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A different spin on SWR, question.
Old 02-07-2011, 11:53 PM   #1
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A different spin on SWR, question.

I have a specific question about everyone's use of Firecalc.

Firecalc uses a 75% equity / 25% bond mixture. Did the creator find that to be the best structure for a portfolio with 4% (plus inflation indexed, yada yada) withdrawals. Defining best as "lowest failure percentage".

I know that Jim Otar's book gets into more detail and breaks down all the scenarios, but everyone on here seems thrilled with FireCalc, so I thought I'd ask this. If 75/25bond is the "best" system for a 4% withdrawal, how would that ratio change if someone was aiming to make 2% withdrawals?

My question is very selfish. I'm in a position where I have a very long outlook (60 years), and may need to make 2% withdrawals over the next couple years (hopefully reduce?). I'm using all DFA products.

Thanks in advance to all contributions,
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Old 02-08-2011, 12:55 AM   #2
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Hi verygoodthings,
Just below the title on the main FIRECalc page are a series of tabs:
  • Start Here
  • Other Income/Spending
  • Not Retired?
  • Spending Models
  • Your Portfolio
  • Portfolio Changes
  • Investigate
Click on "Your Portfolio" and you can change your asset mix.
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Old 02-08-2011, 06:13 AM   #3
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The Trinity study (the basis for the 4% SWR 'rule') and some work studies IIRC (regarding Modern Portfolio Theory) found that 75% Equity/25% Bond produced the highest survival rate for long >30 years retirements. I believe (and I could easily be wrong about this) that for 40+ year the optimum AA was 80/20%. So yes that is why the default AA is 75/25% historically it has been the best. (Although this may have changed with last 3 years.)

The nice thing about FIRECalc is lets you easily explore different AA using historical returns. I have not played extensively with retirement calculator in the last 5 years or so, but I found that FIRECalc has the most flexibility.


If you are using DFA products you may find it difficult to input your exact type of assets (example foreign stock). Evidently this is because the author initially couldn't find good data for a number of asset class, like international, microcap, small cap value.

Question about DFA, how do you have access to them? I am toying with moving my index portion of my portfolio to DFA, but the fees have always stopped me.
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Old 02-08-2011, 06:49 AM   #4
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The need for equities diminishes as the WR declines, regardless of the length of retirement. At 2% and below, the need is very small, even nonexistent. Consider that even in the current low interest rate environment, a 100% 30-yr TIPS portfolio produces a "real" (or at least CPI** adjusted) annuity of 2.1%.

For withdrawal rates at or below 2% the reason to hold equities is because you want a chance to increase your standard of living, rather than just maintain it, and to hedge against some of TIPS shortcomings. That can probably be accomplished with 20% of the portfolio.

Here's another way to think about it. If 75/25 is "Ideal" for a 4%, 30 year withdrawal period, then we can take the portion of our portfolio that equals our annual expenses * 25 and allocate that 75/25. The balance, we can invest 100% in 30 year TIPS. So for someone with a $2MM portfolio and $40K in annual expenses, he takes $1MM of the portfolio and invests it in the "traditional" 75/25 mix and the remaining $1MM goes into 30yr TIPS. That gives him an equity allocation of just 37.5%

The logic goes like this . . . If FIRECalc is right, the first $1MM invested 75/25 and rebalanced annually should "safely" support a $40K real payout for 30 years or more. But if not, we still have half the portfolio growing at 2% real as an insurance policy.


** Before people start saying how bad CPI is, remember that FIRECalc assumes inflation equals CPI. Whatever problems TIPS have with CPI tracking error, FIRECalc results suffer from the same thing.
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Old 02-08-2011, 06:57 AM   #5
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As mentioned in this thread, your premise that FIRECalc uses 75/25 is simply incorrect. Next question.

I'm curious about what your advisor tells you. What did they say?
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Old 02-08-2011, 07:32 AM   #6
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Quote:
Originally Posted by clifp View Post
The Trinity study (the basis for the 4% SWR 'rule') and some work studies IIRC (regarding Modern Portfolio Theory) found that 75% Equity/25% Bond produced the highest survival rate for long >30 years retirements. I believe (and I could easily be wrong about this) that for 40+ year the optimum AA was 80/20%. So yes that is why the default AA is 75/25% historically it has been the best. (Although this may have changed with last 3 years.)

The nice thing about FIRECalc is lets you easily explore different AA using historical returns.
What clifp said.

75/25 is the default in FIRECalc but it was not intended to represent the best allocation in all situations, that's why FIRECalc allows you to change allocations and test the results. That's further reinforced by the information accompanying the equity percentage box in the "Your Portfolio" tab:

Quote:
Percentage of your portfolio that is in equities, versus fixed income? Research seems to suggest about 50% for a 10 year term, almost 70% for a 20 year term, and around 85% for a 60 year term.
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Old 02-08-2011, 10:37 AM   #7
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What clifp said.

