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Milevsky: Is There an Optimal Portfolio Drawdown Rate?

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Financial advisors wedded to a 4 percent annual withdrawal rate for their clients’ retirement portfolios are likely doing their clients a grave disservice, according to annuity expert Moshe Milevsky in his keynote address to the Retirement Income Industry Association’s spring conference in Chicago on March 23.

The York University finance professor regaled the audience of advisors and retirement income executives at the recent gathering with common discrepancies between retail financial professionals and financial economists such as himself who seek to optimize investment outcomes.

According to Milevsky, who is based in Toronto, the well-known Bengen rule that says investors can draw down 4 percent of their portfolios without fear of outliving their money fails to take into account that investors of the same age and equal portfolios nevertheless differ widely in two key attributes: tolerance for longevity risk and pension income resources.

Whereas Bengen-influenced financial planners might look at two 65-year-olds with $1 million portfolios and argue they could draw down $40,000 annually, replenishing funds through the growth of their portfolios, Milevsky was emphatic that there is no universally optimal spending rate.

One’s attitude toward drawdowns will be heavily influence by whether there is pre-existing pension or annuity income and how much that is; someone with $24,000 in Social Security income will be more confident than someone with no pension at all, but not as confident as someone with $60,000 in pension income.

Also, a retiree that expects to live to 95 and is in dread of outliving his portfolio will be far more cautious about his withdrawal rate than a risk tolerant investor.

These factors — and there are others (for instance, some investors are more optimistic than others about the rate of return on their investment portfolios) — can spell the difference between a Bengen-recommended 4 percent withdrawal rate and a drawdown of 8 percent.

Some advisors might be inclined to dismiss this analysis. They might think that pension income is an objective asset that can be factored into the withdrawal rate, but discount an investor’s subjective impressions about the probability of his longevity.

Such advisors might argue that boosting the equity allocation of the portfolio will address the retiree’s longevity fears. But this is completely unrealistic, according to Milevsky, since retirees who are averse to longevity risk will also be averse to the volatility of equity portfolios. The client’s psychology must be taken into account.

One conclusion flowing from this analysis is that annuities or other pension income ease investors’ anxiety about drawing down their portfolios at a greater rate, enabling them to enjoy their retirement more than the pensionless retiree worried about living too long.

For a fuller treatment of this topic, see the working paper Milevsky co-wrote with Huaxiong Huang, which is now available online.


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