Portfolio Design: A Modern Approach to Asset Allocation

EFFECT OF LOWER STOCK RETURNS ON SPENDING RULES

Basing spending rules on the returns since 1951 may be a little optimistic because historical returns on stocks may be unsustainable in the future (for the reasons discussed above). It makes sense to study the sensitivity of spending rules to alternative sets of stock market returns. The simulations will continue to be based on the 2.4 percent real return on Treasury bonds and 5.2 percent nominal return on the Barclays Aggregate index. But in place of the 6.7 percent historical return on the S&P index, we will consider the estimate of real returns based on S&P 500 earnings growth. As reported in Table 14.1, this alternative estimate is that the S&P 500 will give average real returns of 5.3 percent rather than 6.7 percent. The equivalent compound nominal return based on 2.5 percent inflation is 7.9 percent. Some market observers would consider stock return estimates in the 8 percent range as being more realistic than the 9.4 percent returns implied by historical averages.

The returns for the Russell 3000 and EAFE indexes used in the simulations are reduced along with the return on the S&P index. With a 75/25 stock/bond allocation, the nominal expected (compound) return for the portfolio as a whole falls to 7.7 percent from 8.8 percent for the simulations based on historical data. With such a fall in expected returns, there is a correspondingly large increase in the failure rates for each spending rule.

Figure 14.3 reports failure rates ...