Asset Allocation and
the Implementation of the Four Percent Rule
The most commonly used version of the four percent rule sets
initial disbursement at four percent of the assets of a 401(k) plan and links
future disbursements to inflation. The rule
is a useful rule of thumb used by many financial advisors to guide disbursement
decisions from 401(k) plans during retirement.
Whether or not the rule is sustainable depends on a number
of issues. This post deals with one
narrow issue impacting the performance of the four percent rule, the mix of
assets in the 401(k) plan. The post
examines one narrow choice of assets and one time period.
Situation: A person retiring in January 2003 has
$300,000 in assets. She will take a
monthly disbursement of $1,000 (0.04/12 x $300,000.)
She is considering two different investment strategies. The first strategy involves placing all
$300,000 in one fund VTSMX, which covers the entire U.S. stock market.
The second strategy consists of placing $150,000 in a
largecap fund VFIAX and $150,000 in a midcap fund VXF.
Disbursements from the twofund strategy are assumed to be
proportional to fund balances at the time the disbursement is made.
There are two sources of differences in financial outcomes
between the two strategies. First, the
returnrisk profiles of the two portfolios differ. Second, the twofund strategy creates a
situation where the retiree will reduce asset sales from a fund that is
temporarily doing poorly.
Questions:
·
What were the return/risk outcomes of the funds
over the 2003 to 2015 time period?
·
Can the twofund strategy provide a more stable
financial outcome and more wealth in the long term than the onefund strategy?
·
What is the lowest level of wealth for the two
investment strategies over the 2003 to 2015 time period?
·
What is the terminal level of wealth from the
two investment strategies?
Description of fund
risk and return:
There are differences in the three funds being considered by
this retiree.
·
VTSMX provides exposure to the entire U.S. stock
market. Its top 10 holding are around
15% of the fund’s value.
·
VFIAX invests in the 500 largest U.S. companies. Its top 10 holding are around 19% of the
fund’s value.
·
VXF seeks to track an index composed of small
and midsize companies. Its top 10
holding are less than 5% of the fund’s value.
Below are the statistics on the financial performance of the
three funds over the 2003 to 2015 time period.
Financial Statistics for
Three Funds


Fund

# of Months

Mean Return

STD of Return

Minimum Monthly Return

Maximum Monthly Return

VTSMX

155

0.00772

0.04207

0.19393

0.10892

VFIAX

155

0.00737

0.04061

0.18372

0.10376

VXF

155

0.00914

0.05148

0.24342

0.15091

Sample covers 155 monthly
returns from February 2003 to December 2015.
Observations:
·
VXF (the smallcap and midcap fund) had higher
returns and higher variability of returns than either the overall stock market
fund or the largecap fund.
·
The return/risk profile for the overall stock
market fund and the S&P 500 fund are really quite similar. VTSMX has slightly higher returns. VFIAX has a slightly lower level of
risk. (This is as expected.) Basically, it appears as though the S&P
500 firms dominate VTSMX so there is little difference between the two funds.
Discussion of
potential advantages of the twofund strategy:
Total disbursements are $1,000 regardless of whether the
retiree chooses one fund or two funds.
There is however a major difference between a onefund strategy and a
twofund strategy.
The person who invests all money in one fund must disburse
all funds from the single fund each month regardless of market conditions. The shares sold each period from the onefund
strategy are
Share sold VTSMX =
$1,000/Price of VTSMX
The person who chooses to invest in two funds can choose to
increase disbursements from a fund that is doing well and decrease
disbursements from a fund that is doing poorly.
The twofund example presented here assumes disbursements
are proportional to asset balances.
Shares sold VFIAX=
(Value VFIAX/Value Both Funds) X $1,000
/ Price VFIAX
Shares Sold VXF =
(Value VXF/Value Both Funds) X $1,000/ Price VXF
When VFIAX increases relative to VXF disbursements from
VFIAX increase. When VXF is high
relative to VFIAX disbursements from VXF increase.
The proportional disbursement rule is quite passive. I could come up with a more aggressive
disbursement policy. This question is on my todo list.
Wealth outcomes for
the onefund and twofund strategies:
Payout and the wealth trajectory from the two strategies are
calculated in a spreadsheet.
Financial Results From
Two
Investment Strategies


OneFund Strategy

TwoFund Strategy


Minimum Account
Balance

$254,812

$271,417

Maximum Account
Balance

$724,887

$839,960

Ending
Balance

$701,027

$792,356

Observations:
The twofund strategy dominated the onefund strategy in
terms of both return and risk for this particular time period.
·
The minimum account balance (which occurs in
early 2009 during the financial crisis) is around $17,000 higher for the
twofund strategy than for the one fund strategy.
·
The difference in the max balance of the two
funds an event that occurred in early 2015 was around $115,000.
·
The gap between the twofund and onefund
strategies has fallen in 2015 because of the recent decrease in the price of
the midcap and smallcap fund. The
difference in wealth from the two strategies is now around $90,000.
A prescient investor or astute wealth advisor would have
taken money off the VXF table early in 2015. Hindsight is always 20/20.
One final thought: Part of the savings from the twofund
strategy is from the higher disbursements from the VXF fund.
·
The proportionate disbursement strategy led to
$68,000 in disbursements from VFIAX.
·
A $150,000 investment in FVIAX in isolation
under the four percent rule would have led to a disbursement of $77,500.
In this period superior returns from VXF reduced
disbursements from VFIAX.
The analysis in this post is not a recommendation of a 50/50
VXF VFIAX allocation. Such an asset mix
is
Concluding thoughts:
The analysis in this post is not a recommendation of a 50/50
VXF VFIAX allocation. Such an asset mix
is fairly risky. Investors need to
but some money in other asset classes and have some liquidity.
The four percent rule gives decent results so far for the
person who retired in January 2003. The
outcome for an investor who follows the four percent rule and uses either of
these asset mixes would not have been nearly so pretty for a person who retired
at the start of the financial crisis in 2007.
Wall Street’s solution to obtaining a secure pension is for
people to save more. Unfortunately,
saving more will not help if you retire at the wrong time and adopt the wrong
investment strategy.
More posts on how to manage your retirement fund will
follow.
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