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Won the game? Where to set AA?
Old 11-29-2013, 11:01 AM   #1
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Won the game? Where to set AA?

Recently with the equity markets runup, I've begun to wonder if I should reduce risk since we are at relatively nice numbers. But how to do an analysis that shows where we are at? And how much should we cut back in equities?

To answer these questions I ran FIRECalc with various equity allocations and looked at spending levels for 100% success rates with a minimum portfolio balance at all times. One run results looks like this (snipped off the spending level numbers for privacy):



It shows success rate (Y-axis) versus spending levels (X-axis). I took the portfolio's result at the point where the curve breaks (blue arrow). Then I ran several portfolios varying only the % equities. The results are shown here:



The spending numbers are spending from the portfolio (not our actual numbers). The green line is for a portfolio that never goes below 50% of our current portfolio. The blue line is for a portfolio that never goes below 40% of our current portfolio. It is portfolio spending only and does not include Social Security although the FIRECalc analysis needs the SS numbers.

I was impressed that a maxima could be easily found. Of course, this is nothing particularly new but it helps me a lot in weening myself off some equities. One would expect that in very bad markets the volatility (and thus spending levels) would be enhanced by having more bonds in the portfolio.

So right now I'm considering going down from 65% to 50% equities and using the green line (50% of current portfolio value at all times). If the market really got insanely high, I'd probably go to 40%. This analysis assumes inflation adjusted spending, but we might just go with "percentage of current portfolio" to be more conservative. I doubt we would spend more highly should we get another 2008 type crisis.

Just wanted to share this in case it helps anyone in a similar review. Also maybe I'm missing some magic buttons in FIRECalc ? Probably somebody has already posted this sort of thing and I've forgotten, sorry if that is the case.

Of course, the numbers and conclusions depend on your own analysis. Comments encouraged.
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Old 11-29-2013, 11:50 AM   #2
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Are you retired Lsbcal? - sorry I don't remember.

And if so, have you been retired for at least two years? I'm inclined to believe that if a portfolio met someone's needs when they retired between 2 and 5 years ago, they can withstand a pretty good market selloff without really "noticing". I don't know why they would change their AA to a more conservative equity allocation.

Arguments have been made recently (see Kitces and Pfau) that portfolio survival improves when a retiree to has a low equity exposure right at retirement, and then lets that equity exposure drift higher over the years spending down more from fixed income at first. We're going to let our equity exposure gradually drift higher with time. This is a completely different scenario from what FIREcalc can compute AFAIK.

We've been retired for over 13 years now. Been through a couple of nasty bear markets too. Our overall AA is currently at 53% equities, 5% cash, 42% short & int term fixed income. We were gradually dropping our equity exposure with age, but I'm changed my mind about that and we are reversing course and will very gradually let it rise instead.

Being already retired, I sort of look at the concept of "market froth" or worry over the market having run up too far too fast and an imminent correction/bear market around the corner this way:

How much of a drop could we suffer in our portfolio (including withdrawals) and still meet current spending levels? I have done some analysis along these lines looking at various market scenarios.

Bottom line for us currently is - our portfolio could probably take a 27.5% hit (like we experienced in 2008) after our annual withdrawal of 3.33%, and we would still be above our current spending levels after taxes. (knocking on wood! )

We take X% of our portfolio out each year, so after a strong market year we get quite a "raise". This lets us take advantage of a rising market especially if it "gets ahead of itself" by taking a little extra fixed $ wise off the table. Of course that means the next year we might face a cut, but I'd rather take the extra while the going is good, and stash part of it for a year when the going is bad and our withdrawal $ amount goes down.

P.S. I always enjoy your analysis, so don't ever worry if it's been presented before - you tend to be very thorough and you supply pretty graphs!
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Old 11-29-2013, 11:52 AM   #3
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I've done the same sort of runs. Started thinking about it sometime back, Bernstein I think made a comment "If you've won the game, why keep playing it". I've used my actual spending as well what the portfolio could support ( actual is much lower ).

Under the investigate tab, the option "Investigate changing my allocation" will do some of this. The results shows success versus % equities.

