How to Calculate An Advisor’s Value: Dynamic Withdrawals

with No Comments

How to Calculate An Advisor's Value: Dynamic WithdrawalsAllan S. Roth wrote an article for Financial Planning magazine entitled “Calculating An Advisor’s Value.” The article claimed that five different components of intelligent planning decisions comprised the value brought by a smart financial advisor. According to Morningstar, planners can add the equivalent of 1.82% annual return to clients through these five components of what they call “gamma.”

I commented on the introduction and indexed of all five components (plus two additional items) in a previous blog post. In this post I am just going to comment on the third of the five, “Dynamic Withdrawals”, to which Morningstar suggests that advisors bring an additional 0.54% to their clients. Here is they describe the component:


How much money can your clients spend safely without running out? Should it be chosen using a 10% chance of failure, or a 25% chance?

Morningstar itself has said that, because of low bond yields, the old 4% rule has become a 3% rule. That means for every $100,000 in a portfolio, it considers the new safe spend rate to be $3,000 annually, increasing with inflation.

In reality, picking the safe spend rate is also related to the prior two components – selecting the right asset allocation and achieving tax efficiency. Advisors must minimize both investment expenses and client emotions in order to achieve the highest safe spend rate from a portfolio.

Moreover, these safe spend rates must be somewhat flexible. If stocks lose half their value again, clients may have to accept that, at least temporarily, they might need to reduce spending. If you can help clients figure out in advance where they would cut spending if the markets tumbled, you allow them to more readily implement changes if their investments perform worse than the bad-case scenario.

There is a lot packed into this section. Let me see if I can explain some of the assumptions.

In the 1990s, Bill Bengen proposed the 4% rule which stated that retirees can start to withdraw 4% of their portfolio at age 65, increase the dollar amount by inflation, and have a high probability that they will not run out of money before they die. Historical studies suggest that 4% is slightly low and 5% is too high. Bengen eventually set the figure at 4.5%. Other advisors have suggested amounts all over the map from 2% to 6%.

The studies associated with the 4% rule are important touch stones, but they don’t help when a client comes to you at age 78 and you don’t know how to calculate the safe withdrawal rate.

Also, the word “safe” is commonly misunderstood. In the financial planning world “safe” generally means an 80% or higher chance of success. But every retiree wants and needs a 100% chance of not running out of money. This miscommunication leads to a great deal of uncertainty and fear as clients approach retirement and asset allocation. Having enough money in 10 years depends on having enough growth to overcome the effects of inflation. But having enough growth means having a portfolio which is more volatile and therefore might drop in value jeopardizing the safety of their retirement.

There is a “right” asset allocation for each age and withdrawal rate. In this case “right” being the asset allocation which gives you the best chance of success. And success, in this case, means not having to reduce your standard of living. In other words, a failure would be any time the client cannot have a full cost of living increase each year, but instead has to take something less for a while in order to let their portfolio catch up from a market downturn.

Having sufficient stable investments (fixed income) to cover the next 5-7 years of safe spending rates is an important part of your total wealth management. Perhaps this is where the study is suggesting that a smart advisor might bring an extra 0.54% of value. Assuming your stock investments average 11% (6.5% over inflation and 4.5% inflation) and you have a 4.5% withdrawal rate dynamic withdrawals might boost returns by 0.495% over the entire portfolio. Taking withdrawals from the equity side of the portfolio when it is down is a costly mistake in retirement.

I spent a year and a half studying the systematic withdrawal rate studies and created safe initial withdrawal rates for every age from 0 to 100. Our study is based on living through your 100th year (to your 101st birthday) on average with a portfolio earning, on average, 3% over inflation which is the average for a bond portfolio. On average means a 50% chance of success, but because the age is high and the growth is conservative, these withdrawal rates give retirees an over 80% change of being able to adjust their initial withdrawal rate up by inflation each year. And because the straight line projections are conservative (stocks on average earn about 6.5% over inflation) if the markets go down retirees can keep their spending constant, forgo that year’s inflation increase, and wait for the markets to rebound and pick them back up on the way up.

I believe the Marotta maximum safe withdrawal rate chart is probably one of our most significant contributions to the body of financial planning wisdom.

And for the curious, at age 65 our safe withdrawal rate is 4.36%, right in line with what the studies would suggest. But if you want you can retire at age 50 so long as you can live off 3.82% of your after tax assets. And you can retire as a trust fund baby at age 20 assuming you can live off less than 3% of your after tax portfolio. Having said that, there is an important caveat:

The most important point of this article is that “picking the safe spend rate is also related to the prior two components – selecting the right asset allocation and achieving tax efficiency.” If you put your entire portfolio is gold coins or even worse cash you are unlikely to archive an average return sufficient to support these withdrawal rates. In other words, being too safe jeopardizes your standard of living in retirement.

Finally, an asset allocation must include rebalancing back to that allocation. And the genius of rebalancing often means selling what has gone up and buying what has gone down even if you think it is “going down” (present tense).

The Morningstar suggest suggests dynamic withdrawals add 0.54% to client portfolios. But having a plan not to run out of money is priceless.

Here is an index to the entire “How to Calculate An Advisor’s Value” series.

And here is a link to having us help you with your comprehensive wealth management.

Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.