Episode 340 Ben Mathew: The Lifecycle Model vs Safe Withdrawal Rates SWR

And the problem with SWR is it’s not assuming a concave utility function effectively. It’s worth thinking about the role of that utility function. This concave utility function makes us want to spread spending over time. Usually, people wonder what about lumpy expenses? My spending should not be smooth because I need to send kids to college for four years and my expenses would be high during those four years.

It was supposed to be like for a few weeks, he’s going to turn that spreadsheet into software, and then he got really into it. He was like, “Oh, wow.” This thing where people hear about the lifecycle model, and they get excited. First, he thought it was just retirement planning, but then he saw how other things would fit in. It’s like, “Whoa, this is all a financial planning. Wow, this is so interesting.” He’s been very excited about it, and he continues to build, so it’s getting more and more features.

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We want to think about the whole many different years, and many different goals, and future income, and things like that. But this is the basic principle around which that’s built. So when you have multiple goals all with the same asset allocation, your glide path will still be flat because all of the individual goals are being allocated at 50%.

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Maybe people may care about leaving money to their heirs, and the million dollars left to their kids and charity is preferable to squeaking by with a penny. It’s this pass-fail grading that doesn’t capture how the retirees actually feel. There’s that mismatch in the grading scheme. I think it’s important to recognize that all of these are reasonable utility functions.

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One is kind of okay, and the other is a fiasco. Our grading scheme is not reflecting what the retiree cares about. Look, I’m worried about the Great Depression, or the World War 1, or the 1970s. And you can amortize with that in mind. You can definitely tune that, so that when you compare what the outcome of a crash like this would be compared to your starting spending, you don’t want it to drop too low. So you start out low and then slowly climb up if the market does well.

When you assume fixed withdrawals, the nature of risk changes dramatically. When you assume variable withdrawals, if the portfolio does better than expected, all of spending increases. It’s evenly distributed across all of spending. But if you assume fixed withdrawals, you’re fixing that initial withdrawals. Then if the portfolio comes in lower than expected, all of that impact of that is being applied to the final year. The final year has become funded or not funded.

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• Let’s say three years of lower than expected returns brought you to the bottom of the crash.
• If you’re actually using a variable strategy, then a fixed asset allocation from the lifecycle model tells us it makes sense.
• If you look at what happened with the equity premium, it increased from 3% to 4%.
• So that even though the market crashes, the spending doesn’t decline by as much.
• It’s always positive, but it’s flattening out as we get more and more.

Then you would try to reduce your spending by 5%. That 7% drop in total wealth might be only a 5% drop in the wealth that funds your retirement spending. So that’s an extra layer of separation from the portfolio down to your spending.

Episode 340 – Ben Mathew: The Lifecycle Model vs. Safe Withdrawal Rates (SWR)

An assumption that economists have suggested is to assume that this human capital is bond-like, that this $2 million is bond-like. Then that tells you what you need to do in your savings portfolio. Even if you invest all $1,000 into stocks, when you look at your total wealth, that’s still too little stocks.

• The other issue that makes us hard that people don’t talk about as much is the issue of risk.
• But the assumptions that are made in the SWR model turn out to be very problematic.
• What fraction of time would they have failed or run out of money?
• And the intuition for that is time diversification.

And then the next year, if your wealth is 5% lower, your spending goes down by 5%. You keep jumping on to these new schedules. You jump up to a higher schedule when the returns come in better than expected and down to a lower schedule. The spending sequence that it traces out is basically variable spending. It’s not fixed spending because you’re constantly recalculating. But just hearing that 95% or 80% probability of success doesn’t create this picture, doesn’t tell you this trajectory and the cloud around it.

The reason we want to spread this consumption, spread spending over time and not have the sudden drop, is really because we have a diminishing marginal utility of consumption. We value the first loaf of bread more than we value the second loaf of bread, which we value more than the third loaf of bread. Because that second loaf of bread is not that valuable. My brother is a software engineer, so I recruited him. I asked him if he can help turn the spreadsheet into software. He started doing that, and he got really into it after a while.

The safe withdrawal rate method is not being the right choices. It’s simplifying away these important parts of how we behave and what we care about. It’s not a good model in order to get that rough approximation. You don’t get a good rough approximation by using a model that has simplified away the important parts of the problem. The answer is that all three are reasonable. You could reasonably have preferences that need you to do any of these things.

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Given current valuations, that would be a very optimistic expected return assumption to use. Market crash https://www.inkl.com/news/sober-house-rules-a-comprehensive-overview was lower than expected returns year after year after year. Let’s say three years of lower than expected returns brought you to the bottom of the crash.

And you’ve had the principles, Victor Haghani and James White, who have written a very good book on the lifecycle model, called The Missing Billionaires. If you’re investing in a Vanguard target-date funds, you are using the lifecycle model, even though you’ve not heard of it. The other model is the safe withdrawal rate or SWR model. This was created by a financial planner named Bill Bengen in 1994. This ended up being widely used in industry. It’s kind of like the standard way of doing things in industry now.