Accumulation –Dynamic
Decumulation Strategy
Executive Summary
Accumulation-Dynamic Decumulation (ADD)
Strategy is an elegant solution for managing withdrawals through retirement. It
withdraws a percentage of the available fund. These removes the risk of ruin at the expense of having volatile withdrawal. ADD also uses:
- A smoothing of the fund: This reduces the retirement date risk and applies a simple filter for a rational estimate of the fund over the long run.
- An increase cap on the withdrawal and accrued withdrawal: This provides a provision for adverse deviation and reduces the retirement date risk.
- A reserve: This manages the negative volatility of the portfolio. It provides protection over 95% of withdrawals.
You can see
below the cash flow path in nominal terms at various retirement dates using
this strategy.
Features:
- No risk of ruin
- No sequence of returns risk over the fund’s value
- Reduces the date of retirement risk
- Reduces the volatility of withdrawals
- Perpetual withdrawals, high bequest*
- No direct protection against inflation
Please consult the Full Study if you want to explore some more the method.
*May use ADD in combination with Variable Percentage Withdrawal to leave low bequest
Introduction
The key challenge for preparing for
retirement is how to ensure enough money for retirement. The two main methods
are buying an annuity or managing our withdrawals. Annuities are safe, illiquid
and do not leave money to heirs. Annuities are insured by a third party and as
such should be honored. The mortality risk is handled by grouping a large
number of participants together and averaging out the mortality. They offer low
liquidity as they can’t be sold after they are bought. In their simplest form,
they offer no lump sum at death. Managing our withdrawals keeps liquidity and
often leaves more than the full principal at death. However, it offers no
safety. This post is focusing on the latter method.
The Accumulation Phase
Often we look at decumulation in silo of
the accumulation phase. However, there are advantages in looking at them in
combination. During the accumulation phase, we can have an early discussion if
and how much we want to manage decumulation versus buying an annuity. Buying an
annuity requires a great lump sum at a fixed target date. For that objective, a
low equity asset allocation is best. However, if you want to manage your
withdrawals only a small portion of the fund will be used each year. Even if
the market value at retirement is volatile, a small portion of the fund is
still available. This enables us to be more aggressive in our asset allocation,
even through retirement because the volatility of the rate of return will be
spread along each year of retirement.
The volatility of the market still exists.
I believe that we can reduce our negative behavior by looking at the linear
smoothed market value (SMV – see annex for more detail) instead of the current
market value. If we look at SMV, it has the same volatility as the 5 years
returns of the market value. It also allows for an automatic sanity check on
how things stand. In an economic crisis, SMV is higher than market value. It
reminds us that the future is likely to be brighter than the past. In today’s
market, SMV is lower than the market value. It tells us that the future is
likely bleaker than the past. By extension making our percentage withdrawal on
the SMV instead of the market value reduces the volatility of the
withdrawals. It is not a silver bullet
as it often only delays the gains & loss. At best, short loss gains are
compensated by short term gains, but there’s no guarantee.
Another step that can be taken through the
accumulation phase is to create a provision for adverse deviation. A number of
ways exist to do this. This strategy explores the idea of capping the “accrued”
withdrawal by 115% from last year “accrued” withdrawal. The accrued withdrawal
is what you would be able to withdraw if you retired today. This cap has two
effects: Calculating it makes you aware of what you could withdraw today
without working anymore; also it adds a buffer in case of economic crisis
following high increases. These sequences of returns have often appeared in the
past. In order to go even further in managing our expectations through
retirement, this strategy cap the first retirement year withdrawal by 108% from
previous year accrued withdrawal.
