Much of the research in retirement income planning focuses on determining the highest sustainable spending rate as a percentage of retirement assets.

However, in a recent paper entitled “Guardrails to Prevent Potential Retirement Portfolio Failure,” published in the Journal of Financial Planning, William Klinger, a software developer and business professor, suggests financial advisors worry more about their clients coming up short. Advisors need to identify events or behaviours leading to potential failure early enough to rescue the portfolio. These signs can be used to establish “guardrails” to modify a retirement strategy, he says.

Klinger examined the failures that occur when using the 4% rule, a guideline that suggests clients who withdraw 4% of their savings in the first year of retirement and increase that dollar amount annually by the rate of inflation have an 80%-90% assurance that their savings will last for at least 30 years.

This rule then was tested, assuming portfolio returns are less than their historical averages, by reducing the annual withdrawal rate to 3% in order to observe the characteristics of failures using a more conservative withdrawal strategy.

Failures were analyzed and a set of early warning signs were used to create guardrails that might protect investors from depleting their portfolios prematurely.

Negative early returns, coupled with annual withdrawals, are clear indicators – but low, single-digit returns also can deliver a fatal blow to a portfolio, Klinger notes.

Portfolios with positive, yet low asset returns during the first 10 years of retirement failed at the same average rate of all simulated scenarios because withdrawals overwhelmed the weak gains.

For a constant, inflation- adjusted withdrawal strategy, the withdrawal rate ratio and portfolio value ratio are likely the most useful potential triggers.

If at any time in the first 10 years the withdrawal rate is 20% more than the initial rate (i.e., it exceeds 4.8% using the 4% rule), the study’s scenario failed 27% of the time within 21 years. If the withdrawal rate is 50% higher during the first 10 years, half of the scenarios failed. A drop in portfolio value both increases the failure rate and reduces the time to failure. Every 5% drop in the portfolio value ratio hastens failure by roughly a year.

For the research purposes, withdrawal incomes were reduced by 10% when an early warning was reached. For example, a guardrail could be specified to decrease the withdrawal rate by 10% when the withdrawal rate ratio has increased by 20%.

Simulations with such guardrails that use a withdrawal rate ratio as an early warning sign did not produce any failures until the ratio reached 20%. More important, the average failure occurs 28 years into retirement.

A guardrail was applied in the first 15 years of retirement only, however, with the reasoning that the withdrawal rate could increase later in retirement if the investor is not concerned with leaving a significant estate.

The guardrail rule all but guarantees that your clients won’t run out of money. But, faced with a sustained drop in the stock market, they could be forced to trim spending by 10% year after year.

© 2016 Investment Executive. All rights reserved.