Monday, November 27, 2023

But people do enjoy spending their money !

In the rush to come up with sustainable ways to spend down your retirement assets, we often run into the problem where the thought leadership would reduce the withdrawal rate to achieve a safer withdrawal plan. It is only within the financial blogosphere that this is encouraged and celebrated. 

Everywhere else in the real world, we tend to forget that people actually enjoy their money and if you actually want to make your finances sustainable until you are age 120, a lot of your wealth will remain unspent. For me, unspent wealth is fine as I have biological kids, but the FIRE movement is full of singles so this will just result in a lot of extremely wealthy godchildren, nieces and nephews. 

The problem is that the conventional approach to FIRE using the Bengen approach, suppose you begin with a portfolio size of $1,000,000, and you designate 4% or $40,000 as your expenses the following year. Then you adjust it by the inflation rate the following year, and so on. The idea is that you won't run out of money in about 30-40 years. 

But in reality, folks are living longer, and that fear of running out of money will cause advisors to recommend lowering the starting amount to around $25,000 to increase the probability of sustaining the retirement portfolio closer to 50 years.

I leave it to readers to see how ludicrous it is to tell a millionaire to live within an inflation-adjusted $25,000 a year every year, some people may even think that some work is better than early retirement. 

How do we address this critique in a data-driven manner?

My solution is to run a Monte Carlo simulation of a 60/40 ETF portfolio and actually simulate the probability of having cash left after 50 years. However, I also enhanced my code with a measurement of utility.

When it comes to spending money, we prefer to spend it spread over a period of time rather than concentrate on a particular year. Spending more money creates more happiness, but does so with diminishing returns. There should also be a reasonable discounting factor where spending money now when you are young is better than spending it when you are old. The solution from economists is to apply a discounting factor into a class of Constant Relative Risk Aversion (CRRA) equations to amounts withdrawn for enjoyment. 

[You don't have to worry about the math because I have already coded it into Python Jupyter Notebook. ]

So let's start with a baseline. 4% withdrawal rate of a 60/40 portfolio. Adjusted annually by inflation that averages 3%. Risk aversion is that of a seasoned but cautious investor. We have a fixed time preference of 2%.

The first problem is that there is only a 16% chance of surviving 50 years. However, the expected utility of 24.66 is a baseline that measures the pleasure of spending the money over time. 

Now let's observe what happens when advice is given to reduce the withdrawal rate to 2.5%.

As it turns out, my simulations would support this lowering of the withdrawal rate to 2.5%. The probability of surviving 50 years is increased to 72%. We also have a higher utility as the money lasts longer and spreads over a longer period of time thanks to more compounding from money not spent.

So my models vindicate the advice to reduce the withdrawal rate to 2,5%!

Now, let's see what happens if we stop the Bengen approach. I modified my code to withdraw the prevalent balance of the portfolio at the same 2.5% rate. So if the portfolio rises to $1,100,000, we will spend $27,500 in the subsequent year. We ignore the effects of inflation. 

Because we have to draw 2.5% of the prevailing portfolio, the withdrawal system is 100% sustainable over many years, but note that the expected utility is even higher than the Bengen system because where the underlying portfolio does very well, you keep up with spending and enjoy more in that particular year. I repeated the simulation with 3% with no significant change in the expected utility.

What can we conclude from this series of experiments?

If you are offered a safe rate withdrawal of 2.5% for your portfolio by an advisor, do consider the feasibility of withdrawing 3% of your prevailing portfolio size instead. You will derive more enjoyment from your money over the next 50 years.

However, there is a weakness of this approach. What happens when you come across a year where your portfolio has shrunk so much that 3% of its size cannot sustain your expenses?

In a vacuum, it may be a reason to abandon this approach. 

But in reality, our basic needs should be reinforced by having an Enhanced Retirement Sum in our CPF Life before taking into consideration returns from our diversified ETF portfolio. Most of us are also sitting in gold mines otherwise called our residential properties. 

Ultimately, it may even be a reason to struggle hard when young to have a spouse and children. 

As I've said in a podcast before, children are the annuities of last resort. 

[ My program allows different risk appetites and time preferences. It can also adapt to a different mix of ETFs. The backtest is extreme and stretches back to the first availability of Yahoo finance data. ]



No comments:

Post a Comment