Mechanism for regular withdrawals from the VP

[tarentola]

From the PP, withdrawing is straightforward: the cash reserve is built in. The subject of withdrawals from the PP has been discussed several times in this forum, notably in a thread that is unfortunately in the "Other Discussions" section: http://gyroscopicinvesting.com/forum/ot ... a-myth/48/

For a VP, the cash reserve is not necessarily built in and must be added. I am retired and the withdrawals are to complement my pension.  I wanted a mechanism that was more or less automatic, to reduce decision-making, and allowed payments to me that are relatively independent of short-term variations in the market. So I have set up a mechanism for regular withdrawals from the VP. The method is based on the method of galeno on the Motley Fool [url=http://(http://boards.fool.com/mechanical-investing-and-mechanical-withdrawing-12423886.aspx](http://boards.fool.com/mechanical-inves ... 23886.aspx[/url].

Two decisions to make are how much to set aside as a cash or near-cash reserve, and how much to withdraw annually.

Assume a starting portfolio of 100,000€ (100 units):

I wanted to have a buffer of reserves in cash or near-cash, to make income less dependent on fluctuations in the active portfolio. Assuming 4% withdrawal (see below) I chose five years, but this figure is arbitrary: I could have decided on three years or six years, or zero years, depending on my tolerance for fluctuation. That is why 20% of the portfolio is the cash buffer (not very different from the PP's 25%). This gives 80 units actively invested + 20 units in cash.

I wanted to withdraw no more than 4% per annum from the actively invested part (equivalent to 3.2% per annum from the total investments). I assume that the invested 80 units will sustainably generate on average 3.2 units per year, or 0.27 units per month. On average - not every year. There is a big difference. Hence the buffer.

1 Jan on year 1: set aside 20 of my 100 units in the buffer and start monthly withdrawals from the buffer to my spending account. My buffer is in a life insurance policy that generates about 1.5% p.a. (I am in Euroland where life insurance gets favourable tax treatment) and makes an automatic monthly payment to my spending account. My year's "salary" is 1/5 of the buffer or 4 units, so every month I receive in my current account  4/12 or 0.33 units, equivalent to 1/60th of the buffer.

31 Dec on year 1: I have spent my 4 units on wine, women and song (the rest I just squandered, to quote the soccer player George Best), leaving 16 units. Suppose the invested portfolio makes 0% over the year, so still has 80 units. Transfer 4% of the 80 units (=3.2) to the buffer. This is an effective withdrawal rate of 3.2% of the whole portfolio. Buffer now contains 16+3.2=19.2 units.

1 Jan on year 2: continue to withdraw monthly to spending account from topped-up buffer: 19.2/60 = 0.32.

31 Dec on year 2: suppose investments dropped 10%, leaving 72 units: on 31/12 I would transfer 4% of 72, or 2.88 units to the buffer. The buffer now contains 16+2.88 = 18.88. My monthly salary for year 2 will be 18.88/60=0.314 units. This 2% down on last year's monthly payment of 3.2.

So a 10% drop in the investments results in a 2% drop in monthly payments (5-year buffer). In the case of a long bear market, I could also choose not to sell any investments and to continue taking my monthly salary, knowing that I do not have to sell any investments for four more years.

The buffer also has an important psychological function in that it may help to avoid panic selling, if one can focus less on the capital value and more on the on the projected monthly income, where the changes are a lot less dramatic!

In summary, to generate a monthly payment from a VP:

1. Decide how much fluctuation in income you can tolerate.

2. Set up cash buffer for the number n of buffered years required to damp this fluctuation.

3. Decide sustainable withdrawal rate w% for active portfolio.

4. Each year, transfer w% of active portfolio to cash buffer.

5. Each month, transfer 1/(12 x n) of the buffer from buffer to spending account .

The challenge is to find the sweet spot between (a) a withdrawal rate that maintains capital and provides a sustainable income (b) a number of years buffered that smooths the income and provides bear market protection (c) an sufficient amount actively invested to generate a reasonable return.

Not to mention choosing the investments themselves! According to the link on PP withdrawal rates above, the backtested safe withdrawal rate for the PP is close to 5%. What makes me think I can beat that with a VP? I can only sheepishly reply that I might not beat it, but that the PP also has good and bad years, and overall returns will be stabilised by diversifying.

This is what I do (thanks to galeno) and I would like to know how other people withdraw from the VP.