The New Math for Retirement Portfolios


A January 21st report from Morningstar Investment Management quantifies what many retirements users have been grappling with on their own recently — how much do you need to save for retirement in the current very low interest rate/low bond yield environment.

According to David Blanchett, Michael Finke and Wade D. Pfau, the long-standing advice of building a portfolio big enough that withdrawing 4% per year would meet your needs for 30 years is simply not true any more. It turns out for a “safe retirement” in today’s low-interest world, you need a portfolio big enough so that taking out just 2.8% per year will meet your needs.

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Retirement Portfolios

The new math for retirement portfolios

Blanchett and colleagues highlight that yields on government bonds have been significantly below historical averages for some time now. Multi-years of low bond yields will have a major impact on retirement portfolios, which tend to be heavily weighted towards bonds, because portfolio returns in the earliest years of retirement have a bigger effect on the likelihood that a retirement income strategy will succeed (last 30 years) than portfolio returns when you are actually retired (sequence risk).

Retirement Portfolios

The authors have developed a new model that takes into account current bond yields and includes a “drift” factor toward a higher value during retirement, autoregressing based mainly on historical relationships between asset classes. They argue this approach more closely models the actual bond returns a current or near retiree can anticipate now and in the future.

They explain the key conclusion of their study: “We find a retiree who wants a 90% probability of achieving a retirement income goal with a 30-year time horizon and a 40% equity portfolio would only have an initial withdrawal rate of 2.8%. Such a low withdrawal rate would require 42.9% more savings if the retiree wanted to pull the same dollar value out of the portfolio annually as he or she would get with a 4% withdrawal rate from a smaller portfolio.”

Four percent withdrawal rate means a 50/50 chance of money lasting 30 years

Retirement Portfolios

Perhaps the most scary finding of the Morningstar report is is that those who stick with the “gold standard” 4% withdrawal plan only have around a 50% of having their retirement portfolios last a full three decades.

Keep in mind that not all retirement portfolios are the same, and Blanchett et al.’s model is based on retirement portfolios that are 60% bonds and 40% equities.

Retirement Portfolios