30 - 40% equities is plenty for me ( even less by the firecalc runs ). As another poster says, I have "reinforcements" coming later in a small pension + SS, I did not include those in firecalc.
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Old 11-29-2013, 11:56 AM   #4
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Should Equity Exposure Decrease In Retirement, Or Is A Rising Equity Glidepath Actually Better? | Kitces.com

Quote:
In this context, the problem with the "traditional" approach of decreasing equity exposure through retirement becomes clear. If the retiree started in an environment like the late 1920s or late 1960s and decreases equity exposure systematically (e.g., by 1% to 2% per year), then by the time the good returns finally show up (about 15 years later) equity exposure will have been decreased so much that there simply won't be enough in equities to benefit when the good returns do show up. In other words, even if spending was conservative enough to survive the time period, selling equities throughout flat or declining markets amounts to liquidating while the market is down and not being able to participate in the recovery and the next big bull market whenever it finally arrives. Conversely, when the equity glidepath is rising and the retiree adds to equities throughout retirement (and/or especially in the first half of retirement), then by the time the market reaches a bottom and the next big bull market finally begins, equity exposure is greater and the retiree can participate even more!

Or viewed another way, the reality is simply that if market returns are poor throughout the first half of retirement, a rising equity glidepath is the equivalent of systematically dollar cost averaging into the market (with all the benefits that entails), while decreasing exposure amounts to reverse dollar cost averaging out of a bad market (with all the adverse results that apply). The strategy effectively becomes a way to ensure that clients are buying at favorable market valuations if they'll need to do so to make their retirement work. And notably, this implies that other valuation-based investment strategies may also have favorable outcomes (as discussed in the May 2009 issue of The Kitces Report); in fact, the reality may simply may that a rising equity glidepath is simple a way to ensure clients add to equities if valuations become cheap (i.e., returns are mediocre) through the first half of their retirement.

Of course, in a scenario where a retiree is following a rising equity glidepath, and it turns out market returns are good - and the client suddenly winds up with far more wealth than ever anticipated - there's always an option to change paths at that point, whether by bringing spending up or by taking equity risk off the table. Though technically they'll be so far ahead that a rising equity glidepath isn't a "risk" (i.e., even with a bear market, they're far enough ahead with few enough years remaining that there's no more failure risk), certainly some clients will decide that after a great bull market that changes their planning outlook and ability to achieve their goals, it may be prudent to get more conservative at that point. But for clients who go through a poor market in the early years, the rising equity glidepath becomes key to being able to sustain through the second half of retirement when the good returns finally arrive (in case the double-digit earnings yields on equities aren't enticing enough at that point!). In other words, the rising equity glidepath becomes "heads you win, tails you don't lose" (and in the latter scenarios, the client can change to whatever they want later instead).
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Old 11-29-2013, 12:16 PM   #5
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We set our kids launched, downsized house, ER budget to less than our income from SS, pensions, hobby jobs and 1% real returns (TIPS, I bonds, CD ladders, dividend stocks).

I am not a risk taker and we can live what we consider quite nice lives on that income without touching principal and having our principal keep up with inflation, so that's our plan. I don't want to lose half my life savings in any given year with riskier investments.
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Old 11-29-2013, 12:58 PM   #6
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I do think that we have won the game already. We have no heirs and therefore no need to build a legacy to pass on to future generations. And we expect some reinforcements coming online in our 60s that should conservatively cover half of our needs henceforth. So I think that we can get away with a lower risk / lower return strategy - one that would allow our portfolio and income to just keep up with inflation. So, at age 40, our AA is fairly conservative (~50% equities).
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Old 11-29-2013, 01:09 PM   #7
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If the idea is to maximize the lowest value your portfolio might reach during a 30-year retirement while still drawing a decent WR, then a 40% equity is the optimal point, as the OP indicated.

Out of curiosity, I also played with FIRECalc and saw that a 100% Long Interest Rate (FIRECalc default for fixed income) portfolio can still drop to 60% after inflation adjustment even with 0% withdrawal!

So, I made a bunch of runs with minimum portfolio value and % equities as the two parameters, in order to see what WR would go with these values. Below is the result. Having zero equities is not as safe as one would think. Red WRs are the highest for the respective minimum portfolio values of 50% and 40% of initial portfolios.

Note that the WR does not change much between 40% equity and 50% equity. I would go with 50% as the upside is better, while the downside is about the same as 40% equity.

