JFP article: withdrawals with a cash buffer

[Htown Harry]

Here's an interesting article in the May Journal of Financial Planning:
Sustainable Withdrawal Rates from Retirement Portfolios: The Historical Evidence on Buffer Zone Strategies

Two links to the article (the first requires scrolling through the magazine to page 46 and may require a log-in):
Digital Edition

Sustainable Withdrawal Rates from Retirement Portfolios: The Historical Evidence on Buffer Zone Strategies by Walter Woerheide, David Nanigian :: SSRN

In a nutshell, they applied the methodology of Cooley, Hubbard, and Walz (CHW) from their 2011 Trinity study update, then ran the numbers with a cash buffer to avoid withdrawals during a down market.

Few of these types of studies consider the role of cash in decumulation portfolios. We are aware that some financial planners advocate the use of buffer zones as a component of a decumulation portfolio. See, for example, Evensky and Katz (2006) and Horan (2011) for a discussion of this strategy.

A buffer zone involves the use of money market funds to assure the safety of withdrawals that will be taken over the near future and to avoid selling in an undervalued market. For example, suppose there is no inflation (for simplicity) and a person has a $100,000 portfolio, and he or she wants to withdraw 5 percent of this amount, i.e., $5,000, per year. If this person were using, say, a three-year buffer zone, then he or she would put three years’ worth of withdrawals, i.e., $15,000, into cash. The rest, $85,000, goes into an investment portfolio that consists of risky assets.

At the end of the year, this person withdraws $5,000 from the investment portfolio if the investment portfolio goes up during the year. If the investment portfolio goes down in value, then the retiree takes the money from the cash holdings. If the investment portfolio goes up the second year after going down the first year, then the retiree takes the annual withdrawal from the investment portfolio, and also liquidates enough of the investment portfolio to bring the cash position back up to its original value. The retiree takes direct withdrawals from the investment portfolio without replenishing the cash position only if the investment portfolio has gone down four or more years in a row.

The basic question in this paper is: would the use of buffer zones have enhanced or reduced the portfolio success rates over what would have been achieved by not using buffer zones over our test period. We will examine four strategies involving the use of buffer zones and a variety of withdrawal rates. We then compare the success of each strategy to the success of the traditional withdrawal strategy as described in CHW (2011).

The results surprised me a little bit, showing that the benefits of not selling in a down market are very frequently outweighed by low returns on the cash portion of the portfolio. Except at a low 3% withdrawal rate or possibly with a 100% bond portfolio, a cash buffer method was found to be less successful than just riding the market and keeping the withdrawals consistent year-by-year.

Am I missing something, or do these numbers go against the conventional wisdom here at ER.org? Obviously, the very high percentage withdrawals would be outliers here, but the lack of a significant advantage for using a buffer at a 4% withdrawal rate certainly caught my eye.

They did make a good point at the very end. Investor psychology being what it is, a buffer can be a good thing if it's what a person needs to be comfortable with the higher stock percentages that increase portfolio survival rates over the long term.

 

[youbet]

Great post Htown, thanks!

While my research and number crunching were amateurish compared to the work done by the authors, my back-o-da-envelope scribbling led me to the same general conclusion. I maintain only a tiny cash buffer and that's for convenience more than downturn safety.

I also am suspicious that many folks vastly over estimate the beneficial impact of small spending reductions during downturns.

 

[Ed_The_Gypsy]

I came to the same conclusion after playing with different combinations. I showed some results here a while back.

Use of a cash buffer reduces your overall return but it does smooth out the ups and downs so it does provide psychological comfort. If you are taking, for example, a fixed percentage of your total every year (say, 4%, NOT adjusted for inflation), your annual distribution can swing wildly. If you take 4% adjusted for inflation each year, your distributions will be steady but your total portfolio will swing wildly.

These days, I am thinking about living off dividends mostly.