75/25 is the default in FIRECalc but it was not intended to represent the best allocation in all situations, that's why FIRECalc allows you to change allocations and test the results. That's further reinforced by the information accompanying the equity percentage box in the "Your Portfolio" tab:
Quote:
Percentage of your portfolio that is in equities, versus fixed income? Research seems to suggest about 50% for a 10 year term, almost 70% for a 20 year term, and around 85% for a 60 year term.
I've wondered about these allocations and what exactly FIRECalc is suggesting them for. Does this mean, for a 4% inflation adjusted annual withdrawal, the suggested equity allocation would give the same portfolio survival rate as the 75/25 for 30 years of 4% SWD?
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Old 02-08-2011, 11:06 AM   #8
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I've wondered about these allocations and what exactly FIRECalc is suggesting them for.
I think they are the Modern Portfolio Theory "Optimal Asset Allocations":
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Old 02-08-2011, 12:56 PM   #9
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I think they are the Modern Portfolio Theory "Optimal Asset Allocations":
This chart is interesting in that it still suggests a nearly 50% equity allocation for a payout as short as 10 years. I am not sure, but from casually reading what board memebers say about their allocations, it appears that many members still in their 50s and early 60s allocate less than 50% to equities. These people may have COLA pensions, I do not know about that.

Most of my life I varied my allocation between all equities down to maybe 20% or so. I think going forward my bands will be tighter- maybe 80/20 down to 20/80. Unless interest rates are high, I tend to stay quite short duration with the fixed income. Of course if payouts are high enough, duration shortens itself too!

If I have quality equities with good growing dividends, I will often keep them even when the overall market valuation seems high.

Ha
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Old 02-08-2011, 01:42 PM   #10
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Originally Posted by haha View Post
This chart in interesting in that it still suggests a nearly 50% equity allocation for a payout as short as 10 years. I am not sure, but from casually reading what board memebers say about their allocations, it appears that many members still in their 50s and early 60s allocate less than 50% to equities.
I'm one of those "over 60/under 50" types - here's why...

My ~40% allocation to equities has to do with the success results shown by FIRECalc runs. While the MPT "Optimal Allocation" equity chart is focused on maximizing returns, the following chart from FIRECalc results is focused on minimizing volatility while still achieving a successful SWR over a 30 year period (success % on the vertical axis, % allocated to stocks on the horizontal):


The graph shows historically you gain very little improvement in success with an allocation of more than 40-45% in stocks.

(FYI, the above is from an October 2005 thread.)
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Old 02-08-2011, 02:18 PM   #11
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I'm one of those "over 60/under 50" types - here's why...

My ~40% allocation to equities has to do with the success results shown by FIRECalc runs. While the MPT "Optimal Allocation" equity chart is focused on maximizing returns, the following chart from FIRECalc results is focused on minimizing volatility while still achieving a successful SWR over a 30 year period (success % on the vertical axis, % allocated to stocks on the horizontal):


The graph shows historically you gain very little improvement in success with an allocation of more than 40-45% in stocks.

(FYI, the above is from an October 2005 thread.)
Thanks, good expanation. Maximum returns is a quite different endpoint from maximum % success.

Ha
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Old 02-09-2011, 12:37 PM   #12
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I'm in a position where I have a very long outlook (60 years), and may need to make 2% withdrawals over the next couple years (hopefully reduce?). I'm using all DFA products.
You may also want to spring for a three-month membership with FinancialEngines.com, where you can tweak away at many more data-intensive paramaters. FE.com includes the actual performance data for most funds, including DFA, and can assess your desired alternatives.

As you notch on the various retirement calculators you'll find a variety of answers that aren't necessarily better or worse, let alone right or wrong. Instead they're a mix of various assumptions and methods that have to be taken into account when making a final asset allocation decision. However it's nice to see a spread of answers from 3-5% and to make a plan that lets you cut your spending to get through a recession if necessary.

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As mentioned in this thread, your premise that FIRECalc uses 75/25 is simply incorrect. Next question.
C'mon, the guy got off on the wrong foot and has made his amends, let's get past it and move on...
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Old 02-09-2011, 04:46 PM   #13
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Originally Posted by haha View Post
This chart is interesting in that it still suggests a nearly 50% equity allocation for a payout as short as 10 years. I am not sure, but from casually reading what board memebers say about their allocations, it appears that many members still in their 50s and early 60s allocate less than 50% to equities. These people may have COLA pensions, I do not know about that.

Ha
Yes, age 52 with current COLAd survivor pension and deferred one (mine) on the way. I try to remember to mention these qualifiers when I post my AA in the related threads.
I realize I'm playing in a whole different ball game than the majority (from what I can derive from posts) here.
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Old 02-09-2011, 04:51 PM   #14
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The need for equities diminishes as the WR declines, regardless of the length of retirement. At 2% and below, the need is very small, even nonexistent. Consider that even in the current low interest rate environment, a 100% 30-yr TIPS portfolio produces a "real" (or at least CPI** adjusted) annuity of 2.1%.
Only if you have all your funds as tax-deferred (or tax-free). TIPS in taxable accounts will (may) nail you on taxes for the phantom income :-(
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Old 02-09-2011, 05:34 PM   #15
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Similar to REWahoo, when I ran my own situation on FIRECALC (60 yrs old, wife 58, modest non-cola pension, SS maxed out for me) I also noticed very little improvement as equities got above 50%. In my case, max income with a 95% success rate came at about 65% equities but it was just a few dollars/year above what 50% equities would do.
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Old 02-09-2011, 05:52 PM   #16
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Originally Posted by REWahoo View Post
I'm one of those "over 60/under 50" types - here's why...

