What Are Possibility of Failure (POF) Rates?
Possibility of Failure (POF) Rates are measures of the likelihood that a retiree will run out of money prematurely due to a particular retirement portfolio withdrawal strategy. A retirement portfolio’s possibility of failure rate depends on life expectancy, a retiree's withdrawal rate, the portfolio's asset allocation, and the volatility of the portfolio’s investments. The possibility of failure rate is also known as the probability of ruin.
- Possibility of failure, also called the "possibility of ruin" rates only apply to retirees with retirement portfolios.
- There are many factors in measuring a retiree's financial portfolio's failure rate, including how assets are placed (for example, stocks or bonds), the life expectancy of the portfolio's owner, and the withdrawal rate.
- Depending on investments, some retirement portfolios may have a higher possibility of failure than others.
- The stock market plays an important role in the possibility of failure rates.
Understanding Possibility of Failure (POF) Rates
Possibility of failure rates have become increasingly crucial to retirees as average life expectancy has increased, and workers are spending more years of their lives retired. A widely referenced 1998 study on retirement savings withdrawal rates, authored by Trinity University 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. The failure rates found by the authors were even with an optimum portfolio and no taxes, expenses, or fees—conditions that aren’t likely to exist in the real world. Why? 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.
Safe Withdrawal Rates and 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 excellent stock market returns during that time might be able to safely withdraw 4% or even more without running out of money. Still, if the economy goes through a prolonged recession, even a normally conservative 3% withdrawal rate might have a high probability of failure.
One rule of thumb is to decrease your withdrawal rate when your portfolio has a 25% possibility of failure.
Investment volatility also increases the possibility of failure. Though riskier investments earn higher returns, those returns aren’t guaranteed. You may not live long enough to ride out a downturn in your riskier investment. Still, 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.