 

[Animorph]

I sort of use a cash buffer, but if everything is working normally the balance should be zero. I don't want 3 years worth of my portfolio in bonds, much less cash. My cash is increased when the portfolio value is above expectations (doing better than I need it to). It gets reinvested if it's still around in a bear market. Otherwise all withdrawals come from the cash until it is back down to zero. Then I just sell equities. In the past few years I've done all of those things.

 

[ERD50]

Am I missing something, or do these numbers go against the conventional wisdom here at ER.org?

I'm not sure that a large cash buffer represents 'the conventional wisdom here at ER.org' - though it represents some posters preferences. I've always questioned if a bunch of cash earning low rates could really offset any benefit from not selling low, and don't keep much in cash at all.

Like youbet, I also question the magnitude of the spending adjustment effect also - and worry about its 'cost' in quality of life.

I wish there was more resolution at the 3-4% WR and 30+ time frames, but interesting nonetheless. Thanks for posting.

-ERD50

 

[Animorph]

I don't like the buffer methodology of equity withdrawal in any up market. If the market drops 50% and then goes up 10% the next year, it asks you to withdraw from equities and refill the cash buffer even though equities are stll way down. You should be either reinvesting in equities or still withdrawing from the cash. They could be making better use of their cash.

 

[MooreBonds]

I also question the usefulness of having such a large wad in (these days) low yielding instruments.

Also, the more important aspect is that even the most aggressive portfolios will produce some distributions each year - so even during a "down year" (whatever that definition is*), you'll receive interest from bonds, dividends from stocks, and some capital gains distributions from mutual funds/ETFs...not to mention the eventual RMDs from traditional IRAs/401ks.

Which means having 2-3 years of full expenses in 'cash' would actually last you quite a number of years of bear markets, during which time the cash would supplement at least some positions producing varying amounts of interest/dividends/cap gains).

IMO, the more useful study would be to estimate an approximate income yield from dividends/interest during the down years, and see what a buffer of just 1 full year of expenses (able to supplement partial expenses for many years) would do. I imagine that would be far more effective in avoiding the low return from a cash-equivalent position, while still mitigating the effect of liquidating some positions in a down year.


*Not only have posters pointed out the game of "if your portfolio drops 30% this year, but rises 10% the next year, you're still down over 20%...but do you count the "10% rise" as a positive return?", but even ignoring that issue, the market does fluctuate quite readily, so would their theory call for just a 1% or 2% loss one year to be funded entirely from your cash stash?

 

[Animorph]

The study did try a one year buffer and it too failed to improve anything, though it wasn't a big drag.

In a total return scheme, if you don't want to touch your equitiy portfolio you should be reinvesting dividends and other distributions. Just because some of your gains come to you as cash doesn't mean they don't count as reducing your equity stake if you remove that value from your portfolio.

 

[Gotadimple]

I wish there was more resolution at the 3-4% WR and 30+ time frames, but interesting nonetheless. Thanks for posting.

-ERD50

There will never be resolution to this debate. For an excellant article by Wayne Pfau, see Retirement Researcher Blog: Valuations and Withdrawal Rates

He points out that the 'rule' doesn't consider a number of variables that affect decison-making, but most of all, what has been ignored in the discussion of the rule is that one needs to have a steady stream of funds to cover basics, before determining how much to withdraw from the portfolio.

-- Rita

 

[ERD50]

Originally Posted by ERD50
I wish there was more resolution at the 3-4% WR and 30+ time frames,

There will never be resolution to this debate. ...

-- Rita

Just to clarify - by ' more resolution', I didn't mean 'coming to an accepted conclusion', I meant 'more detail'. Like 2.5%, 3.0%, and 3.5% points, and 30-35-40 year time frames.

I'll look at your link later - thanks.


-ERD50

 

[MBAustin]

Thanks for sharing - I'll plow through the paper one of these days (I'm backlogged on my withdrawal strategy research).