If we combine these strategies the
retirement date risk is heavily reduced. The S&P500 had 25 times in the
past 100 years of returns below 0%. If we go for a percentage withdrawal or a
constant dollar strategy, we would experience 25 such reductions. Instead, if
we combine capping and smoothing strategies, we only get 4 reductions in
withdrawals between the accrued benefit the year prior retirement date versus at
the retirement year. Here’s a comparison of these 4 events:
Year
|
Percentage Withdrawal
(25 events with
reduced accrued)
|
Accumulation-Dynamic
Decumulation
(4 events with reduced
accrued)
|
1932
|
59%
|
76%
|
1933
|
90%
|
90%
|
1942
|
90%
|
91%
|
1975
|
75%
|
81%
|
While maintaining the accrued withdrawals
is a fine accomplishment, a retiree who needed an extra year of interest would still
not be able to retire. The ADD strategy do not adds money where none exist. Instead,
it reduces this risk by making more conservative accrued withdrawal estimate prior
retirement.
The sequence of return risk
The sequence of return risk for constant
dollar withdrawal like the safe withdrawal rule leads to ruin risk. This risk
can be avoided using a percentage withdrawal method. This method withdraws a
percentage of the fund value each year. With this method or similar method,
only the withdrawal fluctuates negatively from a bad sequence of return. Once
the sequence returns to average, the fund and withdrawals go back to their original
value. We can also gain the insight that
is if the fund loses 5% of its value, the withdrawal only drops by 2.5%.
The Decumulation Phase
In this strategy the main focus is not to
manage the fund volatility, but the risk of the withdrawals. Ultimately, the
withdrawals are not directly controlled by the market. The retiree decides how
much and when he wants to withdraw his fund. A decumulation strategy elaborates
a plan to manage them.
In a
percentage withdrawal class, there’s no risk of ruin. Using an unsustainable
rate of withdrawals will diminish the withdrawals significantly over time, but
never to 0. Like demonstrated in the sequence of risk table a 0% return with a
5% withdrawal reduces the withdrawal by 80%. If the return eventually goes back
to normal, the withdrawal will return to their original value.
To manage the withdrawal volatility risk,
this strategy implements a reserve. 25% of the fund is put in a reserve fund.
This fund will serve to pay for the difference between the withdrawal and 95%
of any previous withdrawal. If the highest previous withdrawal was 100$ and the
new withdrawal would be 80$, the reserve would pay 15$. This means that you
need to be prepared that 5% of your withdrawal may not be available next year.
For the following few years, you may have to remain at this level until market
value returns to normal. To compensate, we increase the withdrawal of the
regular fund accordingly. If you wanted to withdraw 6.5%, you need to withdraw
at least 6.5%/75%=8.67% from the regular fund.
A common question is how should the reserve
be invested? 25% of the fund is a big portion of the fund. My tests indicate any
advantage of being more in bond in the reserve fund. So instead using the same
asset allocation than the rest of the fund seems appropriate.
Using a reserve fund has the advantage that
we can easily apply a limit on its used. For example, this strategy applies a
maximum reserve withdrawal of 10%. This allows for the floor to drop further if
the reserve is unable to sustain their uses.
Having a reserve also provides the opportunity to have a significant
emergency fund which can be used in time of need. If it is used, the protection
erodes. In good time, the reserve is not used the reserve grows since no
withdrawal is taken from it. My test showed that the protection is not eroded
when we withdraw 50% of the excess above 35% level.
The smoothing and increase cap is also
applied in the decumulation phase. The increase cap has to be modified to cap
increase at 105% of previous withdrawal after retirement. This lower increase
accounts for the withdrawal that is occurring after retirement. Having such a
cap provides a great tool to have a constant increase in withdrawals. In case
of consistent increase, the cap is increased by 1% each year above the previous
mark. This allows recognizing more quickly the sustainable increase.
You may notice that it 105% is lower than
the inflation in some of the past years. There’s a strong argument that going
forward, the low inflation rate will be maintained. Going forward the US
federal bank and bank of Canada has both a target inflation of 2%. The Canadian
inflation targets have been stable for the past 25 years and the US for the
past 5 years. These targets inflations have been met by both countries since
their commitment to them. In the end, 105% increase cap provides another
provision for adverse deviation.
