DEFINITION of 'Possibility Of Failure (POF) Rates'
The likelihood that a retiree will run out of money prematurely through the use of a particular retirement portfolio withdrawal strategy. A retirement portfolio’s possibility of failure rate depends on:
- the number of years the retiree will need to draw on that portfolio for (time horizon or life expectancy);
- how much money the retiree takes out each year (withdrawal rate);
- how the portfolio is invested (asset allocation); and
- portfolio volatility (how much the portfolio’s value fluctuates due to market performance).
BREAKING DOWN 'Possibility Of Failure (POF) Rates'
A widely referenced 1998 study on retirement savings withdrawal rates, authored by Trinity University (Texas) finance professors Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz, found that withdrawing more than 6% per year from a retirement portfolio led to significant failure rates even with an optimum portfolio and no taxes, expenses or fees—conditions that aren’t likely to exist in the real world. Because retirees can’t control factors such as market volatility and because part of their portfolios will inevitably be lost to taxes and fees, they must use a conservative withdrawal rate, well below 6%, to minimize the possibility of failure.
A safe withdrawal rate is often considered to be 4%, but even this rate has too high of a possibility of failure under certain economic conditions. A retiree who keeps a large percentage of their portfolio invested in stocks during retirement and experiences great stock market returns during that time might be able to safely withdraw 4% or even more without running out of money, but if the economy goes through a prolonged recession, even a normally conservative 3% withdrawal rate might have a high probability of failure, especially if the retiree’s life expectancy is not long enough to allow the portfolio to recover from recessionary losses.
Investment volatility also increases the possibility of failure. The problem is that you choose riskier investments trying to achieve a higher return, but the higher returns aren’t guaranteed, because they depend on how the market performs and when you need to sell. You may not live long enough to ride out a downturn in your riskier investment. But you are nearly assured that your portfolio value will fluctuate more in the riskier investment, which makes it harder to assess the percentage you can safely withdraw each year.
Financial experts who espouse dynamic updating, a method of portfolio withdrawal management, recommend adjusting your withdrawal rate as conditions change to minimize the possibility of failure rather than using the same “safe” withdrawal rate regardless of what happens. One rule of thumb is to decrease your withdrawal rate when your portfolio has a 25% possibility of failure.