That said, we have a 3-year spending buffer in VMLUX which is a better return than cash although certainly some risk of principal loss. I may revisit, but part of me thinks sleeping better at night is worth a fractional point of additional return.

 

[audreyh1]

I have never seen a buffer strategy like the buffer-zone listed in the article, so I'm not sure it tells me anything about buffers in general. I don't use a buffer like that.

I'm not concerned about which strategy has the best long-term gain, rather how do I balance survivability and short-term volatility i.e. optimize risk-adjusted return for the level of volatility I can live with.

My cash buffer is "outside" my retirement fund. You can think of it as an additional cushion. But when rebalancing and calculating withdrawals, only the amount in the retirement fund is used.

BTW - I do keep a small % of cash in my AA. In models of various asset allocations I studied, having cash + bonds gave a better result on the risk-adjusted return curve (efficient frontier) than bonds alone.

The only way I know to really live off the investment portfolio is evaluate every year. Withdraw, rebalance, and monitor. If things drop over several years, start withdrawing even less. I don't automatically adjust for inflation. The more I read these studies, the more I become convinced that only my own seat-of-the-pants strategy will work for the sequence of years that are served to me. The official numbers and probabilities are just starting points.

Some folks may have "other sources" such as SS or pensions providing that base needed income stream, such that they can use their investment portfolio for discretionary spending only. I don't, therefore I have to learn to live off my investment portfolio. Buying a SPIA to generate that "guaranteed" base income stream doesn't make economic sense until I am much older, so I don't get that advice (to make sure you have that income stream).

Audrey

 

[Chuckanut]

Were they rebalancing each year?

 

[Nords]

The results surprised me a little bit, showing that the benefits of not selling in a down market are very frequently outweighed by low returns on the cash portion of the portfolio.
Am I missing something, or do these numbers go against the conventional wisdom here at ER.org? Obviously, the very high percentage withdrawals would be outliers here, but the lack of a significant advantage for using a buffer at a 4% withdrawal rate certainly caught my eye.
They did make a good point at the very end. Investor psychology being what it is, a buffer can be a good thing if it's what a person needs to be comfortable with the higher stock percentages that increase portfolio survival rates over the long term.

I came to the same conclusion after playing with different combinations. I showed some results here a while back.
Use of a cash buffer reduces your overall return but it does smooth out the ups and downs so it does provide psychological comfort. If you are taking, for example, a fixed percentage of your total every year (say, 4%, NOT adjusted for inflation), your annual distribution can swing wildly. If you take 4% adjusted for inflation each year, your distributions will be steady but your total portfolio will swing wildly.
These days, I am thinking about living off dividends mostly.

Gulp. Interesting. That's exactly what we do, with 92% equities and an 8% (two-year) cash buffer.

We use five-year CDs and hope to only break them once or twice a decade. I wonder if that's significant enough to affect the results.

From the behavioral psychology perspective, it's much easier to pull low-yielding cash out of the buffer than it is to sell Berkshire Hathaway when it's undervalued...

 

[bigla]

I keep cash from taking profits from equities and put it in a MM for emergencies and yearly withdrawals. Your thoughts have given me pause and will rethink my strategy.
Thnks
Larry

 

[rescueme]

Some folks may have "other sources" such as SS or pensions providing that base needed income stream, such that they can use their investment portfolio for discretionary spending only. I don't, therefore I have to learn to live off my investment portfolio. Buying a SPIA to generate that "guaranteed" base income stream doesn't make economic sense until I am much older, so I don't get that advice (to make sure you have that income stream).

Audrey

I'll give you more than a few words and maybe you can see the use of an SPIA (which we have) in our "earlier than normal" (e.g. not ER) retirement plan, being the same as you at this time since we live exclusively on the "proceeds" of our joint retirement portfolio (currently pre-pension, pre-SS).

