Recently we’ve gone series on risk management for our portfolios, it seems that it would be interesting to go back and look at how much you need to retire if you apply some of these techniques.

The full story on the assumptions behind the conventional wisdom can be found at our previous article on how much you need to retire.

You may recall our analysis of the standard rule of thumb only allows withdrawing 4% a year if you want to have your savings last at least 30 years.

So if you wanted to start withdrawing $80k a year, you would need to have $2 million dollars in savings.

We concluded that there were 4 major areas we could explore to reduce the amount we need to have save to create your target income level)?

1. Reduce the number of years you want to ensure income (or the retirment age). (This had a surprisingly low impact on the withdrawal rate).
2. Accept a lower inflation rate. (This has it’s own set of risks)
3. Increase the returns on your investments. (While more is better, if it’s achieved with an increased risk it can actually reduce probablity of success, hence the 75/25 mix of stocks to bonds as the most effective allocation for success in the original analysis)
4. Reduce the risk of your portfolio. This is the area that we suspected could yield the most improvement in our odds of success.

The original analysis in the Cooley, Hubbard, and Walz paper concluded that with 75/25 mix of stocks and bonds you had a 98% chance of having your savings last 30 years if you withdrew 4% a year (this assumed you increased your dollar withdrawal amount each year to match inflation.)

This 75/25 mix has historically yielded about 10% annually, with a standard deviation of about 15% (depending on which historical period you measure it over).

Impact of Improved Risk Adjusted Performance

In our last hedged portfolio that we built in our series on managing investment risk, we constructed a diversified, hedged portfolio that yielded 16%, with a standard devation of 7%. Now, to be clear, this was only backtested over 11 years, while the Cooley paper backtested of almost 70 years. But it is interesting to note that over the 11 years that we backtested, the annual return of the S&P 500 was 11%, with a standard deviation of 20%, which is very close to its 70 year average. So it would seem that the period we were looking at could be considered representative of the larger history base.

We can plug in the annual return and standard deviation of the hedged portfolio and model it over of a large number of randomly generated numbers that match the same averages (this is a process known as a Monte Carlo simulation), and see what we might expect for the longevity of our portfolio.

If we assume that we can match the recent performance of the hedged portfolio over time, and we assume a 3% inflation rate, then it turns out that we can withdraw almost 10% per year, or 250% of what you could withdraw at the standard 4% rate.

But, that may be optimistic. Let’s assume we can’t match that in the future, but there is still an above average risk/ reward ratio. Instead of 16%, we’ll assume 14% annual return, and let the standard deviation of returns increase from 7% to 9%, and let the inflation rate go from 3% to 4%. Even with that considerably more conservative projection, the withdrawal rate could still be 7%, or 75% more than the standard 4% projection.

What Should You Do For Your Retirement?

Any retirement planning you do should be done with the help of your financial planning professional, and the yields of these portfolios have yet to stand the test of time. But the clear message here is that you are best served by focussing your investment strategies on the risk adjusted performance of your portfolio. That eventually has the biggest impact on the longevity of your retirement income. The standard asset allocation of 25% of your portfolio invested in bonds is just a small first step in creating a risk optimized portfolio that will serve you well in your retirement years.

Of course, risk measurements of any sort (even a simple drawdown history) are not readily available from most advisory services. Almost all advertising and ranking focuses exclusively on the annual return numbers, and candidly that’s becuase that is the only number that most investors understand or want to know.

The Hulbert Financial Digest does provide risk adjusted performance rankings of the serivces they track, so if your advisory service doesn’t provide any sort of risk metrics (like drawdown or Sharpe rankings) you might find more information there.