What Is the Possibility of Failure (POF) Rate?
The possibility of failure (POF) rate is used to determine if a person's retirement savings will be adequate. It measures the likelihood that a retiree will run out of money prematurely.
A retirement portfolio’s possibility of failure rate depends on the individual's life expectancy, the rate at which the retiree plans to withdraw money, the portfolio's asset allocation, and the volatility of the investments in it.
The possibility of failure rate is also known as the probability of ruin.
- The possibility of failure rate is relevant to a retiree who relies on an investment portfolio for retirement income.
- The volatility of the assets in the portfolio and the rate at which money will be withdrawn are among the key factors in the failure rate.
- The life expectancy of the portfolio's owner also is factored into the equation.
Understanding the Possibility of Failure (POF) Rate
Calculating the possibility of failure rate has become increasingly important to retirees as average life expectancy has increased. People simply have more years ahead of them to finance after they retire.
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.
That 6% figure was based on retirees with an optimum portfolio and no taxes, expenses, or fees—conditions that aren’t likely to exist in the real world.
In fact, retirees can’t control factors such as market volatility and part of their savings will inevitably be lost to taxes and fees.
The conclusion: They would have to use a conservative withdrawal rate, well below 6%, to minimize the possibility of failure.
What Is a "Safe" Withdrawal Rate?
Retirees who keep a large percentage of their portfolios invested in stocks during retirement and experience 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 or negative economic growth, 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 can earn higher returns, those returns aren’t guaranteed. You may not live long enough to ride out a downturn in your riskier investments.
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.