Here’s two graphics of the Cash Flows
versus Market Value in 1928 and 1965. After 1928, the S&P500 plunged in the
great depression and recovered with difficulty in the following decades. By all
accounts, it was one of the worst years to retire. 3 combinations are
displayed: 100% equity using 6.5% ADD withdrawal; 100% equity using 5.5% ADD
withdrawal; 50% equity using 5.5% ADD withdrawal.
A 1965 retiree would have faced better fate
in nominal terms. However, the 70’s experience low returns and high inflations.
The 80’s and 90’s in the other experience high returns.
Both cases were based on a scenario where
150,000$ were invested 20 years before retirement and 5,000$ with 3% increase
each year up to retirement. This is why the initial
cash flow is so different between each asset allocation.
For comparison with
other decumulation strategy, we will compare them using two metrics. The first
metric is the percentage of runs where the one withdrawal year is lower than
80% of any previous year. Under this metric the Safe Withdrawal Rate (SWR) is
the safest method. In comparison the Constant Percentage Withdrawal (CPW) is
the least safe. The Variable Percentage Withdrawal (VPW) with 50% equity to
bonds asset allocation is less risky than the CPW. Otherwise, we can also get a
feeling of the importance of each of the sub-strategy. The reserve is the most
important strategy in order to reduce this risk. Removing it, allows for
dramatic decrease in most of the asset allocation. The smoothing strategy is
the least effective strategy.
Risk II <80%
|
100%/0%
|
90%/10%
|
80%/20%
|
70%/30%
|
60%/40%
|
50%/50%
|
ADD 5,5%
|
0%
|
0%
|
0%
|
0%
|
0%
|
0%
|
ADD 6,5%
|
1%
|
1%
|
3%
|
6%
|
10%
|
14%
|
ADD 7%
|
6%
|
14%
|
13%
|
14%
|
18%
|
19%
|
ADD 7% minus reserve.
|
100%
|
100%
|
100%
|
100%
|
67%
|
64%
|
ADD 7% minus cap
|
38%
|
32%
|
28%
|
26%
|
21%
|
21%
|
ADD 7% minus smooth
|
6%
|
6%
|
12%
|
12%
|
19%
|
23%
|
SWR
|
0%
|
0%
|
0%
|
0%
|
0%
|
0%
|
VPW
|
100%
|
100%
|
100%
|
100%
|
100%
|
29%
|
CPW 5,5%
|
100%
|
100%
|
100%
|
100%
|
100%
|
100%
|
The second metric is the
Withdrawal Efficiency Rate (WER) as per Blanchett study. This metrics focus on
how much the withdrawal was able to produce out of the fund. It shows if the
methods were able to maximize withdrawal. We can see that the ADD strategy is rather
efficient at the high withdrawal rate. None of the sub-strategy seems to affect
WER negatively.
WER nominal
|
100%/0%
|
90%/10%
|
80%/20%
|
70%/30%
|
60%/40%
|
50%/50%
|
ADD 5,5%
|
64%
|
67%
|
69%
|
71%
|
73%
|
74%
|
ADD 6,5%
|
73%
|
76%
|
78%
|
79%
|
80%
|
80%
|
ADD 7%
|
77%
|
79%
|
81%
|
81%
|
82%
|
81%
|
ADD 7% minus reserve
|
77%
|
80%
|
82%
|
84%
|
85%
|
85%
|
ADD 7% minus cap
|
81%
|
81%
|
82%
|
82%
|
83%
|
83%
|
ADD 7% minus smooth
|
78%
|
81%
|
83%
|
84%
|
84%
|
84%
|
SWR
|
51%
|
54%
|
56%
|
58%
|
61%
|
63%
|
VPW
|
77%
|
77%
|
77%
|
76%
|
75%
|
74%
|
CPW 5,5%
|
74%
|
75%
|
77%
|
78%
|
79%
|
80%
|
Annexe:
Full parameters list:
a.
Portfolio asset allocation
b.
Accumulation-Dynamic Decumulation
withdrawal rate. A higher than usual rate should be used. The sub-strategy
reduces the effective withdrawal rate.
