Authors’ Note

Modern Portfolio Theory has become a customary tool used by investment professionals and, as such, constitutes an industry standard that investment decision makers cannot ignore.  This academic theory has become the bedrock of investment practice.  We have elected to publish three articles in consecutive editions of Wealth Strategies Journal to provide its readership with an understanding of Modern Portfolio Theory and the application of this theory to pertinent issues surrounding the administration and formulation of portfolios.  Sequential publication eliminates the need to redevelop Modern Portfolio Theory and other concepts in each article.  Wealth Strategies Journal readers will have the option of reviewing earlier articles to clarify any points of interest in subsequent articles.

This first article in this series, “Developing and Defining a Well Managed Portfolio – A Primer on Modern Portfolio Theory”, provided a foundation for understanding the underpinnings of Modern Portfolio Theory.  The second article described the usefulness to an investment decision maker of developing an investment policy statement and how the statement can be used to develop a portfolio’s appropriate risk level.  This final article in the series employs Modern Portfolio Theory and the investment policy statement as guides in helping determine an appropriate withdrawal rate for a portfolio. A useful tool in withdrawal rate decision making is the determination of the crossover rate:  the withdrawal rate such that at the end of the investment horizon period  the value of a more aggressive (higher risk) portfolio with a high withdrawal rate is the same as the value of a less aggressive (lower risk) portfolio with a lower withdrawal rate.    

I. Introduction

It was a hot, humid day in July 2007 and Roger Dowling was totally exhausted.  He had just spent the entire day with his attorney in an estate planning session.  Roger’s wife had died six months ago and her death necessitated a new will and a complete review of his estate plan.  Since Roger’s net worth was sizeable, the attorney, who also had worked considerably with experienced financial planners, had devised a will and estate plan that met his charitable and other intentions upon his death as well as minimized the potential estate and generation skipping transfer tax.  Roger, at the age of 65 and with a life expectancy of 20 years, had no intention of remarrying.

One of the issues Roger and his attorney had spent a considerable amount of time developing was the creation of a $15 million revocable trust with Roger as the trustee during his lifetime.  Upon his death, the trust becomes irrevocable with a corporate trustee.  The income beneficiaries of the irrevocable trust will be his two sons, William, age 28, and Milton, age 26.  The remainder beneficiaries of the irrevocable trust will be certain charities and, upon default in the exercise of their general power of appointment, the children of William and Milton, per stripes.

Much of Roger’s net worth consisted of non income producing raw land and since he recently retired he would be depending on the revocable trust for most of his living expenses.  During the planning session with his attorney, Roger had developed a preliminary investment policy statement (IPS) to be used as a guide for the administration of the revocable trust.  Included in the IPS was a rather conservative allocation to specific asset classes and a specified 3% withdrawal rate from the trust for Roger to meet his spending needs. 
           
As Roger reviewed the IPS he had a feeling of uneasiness.  On the one hand he felt the 3% withdrawal rate was not sufficient to maintain his current standard of living.  He planned to travel the world and maintain the second home in Florida.  On the other hand he wanted very much to have the corpus of the trust large enough upon his death to provide considerable income to his sons.  When he reached a final decision with respect to the management of the trust he planned to sit down with his sons and discuss the situation with them.
           
Roger decided to consult with his trusted financial consultant, Rick Hetterington.  During their conversation, Rick requested Roger send to him a copy of the trust document and the trust’s proposed IPS.  Rick promised to provide Roger an analysis within the next three weeks. 

The remainder of this article traces the thought process Rick followed to construct his recommendations.  The steps in the process were: select a feasible set of asset classes; construct an Efficient Frontier; analyze the portfolio planned in the IPS relative to that Efficient Frontier; investigate alternative portfolios with higher risk and return; use a simulation to determine the effect of different withdrawal rates on both the Proposed and IPS portfolios; and arrive at a recommended withdrawal rate.  A by-product of this process is the crossover rate – the withdrawal rate that produces the same projected ending wealth for two portfolios.  In Rick’s case he determined the withdrawal rate for the Proposed portfolio that produced the same ending wealth as was projected for the IPS portfolio.  We conclude with some observations on reasonable portfolio management practices and the importance of communication.

II. The Feasible Set and the Resulting Efficient Frontier

A.  The Feasible Set

Upon receiving and reviewing the information from Roger, Rick’s first step was to create an Efficient Frontier as of the end of June 2007.  He determined the asset classes and their corresponding benchmark indexes, shown in Figure 1, which Rick determined to be appropriate as the feasible set for constructing the Efficient Frontier.

Figure 1

Feasible Set
Asset Classes and their Benchmark Indexes

B.  The Efficient Frontier 

The Efficient Frontier that results from the feasible set is shown in Figure 2.

Figure 2

Feasible Set of Indexes and Their Efficient Frontier
as of June 2007