The need for retirement planning doesn’t end with the onset of retirement. A new retiree’s focus shifts
from building wealth to managing and preserving it. One major challenge is to make the investment
portfolio supply cash flow for the duration of life – and through different economic and market
conditions.

Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of
depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress
of changing markets and spending levels. The resulting models estimate portfolio survival in terms of
statistical probabilities.1 While the technical details are beyond the scope of this article, the general
conclusions are more intuitive.

Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame.
Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly
consider them.

Asset Mix
Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and
expected performance, and is one of the most important decisions investors of all ages can make.
Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium
reflects the higher risk of owning stocks.2 Consequently, the larger the equity allocation, the greater a
portfolio’s expected return—and risk.

Keep in mind that risk and return go together. A higher allocation to equities increases the risk of
experiencing periods of poor returns during retirement. But if you can handle the risk, having more
equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow,
inflation protection, and portfolio endurance over time. This is why most advisors believe that most
investors should have an equity component in their portfolios, with actual weighting depending on
one’s time frame, risk tolerance, and spending flexibility.

Spending Level
Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per
year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal,
however—and for different reasons. Briefly consider each one:

•  Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can

provide a stable income stream and preserve your living standard over time. But the portfolio
may survive only if future withdrawals represent a small proportion of the portfolio’s value. One
academic study quantified this amount. It found that a retiree with at least a 60% stock
allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and
enjoy a high probability of never running out of wealth.3 Choosing a higher withdrawal amount is
not likely to be sustainable, especially if the portfolio faces an extended period of negative
returns.

• Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual

asset value makes it unlikely that you will deplete retirement assets because a sudden drop in
market value would be accompanied by a proportional decline in spending. But this method can
produce wide swings in your living standard when investment returns are volatile.

Retirees who need relatively consistent cash flow may want to combine these two methods. One way
is to withdraw cash flow according to a rule that combines past spending (e.g., an average of the past
thirty-six months of cash flow) with a payout rate applied to current portfolio value. You can weight
these factors to favor your preference for either more stable cash flow or a greater chance of
portfolio survival. In effect, you are customizing your withdrawals to smooth out consumption while
responding to actual investment performance.

Investment Time Frame
Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan.
In this case, you can only guess how long your portfolio must support spending. If you plan to
bequeath assets, your investment time frame may extend beyond your lifetime. This may influence
your risk and spending decisions as well.

Time frame forces a tradeoff between the short and long term. Retirees with a longer investment
time horizon might choose a higher exposure to equities. But they may have to offset this risk by
being more flexible about spending over time. Elderly retirees and others with a short time horizon

may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid
taking more risk than they can afford.

Considerations
Planning involves assumptions about the future—assumptions that may not pan out. Although you
cannot avoid making assumptions, you can ask whether they are realistic and consider how your
lifestyle might change if future economic and financial conditions are much different than projected.
For instance, you may assume an average return based on historical performance. But there is no
certainty that future portfolio returns will resemble the past, regardless of time frame. Moreover,
short-term results may vary drastically, which could force hard financial choices. Investors should
think in terms of probability, not history.

Managing asset mix, payout, and time horizon inevitably involves tradeoffs. Exhibit 1 below illustrates
the dynamics. For example, a bond-dominated portfolio with a lower expected return may suit
investors with a shorter time horizon, or require them to accept a lower payout rate to increase the
odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for
someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption
of risk also results in greater uncertainty about future wealth. Retirees who take this route must be
able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to
market downturns. In fact, investor flexibility plays a role in all of the tradeoffs.

Finally, although you cannot fully control these and other factors involved in portfolio endurance in
retirement, having more wealth can improve the odds of having a less stressful financial life. A more
substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or
extend the productive life of your portfolio.

Endnotes
1. Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz. 1998. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” AAII Journal 20: 16–21. Also see: Bengen, William P. 1994. “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning 7: 171.
2. From 1926 to 2009, the S&P 500 Index returned an average 9.8% per year compared to 5.4% for long-term governmentbonds and 3.0% inflation. Sources: Standard & Poor’s Index Services Group for S&P 500 Index; long-term government bonds and inflation provided by Stocks, Bonds, Bill, and Inflation Yearbook™, Ibbotson Associates.
3. Cooley, Hubbard, and Walz, Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” 16–21.

Copyright © 2010, Merit Wealth Management, LLC, used with permission. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.