Investment advisors typically focus on how to get rich. A neglected question is how do you stay rich?
In the familiar financial advice narrative, the investor saves and invests, ultimately achieving significant wealth—or at any rate a middle-class retirement "number." But how you draw down accumulated wealth can be as important as how you accumulated it, or even more so. That is the provocative thesis of Money magazine blogger Darrow Kirkpatrick in a recent post.
He looks at strategies for liquidating a portfolio over a 30-year period. That much may sound familiar. There have been countless studies on how much you can withdraw each year, without too much risk of running out of money. (Does the "4 percent rule" still work in today's low-return environment?) There have also been studies of tax efficiency. (Should you withdraw from a regular or Roth IRA first? Should you live off your savings a while in order to delay taking Social Security?)
These are important issues. Kirkpatrick looks at something else, something that generally ignored and which may be surprisingly important. He's asking whether a portfolio's stock or bonds should be liquidated in a given year. (Hereafter I'll use "stocks" as shorthand for equities, embracing stock mutual funds and ETFs. "Bonds" will be shorthand for Treasuries, high-grade corporate bonds, money market accounts, and "cash"—and funds buying them.)
Kirkpatrick's study uses historical data from 1928 onward. He assumed you retired in year X with $1 million (in dollars of the time). Your million was initially split 50-50 between S&P 500 stocks and 10-year Treasuries. Then you followed strategy Y, or tried to, for 30 years, dying in year X+30 with a portfolio worth Z.
His calculations assume the "4 percent rule." In the first year of retirement, you withdraw 4 percent of your million, namely $40,000. Each subsequent year, you raise that by the official inflation rate.
Kirkpatrick isn't endorsing the 4 percent rule for today's retirees. He's just using it as a familiar benchmark. We already know that this "rule" would have performed well in the 20th century (since it was that historical record that motivated Bill Bengen to propose it, in 1993).
How do you realize your 4 percent (or whatever) from a diversified portfolio of given tax status?
One strategy is "equal withdrawals." That means you liquidate investments in proportion to your holdings. Should you have a 50/50 portfolio (stocks/bonds) and require $40,000 to live on this year, then you would cash out $20,000 from your stock holdings and $20,000 from your bonds. This sounds sensible, and it's often assumed to be the strategy in many calculations.
Kirkpatrick compares the equal withdrawals strategy to five alternatives. One is a rebalancing strategy in which withdrawals are taken to (help) rebalance the portfolio to a fixed allocation. The value of rebalancing is generally acknowledged, so many real-world strategies approach the one Kirkpatrick tested.
Kirkpatrick also back-tested three strategies that compare stock returns to bond returns. If stocks have outperformed bonds in the recent past, then you assume the opposite will be true in the coming year, and liquidate that year's income from stocks.
This is based on the idea that the pendulum always swings back. There is considerable evidence that when one asset class overperforms in a given time frame, it's likely to underperform in the next time frame. Kirkpatrick tested strategies using the last year's performance of stocks v. bonds, and also 3- and 7-year averages of these asset classes' returns.
Finally, he tried a strategy based on Robert Shiller's Cyclically Adjusted PE ratio (CAPE). The CAPE is a ten-year-moving average of U.S. stock prices divided by earnings. It's a measure of whether stocks are cheap or expensive, relative to earnings. In Kirkpatrick's scheme you liquidate stocks in years when they're "overvalued" (when the Shiller PE is above its long-term median). Otherwise you liquidate bonds.
How is this different from the 1-, 3-, and 7-year strategies? First of all, it pays no attention to bonds at all. It doesn't matter whether interest rates are high or low; whether bonds have done great or lousy lately.
It also doesn't pay attention to whether stocks have done great or lousy. All that matters is where the Shiller PE ratio stands now, relative to history.
Kirkpatrick calculated two numbers for each of his tested strategies. One is the success rate: the percentage of years in which you could have retired for which you would have had enough money, following a given strategy (and the 4 percent rule), for 30 years of inflation-adjusted income. He also calculated the median portfolio value at the end of the 30-year period. Of course, if the strategy fails, the ending portfolio value is zero.
The good news: All the strategies had a high success rate. They ranged from 79.3 percent to 91.4 percent. Again, this shouldn't come as a surprise, as we know the 4 percent rule would have worked well in the 20th century.
But there was a huge difference in ending portfolio values. With the worst strategy it was $2.11 million. With the best strategy, it was more than three times that, $6.77 million.