% EquitiesMinimum Portfolio ValueAnnual Withdrawal
0%60%0.23%
0%55%0.92%
0%50%1.06%
0%40%1.31%
------------
30%60%Not possible
30%55%1.33%
30%50%2.14%
30%40%2.74%
------------
40%60%Not possible
40%55%1.22%
40%50%2.15%
40%40%2.97%
------------
50%60%Not possible
50%55%1.06%
50%50%2.13%
50%40%2.89%
------------
55%60%Not possible
55%55%0.98%
55%50%2.12%
55%40%2.82%
---------
60%60%Not possible
60%55%0.89%
60%50%2.01%
60%40%2.76%

PS. I added the 55% and 60% equity cases to address Audrey's post below.
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Old 11-29-2013, 01:19 PM   #8
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See how close 40% and 50% equities are in terms of WR supported for 50% and 40% of portfolio left over (I assume that's the inflation adjusted remaining portfolio).

I suspect 60% equities will be very close as well. That's how the graphs usually look. In terms of portfolio survival, 40% to 60% equities results tend to be very close.
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Old 11-29-2013, 01:24 PM   #9
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We've also won the retirement game. Being non-USAmericans, we have to share 30% of dividend income with the US Treasury. Our bond income is "tax free" because we use offshore bond funds. ER on these = 0.92%. Bottom line: we must go for "total return" at all times.

We plan to cruise thru our retirement with a 60/30/10 port using a gross 3% AWR by 2018. Right now we withdraw 3.5%. Next year we will go with 3.3%.
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AA = 60/35/5. Expected CAGR = 5.7%. GSD (5y) = 7.8%. USD inflation (10 y) = 1.8%. AWR = 3.0%. TER = 0.5%. Net Port Yield = 1.7%. Term = 36 yr. FI Duration = 4.9 yr. Portfolio survival probability = 86%.
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Old 11-29-2013, 03:30 PM   #10
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Quote:
Originally Posted by audreyh1 View Post
Are you retired Lsbcal? - sorry I don't remember.

And if so, have you been retired for at least two years? I'm inclined to believe that if a portfolio met someone's needs when they retired between 2 and 5 years ago, they can withstand a pretty good market selloff without really "noticing". I don't know why they would change their AA to a more conservative equity allocation.
Good observations Audrey. I was partially retired in 2003 and fully about 2006. At the start of 2008 our portfolio had grown nicely as shown here:



You can see that 2008 was a nasty surprise as we were only at 55% equities. We had some expenses too which we don't now have:
1) DS in college
2) high medical costs
3) no Social Security
4) much higher taxes

So this just illustrates that the picture is very specific to one's life circumstances.
Quote:
Arguments have been made recently (see Kitces and Pfau) that portfolio survival improves when a retiree to has a low equity exposure right at retirement, and then lets that equity exposure drift higher over the years spending down more from fixed income at first. We're going to let our equity exposure gradually drift higher with time. This is a completely different scenario from what FIREcalc can compute AFAIK.
To me this feels counter intuitive. Does it survive a 1930's scenario? Even if it does, will anyone really put it into action should such a terrible set of years occur?

Quote:
We've been retired for over 13 years now. Been through a couple of nasty bear markets too. Our overall AA is currently at 53% equities, 5% cash, 42% short & int term fixed income. We were gradually dropping our equity exposure with age, but I'm changed my mind about that and we are reversing course and will very gradually let it rise instead.
Yes we've had a nasty 2000-2010 decade but again the declines were not nearly as bad as the 1930's. Hopefully we have seen the worst in our lifetimes. I'm not ready to bet the house on that one. Somewhere I presented a comparison of the equity declines of the 1930's and the 2008 decline. They followed similar paths but the 1930's one kept going down way after the 2009 one turned up.
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Old 11-29-2013, 03:42 PM   #11
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Quote:
Originally Posted by NW-Bound View Post
...(snip)...
So, I made a bunch of runs with minimum portfolio value and % equities as the two parameters, in order to see what WR would go with these values. Below is the result. Having zero equities is not as safe as one would think. Red WRs are the highest for the respective minimum portfolio values of 50% and 40% of initial portfolios. ...
When I ran my simulations I put in SS income and used 5 year Treasuries for bonds and Total Stock Market for equities. The WR was 4.1% for our actual numbers (not the graph in the OP).

