Making the money last: Research insights on the decumulation challenge

Multiple authors
2023-04-30
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Among investors pursuing long-term objectives like retirement, there is an understandable tendency to focus on the accumulation of assets. But as populations around the world age and need to tap into accumulated wealth, there will be a growing interest in sound decumulation practices — a complex investment challenge and the subject of a recent research project we conducted.

The path-dependency effect

A decumulation strategy must support regular withdrawals from a portfolio regardless of the performance of the underlying investments. Unless the strategy generates a sufficient return, withdrawals will eventually erode the capital below a desired amount or completely (longevity risk). Even if the return is equal to the withdrawal rate, erosion could occur, as the return replacement process is affected by path dependency (or sequencing risk), which is in turn determined by the interaction between the withdrawals and specific characteristics of the strategy’s realized return (which we will refer to collectively as the portfolio distribution).

Figure 1  illustrates the role of withdrawals in the decumulation challenge. The orange line shows a US$1 million hypothetical portfolio that generates a -10% return and then experiences a withdrawal of 4% of the initial portfolio value (US$40,000). The portfolio would then need to generate a return of more than 16% to get back to the US$1 million starting point, compared to an 11% return for a portfolio with no withdrawals. For comparison, we included an accumulation portfolio (light blue line), in which capital is contributed periodically and portfolio drawdowns are more limited.

Figure 1
making-the-money-last-research-insights-on-the-decumulation-challenge-fig1

Next, we considered how the distribution of returns creates the path-dependency effect. We started with two hypothetical US$1 million portfolios and then assumed withdrawals of 4% of the initial portfolio value (US$40,000) annually, spread over equal amounts on a monthly basis. We assumed that Portfolio A returned exactly 5% (annualized) every month while Portfolio B had a distribution of returns centered around 5% (annualized). While the expected returns were the same, Portfolio A had a 100% probability of capital preservation over 30 years and Portfolio B had only a 71% probability. This is entirely due to path dependency, which is a function of the portfolio distribution.

Figure 2  examines the impact of the portfolio distribution in more detail, showing that even if the withdrawal amount and return target are equal (highlighted in orange), there is only about a 50% chance of preserving capital through time. Why? The actual return is in a range due to the distribution, so 50% of the time, withdrawals will not be matched by an equivalent (or higher) return. To improve these odds, investors need to improve the distribution.

Figure 2
making-the-money-last-research-insights-on-the-decumulation-challenge-fig2

The critical role of the portfolio distribution

The key variables in a decumulation strategy, as we’ve established, are the level of withdrawals and the realized returns of the strategy. Lower withdrawal rates will, all else equal, lessen the erosion and reduce the longevity risk. But this option may not be feasible, depending on the needs of the decumulation investor. With this in mind, we opted to focus on how the realized returns, a function of the portfolio distribution, can be modified to improve the outcome of decumulation strategies. Specifically, we looked at how five characteristics of the portfolio distribution can impact the success of a decumulation strategy: returns, volatility, skewness, peakedness, and the left tail of the returns. Among our key findings:

  • Decumulation strategies should target an expected return above that of the withdrawal rate. However, higher returns are also often associated with higher risk, which can worsen portfolio outcomes, as noted above. Therefore, volatility should be as low as possible for a given level of return, implying maximization of the Sharpe ratio.
  • Decumulation portfolio design should aim for negative skew and higher peakedness. We think this focus on negative skew, which stems from the importance of where the mass of the distribution is concentrated (as opposed to the length of the tails), differs from standard practice, which tends to focus on the tails. In practice, we acknowledge the difficulty in building portfolios that target specific return distributions, but we believe it should be a consideration during portfolio construction.

We share more of our analysis in our paper, Demystifying decumulation: A practical guide. We also suggest practical methods for improving the likelihood of success in decumulation strategies, focusing on portfolio construction, process design, and implementation. These insights may be of use to investors constructing their own decumulation strategies or those evaluating third-party strategies.

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