Smoothing – smallest impact on the risk reduction :
a.
Number of years to smooth: 5
years is used. This is in line with economic cycle.
b.
Conservative rate of return:
Using expected rate of return minus the variance seems to provide on average
smoothed market value equal to the average market value.
c.
Corridor: If the market is very
volatile the smoothed market value assessment is at maximum 20% off the real
market value.
Increase Cap:
a.
Capping % prior retirement:
115%
b.
Capping % at retirement: 108%
c.
Capping % prior retirement:
105%
d.
Capping % increase: 1%. If the
previous year withdrawal is cap, the next year cap is 1% greater than the previous
year. This allows compensating more rapidly during high gains.
Reserve:
a.
Initial reserve fund % : 25%
b.
Maximum reserve withdrawal: 10%
c.
Reserve protection : 95% of
previous withdrawal
d. Maximum reserve %: When the reserve is greater
than 35%, 50% of the excess is return to the main fund.
Simple example of the smoothing assuming a less than expected return
Data:
Year
|
2011
|
2012
|
2013
|
2014
|
2015
|
Average
|
Market value
|
500,000$
|
480,000$
|
490,000$
|
510,000$
|
530,000$
|
502,000$
|
Rate of Return
|
-4.0000%
|
2.0833%
|
4.0816%
|
3.9216%
|
N/A
|
1.7089%
|
·
Smoothed
Value with corridor at 2015 = Min(CorridorMin; Max(CorridorMax; Smoothed
Value)) = 558,359$
o
CorridorMin:
530,000*0.8 = 424,000 $
§ [Parameter]
Corridor Minimum = 80%
o
CorridorMax:
530,000*1.2 = 636,000 $
§ [Parameter]
Corridor Maximum = 120%
o
Smoothed
Value =
1/5*500,000*(-(-4%)+5.67%)+2/5*480,000*(-(2.0833%)+5.67%)+3/5*490,000*(-(4.0816)%+5.67%)+4/5*510,000*(-(3.9216)%+5.67%)+530,000
= 558,359$
§ [Parameter]
conservative rate of return =
5.67%
Simple example of the reserve
25% reserve
covering 95% drop using an ADD withdrawal rate of 8%:
Year
|
2008
|
2009
|
2010
|
2011
|
2015
|
MV BoY
|
500,000$
|
286,700$
|
355,660$
|
350,162$
|
328,096$
|
MV NR BoY
|
375,000$
|
210,450$
|
251,698$
|
263,981$
|
247,720$
|
MV R BoY
|
125,000$
|
76,250$
|
83,962$
|
86,181$
|
80,376$
|
Withdrawal BoY
|
30,000$
|
28,500$
|
28,500$
|
28,500$
|
28,500$
|
Withdrawal NR BoY
|
30,000$
|
16,836$
|
20,136$
|
21,118$
|
19,818$
|
Withdrawal R BoY
|
0$
|
11,664$
|
8,364$
|
7,382$
|
8,682$
|
MV EoY
|
470,000$
|
258,200$
|
307,160$
|
321,662$
|
299,596$
|
MV NR EoY
|
345,000$
|
193,614$
|
231,562$
|
242,863$
|
227,902$
|
MV R EoY
|
125,000$
|
64,586$
|
75,598$
|
78,800$
|
71,693$
|
Rate of Return
|
-39
%
|
30%
|
14%
|
2%
|
N/A
|
Market Value: MV;
Reserve: R; Non Reserve: NR; BoY: Begin of Year; EoY: End of Year
As expected in the
financial crisis, the fund substantially shrinks during the 4 years. However,
we are able to maintain a 95% of the initial withdrawal with relative ease. We
can see that the fund value increase substantially after the fabulous year of
2009 & 2010. The 2011 return is 2%, less than the effective withdrawal rate
(8%*75% = 6%). This lead to the Non-Reserve fund shrunk in 2012. The reserve
would be able to withstand about 10 years at the end of 2012 regardless of
future recovery.
