Variable Percentage Withdrawal: Garbage In, Garbage Out

The concept of Variable Percentage Withdrawal (VPW) for retirement spending is simple enough: you look up your age in a table that shows what percentage of your portfolio you can spend during the year.  The tricky part is calculating the percentages in the table.  Fortunately, a group of Bogleheads did the work for us.  Unfortunately, the assumptions built into their calculations make little sense.

If we knew our future portfolio returns and knew how long we’ll live, then calculating portfolio withdrawals would be as simple as calculating mortgage payments.  For example, if your returns will beat inflation by exactly 3% each year, and your $500,000 portfolio has to last 40 more years, the PMT function in a spreadsheet tells us that you can spend $21,000 per year (rising with inflation).

Instead of expressing the withdrawals in dollars, we could say to withdraw 4.2% of the portfolio in the first year.  If the remaining $479,000 in your portfolio really does earn 3% above inflation in the first year, then the next year’s inflation-adjusted $21,000 withdrawal would be 4.26% of your portfolio.  Working this way, we can build a table of withdrawal percentages each year.

Of course, market returns aren’t predictable.  Inevitably, your return will be something other than 3% above inflation.  You’ll have to decide whether to stick to the inflation-adjusted $21,000 or use the withdrawal percentages.  If you choose the percentages, then you have to be prepared for the possibility of having to cut spending.  If markets crash during your first year of retirement, and your portfolio drops 25%, your second year of spending will be only $15,300 (plus inflation), a painful cut.

A big advantage of using the percentages is that you can’t fully deplete your portfolio early.  If instead you just blindly spend $21,000 rising with inflation each year, disappointing market returns could cause you to run out of money early.

Choosing Withdrawal Percentages

One candidate for a set of retirement withdrawal percentages is the RRIF mandatory withdrawals.  These RRIF withdrawal percentages were designed to give payments that rise with inflation as long as your portfolio returns are 3% over inflation.

Unfortunately, the RRIF percentages would have a 65-year old spending only $20,000 out of a $500,000 portfolio.  Some retirees chafe at being forced to make RRIF withdrawals, but when it comes to the most we can safely spend in a year, most retirees want higher percentages.

A group of Bogleheads calculated portfolio withdrawal percentages for portfolios with different mixes of stocks and bonds.  Most people will just use the percentages they calculated, but they do provide a spreadsheet (with 16 tabs!) that shows how they came up with the percentages.

It turns out that they just assume a particular portfolio return and choose percentages that give annual retirement spending that rises exactly with inflation.  You may wonder why this takes such a large spreadsheet.  Most of the spreadsheet is for simulating their retirement plan using historical market returns.

The main assumptions behind the VPW tables are that you’ll live to 100, stocks will beat inflation by 5%, and bonds will beat inflation by 1.9%.  These figures are average global returns from 1900 to 2018 taken from the 2019 Credit Suisse Global Investment Returns Yearbook.  

So, as long as future stock and bond returns match historical averages, you’d be fine following the VPW percentages.  Of course, about half the time, returns were below these averages.  So, if you could jump randomly into the past to start your retirement, the odds that you’d face spending cuts over time is high.  

For anyone with the misfortune to jump back to 1966, portfolio spending would have dropped by half over the first 14 years of retirement.  More likely, this retiree wouldn’t have cut spending this much and would have seriously depleted the portfolio while markets were down.

The VPW percentages have no safety margin except for your presumed ability to spend far less if it becomes necessary.

Looking to the Future

But we don’t get to leap into the past to start our retirements.  We have to plan based on unknown future market returns.  How likely are returns in the next few decades to look like the average returns from the past?

30-year bonds in Canada pay less than 1.2%.  For them to beat inflation by 1.9%, we’d need to have 30 years of 0.7% deflation.  That’s not impossible, but I wouldn’t count on it.  It seems crazy to expect bonds to deliver 1.9% annual real returns in the coming decades.  Bond returns may get back to historical averages at some point, but retirees can’t expect much for some time.

Expecting 5% annual real returns from stocks may be sensible enough, as long as you have a high capacity for reducing retirement spending if it becomes necessary.  If your ability to reduce retirement spending is more limited, you need a safety margin in your assumed stock returns.  For my own retirement spending plans, I use inflation+4% for stocks (minus investment costs) and inflation+0% for bonds.

If we recalculate the VPW tables with these new assumptions, the annual withdrawal percentages drop by nearly a full percentage point.  This may not sound like much, but let’s look at an example of a 65-year old spending from a $500,000 portfolio invested 50% in stocks and 50% bonds.  The “official” VPW tables would have this retiree spending $25,000, but only $21,000 by my calculations.  It’s not hard to see who most retirees would rather believe.

Pre-Retirees

This disagreement over reasonable assumptions makes a big difference for pre-retirees deciding how much money they need to retire.  For the 65-year old in the earlier example wanting to spend $25,000 per year, the Bogleheads say to save $500,000, and I say nearly $600,000.

Clearly I could never make it as a financial advisor.  I’d be worried about protecting people from future spending cuts, and more “optimistic” advisors would scoop up all my clients by telling them what they want to hear.

Conclusion

Even when smart people develop good retirement spending tools, the results are only as good as the baked-in assumptions.  We can’t count on the high bond returns of the past, and it makes sense to have some safety margin in expected stock returns.  As with so many other calculators, if you input garbage assumptions, the results you get out will be garbage as well.