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

It’s crossing over into risk-loving territory. Even if you’re offered a very attractive bet, a million percent expected return, you say no because I don’t care about the plus side of things. I only worry about dropping below the threshold, so you become infinitely risk-averse. They may say, “Well, that’s tolerable. They’re going to keep their fingers crossed and hope that they are in that 95% chance of not running out of money and not in that 5% bad outcomes.

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

But if you just talk about all retirement years all funded with 50%, the fixed asset allocation would apply to total wealth, not to the savings portfolio. And think of that as the normal thing that people would have done historically in terms of asset allocation. For one, the success rate has lost its meaning. It doesn’t mean anything anymore because you are not going to stick to a fixed withdrawal, you are going to adjust. You’re either going to spend more than you thought or less than you thought. It’s some sort of variable scheme saying that you have a 95% probability of success or a 60% probability of success.

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It’s been studied and built upon by many of the greatest economists that have lived, but it’s underutilized in the real world. That’s really what we discussed in this episode. We talked about the different approaches to financial planning. We talked about the lifecycle model and how it works. And we talked about, to contrast that, safe withdrawal rates. I think it’s a pretty good financial planning discussion.

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What do you do when returns come in higher than expected or lower than expected? It’s simple and straightforward, you just recalculate. I think the arc of lifecycle model is going to be the same. It’s definitely been slower than index funds. Once people see that, people do get excited about it.

But we know that these things do vary over time. We just don’t know in which direction they’re going to vary. Assuming that expected returns are constant is not exactly right, but it’s not too bad because you’re at least in the middle of the set of possibilities. Look at this case where you actually had the $10,000 in your hands. And there’s no more income coming in to fund that goal. The asset allocation on this should be that fixed 50% the whole time.

• So that would be a sensible thing to do in light of the fact that we don’t know how it’s going to change.
• This was the fallacy of time diversification.
• That’s a 33% increase in the rewards offered by stocks over bonds.
• The price of doing that, it only involves high school algebra to figure out.
• You may have momentum over short horizons and then reversion over long horizons.

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Then if returns come in better than expected, you’d end up higher than this line. If returns come in lower than expected, you would end up below this line. That creates some variability, a cloud of possibilities around that line. It’s important when we’re looking at these models to make the right kind of simplifications. We should retain the important parts of the reality and then simplify away the less important.

Both risk and reward are increasing over long horizons. If returns are independent, they’re increasing at the same rate, and so the asset allocation becomes independent of the time horizon. You call the same asset allocation over long horizons as you do over short horizons. I think that’s why it’s important for people to not hide the expected return assumption like this and to pull that out and stare at it and see if it makes sense. People like to hide it because it’s hard to think about and it’s hard to face the fact that expected returns do matter. When it comes to stocks, we don’t know.

That’s a really bad thing because that first loaf of bread is very valuable to you, or the first slice of pizza is really valuable to you. Lots of people talk about it, gets a lot of airtime. The other issue that makes us hard that people don’t talk about as much is the issue of risk. We’re also pretty bad at thinking about risk. And in financial planning, risk doesn’t show up in simple ways.

But one is the fact that we typically get a positive rate, a real rate of interest. So after inflation, we still get more money. If you save money, you still get more later on. If you give up a loaf of bread today, you get two loaves of bread in the future. There’s an incentive to try to save more and try to spend more later rather than early because you can increase your average spending if you delay spending.

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Then we have to try to evaluate the outcomes. In the absence of a sensible utility function, people, it’s not that they become wiser and use more nuance and so on in their evaluation. They resort to the zero-one utilities function that produces very bad recommendations and inappropriate results.

But they naturally started doing it because it’s so natural to amortize your portfolio to calculate withdrawal. So then it seemed like academia and at least what some people are doing are so close that the gap seemed bridgeable. If I just write a book about it, people read it and say that’s interesting, but you really need tools to implement it. I started out by creating some spreadsheets to do these calculations. Spreadsheets are always cumbersome to customize, change the number of rows and so on. Using the toolkit of economics, the economists have thought hard about this and try to understand how we think about risk versus return.

That can imply that upward sloping glide path would reduce risk. If you’re actually using a variable strategy, then a fixed asset allocation from the lifecycle model tells us it makes sense. It would be the right approach in retirement. It’s quite hard to see, I would say, that the fixed withdrawal assumption is actually impacting the asset allocation coming back an upward-slipping glide path. If you’re looking at the probability of success, you don’t look at the sober house severity of the failure. You’re just focused on counting the times that you were successful.