Were your WR's lower because you ran with no other income sources?

If so, I think the difference in WR's for my runs were somewhat higher (more concave a curve) for different % equities. For example, the 50% equity case allowed us to actually spend about $5k/year more from the portfolio then the 65% equity case.
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Old 11-29-2013, 03:48 PM   #12
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If you now plot all that stuff for different time periods, we would get a sense of SWR as we age in retirement. All of these numbers are just starting values.
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Old 11-29-2013, 03:51 PM   #13
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Originally Posted by Lsbcal View Post
When I ran my simulations I put in SS income and used 5 year Treasuries for bonds and Total Stock Market for equities. The WR was 4.1% for our actual numbers (not the graph in the OP).
Is that real or nominal 4.1%?
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Old 11-29-2013, 03:57 PM   #14
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Is that real or nominal 4.1%?
FIRECalc takes inflation into account. So that would be real WR's.
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Old 11-29-2013, 04:01 PM   #15
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Make sure you put your ER into the "expense box". I put our ER + TR into that box to get OUR annual spendable net.
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AA = 60/35/5. Expected CAGR = 5.7%. GSD (5y) = 7.8%. USD inflation (10 y) = 1.8%. AWR = 3.0%. TER = 0.5%. Net Port Yield = 1.7%. Term = 36 yr. FI Duration = 4.9 yr. Portfolio survival probability = 86%.
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Old 11-29-2013, 04:07 PM   #16
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Further affirmation of my 45% equity allocation. While not optimal by any estimation it has a sleep well factor once the target has been reached or is in sight.
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Old 11-29-2013, 04:15 PM   #17
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FIRECalc takes inflation into account. So that would be real WR's.

If WR is the withdrawal rate, does that withdrawal rate include drawing down the portfolio principal? Sorry, if I am being a bit dense, I usually use my own spreadsheets so I don't know a lot about Firecalc.
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Old 11-29-2013, 04:42 PM   #18
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If WR is the withdrawal rate, does that withdrawal rate include drawing down the portfolio principal? Sorry, if I am being a bit dense, I usually use my own spreadsheets so I don't know a lot about Firecalc.
Yes it includes drawing down principal and loads of historical data. You can check it out here and free: FIRECalc: A different kind of retirement calculator . There are also lots of FIRECalc related posts to look at on this site.
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Old 11-29-2013, 04:47 PM   #19
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FireCalc does draw down principal. E.g. our port has a net nominal yield of 1.4%. Our gross AWR = 3.1%. These means we must sell 1.7% of portfolio shares to make the AWR.

As is, our expected REAL NET portfolio return over the duration of our retirement = 2.4%.
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AA = 60/35/5. Expected CAGR = 5.7%. GSD (5y) = 7.8%. USD inflation (10 y) = 1.8%. AWR = 3.0%. TER = 0.5%. Net Port Yield = 1.7%. Term = 36 yr. FI Duration = 4.9 yr. Portfolio survival probability = 86%.
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Old 11-29-2013, 05:01 PM   #20
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The runs I made was without any additional income sources. The fixed income part was "Long Interest Rate" and the equity portion was Total Market.

I just now reran the two 40% equities cases with the WR shown in red in the table I posted, but with 5-year Treasury instead. The WR numbers turned out better, at 2.00% and 3.08%.

I am currently drawing 3.5%, and expect our SS to replace at least 1% WR, but have not bothered to figure it out exactly. Of course that would also depend on when we start SS.

And our portfolio has foreign stocks and is not as simple as the test cases. These do provide an understanding of how equities are needed in a portfolio, however.

Quote:
Originally Posted by Lsbcal View Post
When I ran my simulations I put in SS income and used 5 year Treasuries for bonds and Total Stock Market for equities. The WR was 4.1% for our actual numbers (not the graph in the OP).

Were your WR's lower because you ran with no other income sources?

If so, I think the difference in WR's for my runs were somewhat higher (more concave a curve) for different % equities. For example, the 50% equity case allowed us to actually spend about $5k/year more from the portfolio then the 65% equity case.
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