Both of us planned to retire at age 59 (DW did not actually do so until five years later, since she was not "emotionally ready" at the last moment, even though she said she was during our planning) and part of the decision of our income was an analysis of our required budget along with the inclusion of future income streams along the way, over an 11-year period (from planned joint retirement at age 59 until my SS income, at age 70 started).

We had already moved/converted a good portion of our joint holdings to cash (e.g. MM) in preperation for retirement in our mid-50's, in which we decided to hold enough to draw 3-5 years (including taxes on tax deferred holdings) to allow us to "ignore the noise" of the market over an extended period of time. Sure; if one was to look at the paper and say that we could have better use by investing that cash in a different (whatever) manner, then we would agree. However, one must look (depending on your personal situation, along with risk/desire) if you really need to maximize the return on that cash.

During our accumulation stage, for the majority of time between 1982 and 2007 we held 90+% in equity, with no problem. Sure, we had up/down periods, but then again we did not depend on our portfolio for our income since we both were employed during the entire period.

However, facing retirement (again, with our modified acceptance of risk for the situation we were in), we lowered our equity holding target to 60% (today at 50%, after five years of retirement for me, and both at age 64).

But the question of how we could reduce our exposure to the market (be it equity or bonds) and reduce the amount of money we had subject to risk was answered by the purchase of our first SPIA, purchased at age 59 in 2007.

Sure, we were aware of the "standard advice" of never to consider an annuity (specifically an SPIA) before our late 70's or early 80's, but doing more investigation of the product and its use in retirement income planning, we came to the conclusion that an SPIA is not an investment vehicle, but rather and income vehicle such as a pension or SS but a bit better than both since unlike most private (fixed) pension plans, it offered a return and unlike SS it was guaranteed to return a minimum amount over time. Maybe not like SS (not being inflation adjusted - our decision since we were looking for maximum return over our 11-year "gap"), but also having a defined value even if one/both would pass before the end of the calculated period.

We never looked at the SPIA as an investment, but since it supplied (and still does) a good deal of our base income needs, and unlike cash pays much more than current short-term interest (that's just a bit of luck - we know that), it worked out well.

It also removed a portion of value from our portfolio, along with the reduction in risk of a down market, along with further decision making for that portion of where/how to invest.

We know the advice is to wait till you are older to get an SPIA due to the "higher return", but that return is not due exclusively due to expected interest rates, but rather the return of your own money over a shorter lifespan. It's no different than say SS; the longer you wait to claim, the higher your monthly payment will be. Whatever current interest rates are, they have less of an impact to your monthly "paycheck" than you may think.

As an investment? An SPIA should not be considered. As an income vehicle? It should be considered as an option - assuming it is part of an overall retirement income plan, as it was in our case.

BTW, as far as my comments on the article refrenced by the OP, I'll agree that cash is a poor investment vehicle but then again it's not designed as such. Sure, you can do better with other options (even CD's, at today's rates) but than again for me/us it's used as an income instrument that also meets our joint ability to handle risk.

One other thing to also consider is not the % of cash vs. portfolio value, but also how that % will change over time. In our case our retirement income sources will start next year with my DW's two (small) pensions starting. A year after that? She will start drawing her FRA SS, along with my 50% claim against her. Four years later (at age 70), I'll claim my SS. At that time, in just over five years (assuming we're alive) we will still probably have that 3-5 year holding in cash, but the actual amount held will be very little due to our additional four sources of income. This is just to point out that depending on your personal current situation, the amount of cash held later in retirement may be greatly reduced, resulting in much less perceived drag to your total portfolio return.

For those who enter retirement and need that extra "punch", directing cash to (whatever) investments may need to be done to achieve their retirement income goals I can understand the article, but for those that are fortunate (as we are) and have a lower desire to maximize our returns, a healthy holding in cash makes sense for "old fogey's" as we are.

Just some thoughts based upon actual experience, rather than some post of "what you should do", without actually taking the "plunge"...