Determining safe retirement withdrawal rates using forward-looking distributions

Abstract

An important topic for retirees is determining how much they can safely withdraw from their retirement savings: draw too much from their retirement fund and risk outliving their retirement savings, or draw too little and live below their means. For retirees to decide on the appropriate withdrawal rate, retirees need to have the tools available to decide on their spending rates. There are many factors that influence withdrawal rates, such as initial wealth, asset allocations, age, life expectancy, and risk tolerances. The topic of safe withdrawal rates aims to optimise spending rates while minimising the risk of running out of retirement savings. The focus of this study was on using forward-looking moments of the risk-neutral and real-world asset distributions in determining safe withdrawal rates for South African retirees. The use of forward-looking information, typically derived from traded derivative securities (rather than historical data), is essential in optimising safe withdrawal rates for retirees. In particular, we extracted the forwardlooking risk-neutral and real-world distributions from option prices on the South African Top 40 index, and used the moments of the distributions as a signal in a simple tactical asset allocation framework. That is, when we expect the growth asset to decrease in value, we hold cash (or short the asset) and, alternatively, when we expect the growth asset to increase in value, we hold the growth asset for the period. Using this approach, we found that we can sustain withdrawal rates of up to 7% compared to the commonly quoted 4% safe withdrawal rate obtained by historical simulations. Significance: Through this paper, we aim to create further awareness on safe retirement spending rates. It is important that retirees are guided through this process with the correct knowledge of the risk and return of asset classes. Using forward-looking information allows for a more realistic modelling of portfolio returns, which allows for the possibility of better modelling of safe withdrawal rates. We show that using the moments of the forward-looking distributions in a simple tactical asset allocation framework yielded superior portfolio returns to a fixed asset allocation structure.