope away and try analyzing it with different instruments. Perhaps instead of looking at it through a microscope we’ll look at it through some eclipse glasses and see if that gives us some new inspiration…
Come on guys less chatter, we need to get to work!
Testing the Claim
There are essentially three ways to test the credibility of a safe withdrawal claim, one of these methods looks backward, and two look forward.
- Back-testing with historical data
- Monte Carlo simulations of future scenarios
- Financial economics
#1 has been covered numerous times in many great studies, and the result seems to be that over many historical periods a 2% withdrawal rate would be safe.
#2 just gets me all riled up. So let’s leave that until another day as I’ll just get grumpy and you don’t want to read an angry post do you?
#3 is the secret Actuary method. It sounds scary huh? And at this point I’ve now lost half my readers. But for the three of you remaining, if you enjoy this half as much as I do, then you are in for a treat!
Financial economists say that you don’t need to make up a load of assumptions about risk and return since market pricing will tell you all you need to know. For example you don’t need to estimate the price of a new lawn mower by back-testing previous pricing, or projecting out economic scenarios and developing complex mathematical models to predict lawn mower prices. You simply go to Home Depot and look at the market price. That is the price at which many lawn mower suppliers and many potential lawn mower buyers have agreed is the price at which they are willing to do a deal. You may not agree with that price, and you may claim that due to the Fed the price has been manipulated to unreal proportions – but it is what it is.
It’s the same with the financial markets. If I want to evaluate the risk in providing a 2% per year income, then I need to search
Home Depot the financial markets for a financial instrument that pays 2% per year above inflation. I can then look at the risk of that particular security to tell me how risky that income stream is.
Risk Free Return
The starting point in financial economics is to establish the risk-free return. This is the return that you can be certain to achieve. You might think that Berkshire Hathaway stock is risk-free, but it’s not. In fact no stock is risk free, there is always the risk of the company folding. For example only one of the original twelve Dow Jones companies is still in the index. So the risk free return is generally assumed to be the return you can get on Government Bonds, or “Treasuries”.
To achieve a 2% safe withdrawal rate we really need to generate a return of 2% in excess of price inflation, i.e. a real return of 2%. This will preserve the real value of capital and generate sufficient income every year to live on.
So ideally we need a Government bond that will pay a 2% real return for a lifetime. If only we could find that then we would be done. But it does not exist.
The nearest security we could consider is the TIPS (Treasury Inflation Protected Security), and I can tell you that a 30 year TIPS is yielding about 0.9%. So if we bought a load of 30 year TIPS bonds with our savings we could generate a real return of 0.9%. So I would say that a 0.9% safe withdrawal rate is super-super-safe. [Your only risk is Government default, and re-investment risk at 30 years.] However I’m not sure that many of you are targeting a safe withdrawal rate of 0.9%, and our target was 2%, so we need to press on.
We now know that the market is pricing the risk-free long term real return at 0.9%. This is like the lawn mower, we went to the market and they have told us the price. We don’t need to assume anything, it’s there. We may have a different view about what the long term real return should be, but the sum total of all buyers and sellers have determined that 0.9% is the right number.
The trouble is, 0.9% is not enough. We need 2% return – remember?
But Financial Economic can come to the rescue again. If we want more return then we need to take more risk. That’s a basic axiom of finance, and the market accommodates with a whole load of securities across the risk spectrum. So let’s select one that gives us the right return.
More Bonds to Analyze
It is not just the US Treasury that issues bonds to borrow money, most corporations borrow money by issuing bonds. Just like you and me, companies have a credit rating that determines how low an interest rate they can borrow with. The best rating is AAA, but there are not many companies with that rating. The next best rating is AA. This is equivalent to having a credit score in the high 700’s and 800’s.
Now, I can tell you that a 30 year bond issued by a AA-rated company is yielding 1.2% more than Treasuries. With our financial economist glasses on this is telling us that investors are demanding more return for holding a slightly more risky bond. The US Government is generally recognized to be safer than a AA-rated Company and investors have evaluated the risk of investing in a AA company and determined that 1.2% additional return is sufficient compensation. [The 1.2% is called a ‘spread’ if you wanna impress your Wall Street friends]
So I could theoretically generate a 2% real return by buying an inflation linked long bond issued by a AA Company. Since that should yield about 0.9%+1.2%; the risk free rate of 0.9% plus the additional return that compensates us for investing with a AA company. That’s enough return to cover our 2% withdrawal rate – yay!
So we have found a security that provides a 2% long term real return – it’s a long AA inflation protected bond.
We also know the expected default rate for AA companies. It’s miniscule. The default rate for a AA company over one year is practically zero. Unfortunately over a number of decades the probability of default will rise. I don’t have a fancy credit migration default calculator but I’m going to say the chance of a AA company defaulting over a 30 year horizon is low single digits.
In conclusion we’ve found a market instrument that replicates the 2% real return we need. And we’ve found that the market default probability for that is low single digits.
You’re going to struggle to get an actuary to say something is “safe”, but I’m going to stick my neck out and say that a 2% withdrawal would have an extremely low probability of failure in the low single digits. Praise indeed!
How can I use this?
You should use this analysis as a smell test. For example if you want to roughly get an idea how risky a 4% withdrawal rate is, then you first observe the risk free rate is 0.9% (real) and you need to earn another 3.1% on top of that. Given that high yield bonds are yielding 3.5% above the risk free rate, then you can conclude that a 4% withdrawal rate is perhaps a bit less risky than equities. I’m assuming here that high yield bonds are similar in risk to equities (not quite true). So my best guess for a portfolio that currently has the market risk to support a 4% withdrawal rate might be around 70% equities and 30% bonds. Make sense?
Was that crazy technical, too much? Did you find it gibberish or interesting? Let me know whether you want more financial based articles like this.
[Technical notes. I calculated the risk free rate as a 30 year TIPS and then found the spread on a 30 year AA bond. This gave a yield of 0.9%+1.2%, which would fund the 2% withdrawal rate. We then observed that the default rate on 30 year AA bonds is really low and so concluded that a withdrawal rate of 2% is pretty damn safe. You might think that Treasuries are not risk free over a retiree’s lifetime, and you would be right. We could argue about the hair cut, but 10bps might be ok, and that still gives us 2% return. I did look at CDS on US Treasuries, but I don’t think they are a very useful proxy for Treasury default. Since if the Government defaults over 30 years, do you really think the bank will be around to pay out on the CDS? Also note that inflation protected corporate debt does not exist. Let alone over 30 years. But that doesn’t matter since we constructed from first principles what the market would price if it did exist. The biggest hole in this analysis is the re-investment risk. We simply don’t have securities with long enough tenors. So I had to work with 30 year tenors. Are you still reading this… wow! You’re now my best friend.]