Unlock a 6% Withdrawal Rate: The Power of Small-Cap Value Stocks and Long-Term Treasuries


The "4% Rule" has long been the gold standard for retirees planning to withdraw from their portfolios. However, recent research and alternative strategies suggest it may be possible to safely increase your withdrawal rate to 6% under specific conditions. One such approach involves using an 80% allocation to small-cap value (SCV) stocks and 20% to long-term Treasury (LTT) bonds. Let’s explore how this unconventional portfolio design works and why it can support a higher withdrawal rate.

The Theory Behind the 6% Withdrawal Rate

The 4% Rule is rooted in historical backtesting, aiming to ensure a portfolio lasts 30 years under various economic conditions. While it prioritizes safety, it is often overly conservative due to its reliance on broad market averages and assumptions that ignore more aggressive yet historically reliable allocations.

By allocating 80% to SCV stocks, which have higher historical returns and volatility, and pairing them with 20% in LTT bonds, known for their ability to hedge equity downturns, you create a portfolio with:

  1. Higher Expected Returns: Small-cap value stocks have historically outperformed broader indices due to their risk premium and value tilt.

  2. Crisis Diversification: Long-term Treasuries tend to perform well during equity market drawdowns, smoothing portfolio returns.

This combination offers the potential for a higher withdrawal rate without significantly increasing the risk of portfolio depletion.

Historical Performance: SCV + LTT

Over the past century, small-cap value stocks have delivered average annualized returns exceeding 12%, compared to roughly 10% for the S&P 500. Meanwhile, long-term Treasuries, though yielding lower returns, have acted as an effective counterbalance during bear markets. This uncorrelated relationship between SCV and LTT enhances the portfolio’s resilience.

Backtesting shows that an 80/20 SCV/LTT portfolio could sustain a 6% withdrawal rate with a similar or lower failure rate than a 60/40 stock-bond portfolio at a 4% withdrawal rate. This is due to the higher compounded growth rates of SCV stocks and the stabilizing influence of LTTs during market stress.

The chart above illustrates how an 80/20 SCV/LTT portfolio compares to a traditional 60/40 portfolio, a 100% S&P 500 portfolio, and an 80/20 S&P 500/Total Bond Market portfolio in terms of growth over 30 years, highlighting the enhanced compounding potential of the SCV-heavy allocation.

Key Assumptions and Risks

  1. Consistency with Historical Data: The strategy assumes that the historical outperformance of SCV stocks and the negative correlation between LTTs and equities persist. If these dynamics change, portfolio performance may suffer.

  2. Increased Volatility: An SCV-heavy portfolio experiences higher short-term volatility, which could cause emotional stress for retirees during market downturns.

  3. Interest Rate Risk: LTTs are sensitive to rising interest rates. If rates rise significantly, their hedging effectiveness and overall returns could diminish.

  4. Long-Term Horizon: The higher withdrawal rate is more likely to succeed over 30+ years, making it less suitable for shorter retirement periods.

Practical Considerations

  1. Rebalancing Discipline: Maintain the 80/20 allocation by regularly rebalancing to capture returns from outperforming assets while mitigating risk.

  2. Tax Efficiency: Use tax-advantaged accounts to minimize the impact of capital gains and income taxes, especially with frequent rebalancing.

  3. Contingency Planning: Be prepared to adjust withdrawal rates during prolonged downturns or periods of underperformance.

  4. Customizing for Risk Tolerance: If the volatility of SCV stocks is too high, consider reducing the allocation to SCV slightly while keeping the essence of the strategy intact.

Conclusion

An 80% small-cap value and 20% long-term Treasury allocation represents a powerful alternative for retirees aiming to increase their withdrawal rate to 6%. By leveraging the high returns of SCV stocks and the hedging properties of LTTs, this portfolio offers a compelling combination of growth and risk management. However, it’s essential to understand the assumptions and risks underlying the strategy and to evaluate whether its increased volatility aligns with your personal risk tolerance.

As with any retirement strategy, consult a financial advisor to tailor this approach to your unique needs and ensure it aligns with your long-term goals.

 

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