To illustrate, let us use the example of a 65-year-old man who has just retired. He has a moderately conservative attitude to risk, and would like a high probability that his money won’t run out over the planned period – which we have quantified as a 93-96 per cent confidence level. Figure 1 assumes that his money will be split between 65 per cent equities and 35 per cent fixed income, which is quite a traditional approach.
Figure 1
In figure 1, our pensioner is able to take a 4.1 per cent sustainable withdrawal rate from his 65:35 portfolio with a 94 per cent probability of success. So, our pensioner can draw down from his portfolio at a rate of 4.1 per cent, being unlikely to run out of money during his lifetime. The 4.1 per cent is taken in the first year of retirement. The amount drawn down is then increased in subsequent years assuming a 2.5 per cent annual inflation rate.
In other words, our stochastic analysis of the traditional approach to generating a sustainable withdrawal rate arrived at a remarkably similar conclusion as the 4 per cent rule.
As an interesting aside, if the portfolio had been put 100 per cent into equities, the sustainable withdrawal rate would be 3.6 per cent and, if the portfolio was 100 per cent fixed income products, the sustainable withdrawal rate would be just 3.2 per cent; a view supported by William Bengen: “The one alternative [your client] cannot afford, and which we as advisors must work hard to dissuade him from doing, is to pull back from the stock market and retreat to bonds.”
The development of a sustainable withdrawal rate model is critical but, in itself, it merely measures threats facing pensioners’ financial sustainability rather than addresses them.
So, what are the alternative investment strategies that will address the main risks facing pensioners?
Futures-based hedging has been in existence for many years. Large financial institutions use futures contracts on major market indices to seek protection against volatility and broad-based stock market declines. With the world’s economy relying on futures contracts for price stability, risk management and long-term planning, we believe it also makes sense to include this type of risk management at the retail level, providing pensioners efficient access to well-established risk management strategies.
Prior to 2008, this type of financial risk management was available only at the institutional level. Today, futures-based risk management strategies can be accessed at the retail level through various mutual funds, exchange-traded funds, collective investment trusts, target-date funds and variable annuities, in an effort to weather market turbulence and improve clients’ likelihood of meeting retirement goals.