My ~40% allocation to equities has to do with the success results shown by FIRECalc runs. While the MPT "Optimal Allocation" equity chart is focused on maximizing returns, the following chart from FIRECalc results is focused on minimizing volatility while still achieving a successful SWR over a 30 year period (success % on the vertical axis, % allocated to stocks on the horizontal):


The graph shows historically you gain very little improvement in success with an allocation of more than 40-45% in stocks.

(FYI, the above is from an October 2005 thread.)
Nice summary.... Thanks
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Old 02-09-2011, 06:01 PM   #17
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Only if you have all your funds as tax-deferred (or tax-free). TIPS in taxable accounts will (may) nail you on taxes for the phantom income :-(
It's not phantom income anymore than the inflation component of regular bonds is phantom. 30-yr TIPS pays 2% plus an inflation adjustment, all of which is taxable. Treasuries pay 4.6% which includes an expected real return and an expected inflation component, all of which is taxable. So TIPS and regular bonds are treated the same.

Having said that, I agree that there is tax leakage that can reduce TIPS inflation hedging effectiveness if held in taxable accounts. But that doesn't change the main point that lower WR require lower equity allocations.
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Old 02-09-2011, 07:17 PM   #18
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It's not phantom income anymore than the inflation component of regular bonds is phantom. 30-yr TIPS pays 2% plus an inflation adjustment, all of which is taxable. Treasuries pay 4.6% which includes an expected real return and an expected inflation component, all of which is taxable. So TIPS and regular bonds are treated the same.
By "phantom income" I did not mean to diminish the value of it - I think I heard this as an accepted term to describe such an income (i.e. income you get in future while paying taxes today). If I recall correctly, difference between regular bonds and TIPS with respect to taxation is that regular bonds give you all the interest in the same year in which you pay the tax on it, while with TIPS, you will not see your increases until maturity, while you pay taxes in prior years. (Again, this does not mean one is "better" than the other... only that they are not quite treated the same wrt taxation.)

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Having said that, I agree that there is tax leakage that can reduce TIPS inflation hedging effectiveness if held in taxable accounts. But that doesn't change the main point that lower WR require lower equity allocations.
And I agree with your main point of lower equity allocation for lower WR.

Unfortunately, unless you assume there is an investment that can give you 2% real return for the next 60 years (as OP requested), seems like equity allocation percentage will not be "nonexistent" (to use your word). TIPS with 2% fixed in taxable account would not be such an investment (without even bringing up the reinvestment issue). Perhaps SPIA with inflation protection (without inflation caps) could be such an investment but SPIAs have their own risks as well...
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Old 02-09-2011, 10:12 PM   #19
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I'm one of those "over 60/under 50" types - here's why...

My ~40% allocation to equities has to do with the success results shown by FIRECalc runs. While the MPT "Optimal Allocation" equity chart is focused on maximizing returns, the following chart from FIRECalc results is focused on minimizing volatility while still achieving a successful SWR over a 30 year period (success % on the vertical axis, % allocated to stocks on the horizontal):


The graph shows historically you gain very little improvement in success with an allocation of more than 40-45% in stocks.

(FYI, the above is from an October 2005 thread.)
You could also say that by holding less than ~80% equities you're giving up a lot of potential portfolio growth with little or no improvement in SWR.
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Old 02-10-2011, 06:07 AM   #20
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If I recall correctly, difference between regular bonds and TIPS with respect to taxation is that regular bonds give you all the interest in the same year in which you pay the tax on it, while with TIPS, you will not see your increases until maturity, while you pay taxes in prior years. (Again, this does not mean one is "better" than the other... only that they are not quite treated the same wrt taxation.)

Agreed that TIPS don't distribute 100% of their earnings, but that value still accrues to you and can be monetized in the year it is earned and taxed. Consider a 2% TIPS bond and 4% treasury with 2% inflation. Both will earn, and be taxed on 4%. TIPS will distribute 2%, and another 2% will be added to the principal as an inflation adjustment. There is no requirement that you wait until maturity to monetize the inflation adjustment. If you sell the inflation adjustment your cash flow and taxes look exactly like that of an ordinary treasury. If they didn't tax the inflation adjustment, TIPS would benefit from a tax deferral feature not available for ordinary bonds (and would also make them less useful instruments to gauge inflation expectations).

Although tax deferral on the inflation adjustment (or better yet, only tax on real income) would be a huge improvement, it would mean giving TIPS preferential treatment relative to vanilla treasuries, corporates, and other fixed income products.
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