The Volatility Buffer - Making "Safe" Safer (Part 2 of 2)
By Tom Wall
In my last post titled “A Primer on Safe Withdrawal Rates (Part 1 of 2),” I discussed how level income may be a better match for retiree spending patterns and unlock a lot of value for your clients. In this post I take that a step further and review my research on how the addition of a strategic asset to the portfolio would have historically improved safe withdrawal rates.
Since you cannot know which future you’ll be retiring into, you must develop a strategy to weather the worst of times, but in a way that still works for you in the best of times. To do so, you can identify or create a buffer asset in your portfolio. This will be a place you draw income from in years following a down market. Before we identify the types of assets that could serve in this capacity, let’s look at the concept and how it has impacted safe withdrawal rates over time. The following chart is the same as the safe withdrawal rates chart with level income, but with a twist. In this chart, I told the software to take a year off from taking income from the portfolio in the first __ years following a negative portfolio return. For example, if in year 3 the market crashed, then in year 4 income would come from somewhere else and we would take zero from the portfolio. If we only had enough to do this once, we would have 1 year of “volatility buffer” and would pull income from the portfolio in all subsequent years regardless of market performance. In other scenarios, I tested what safe withdrawal rates would look like if we could take the first 2, 3, or even 4 negative years off. The results are dramatic, improving some safe withdrawal rates by over 4%. To put that in real perspective, that improvement was over 40% more income, which is an entirely different lifestyle.
By viewing safe withdrawal rates in terms of probability of success like we did before, adding years of buffer income dramatically improves the probability your portfolio will last. Illustrated below, you can see that being able to take even one or two years of income from elsewhere improves probability of success dramatically. Having the ability to avoid selling low and exacerbating losses clearly has been a strategy that would have historically tamed sequence of returns risk.
The result of all this research can be summarized to say that for every year a retiree was able to pull income from somewhere else, they could have taken about 10% more income from their investment portfolio with a similar historical probability of success.
As discussed in part one, if you can approach your retirement income with a high level of adaptability, you can absolutely take higher initial withdrawal rates and intend to keep income level throughout retirement. Once again, keeping in mind that if unlikely financial shocks occur, you may need to adjust expectations for the future or pull back on lifestyle expenses for a bit. However, if you can also add a volatility buffer to the mix, you’ll be in tremendous shape to weather any storm. Putting it all together, the following chart shows where retirement income probabilities began with the “4% rule,” but how the power of a level income mindset and the addition of three years of buffer income could improve things. With level income and three years of buffer income, a retiree could roughly double their safe withdrawal rate.
Your unique value as a financial advisor is to help your clients have a conversation with their future selves, so they make the decisions today that their future selves will be wishing they had made. We are not stock pickers, and we cannot promise market outperformance. We act as coaches, strategists, and experts that our clients rely on for guidance in an impossibly complex world of personal finance. The volatility buffer strategy doesn’t need whole life insurance to work – it can be cash, alternative assets, home equity, or anything else that’s relatively stable and not tied to major investment markets. However, whole life insurance’s unique performance characteristics and incredible tax advantages without limitation make it the ideal place for cash within a retiree’s portfolio. Having this discussion with them before retirement elevates your status as a value-adding advisor, and gives them the time to build into this powerful strategy.
