4% Rule Under Fire- Again
The volatility of the last few years should have already given most conservative investors enough heartburn to not stake their life savings on this faulty rule of thumb. But new research is showing just how disastrous bad advice can be. We’ve written about this flawed approach before as well.
The 4% Rule Background
The ‘4% Rule’ isn’t really a rule. Rather, it’s an asset withdrawal rate promoted initially by a retirement planner named William Bengen. The theory states that a safe retirement withdrawal rate starts out by drawing down just 4% of your portfolio and adjusting up only for inflation. Testing against 75 years of historical stock and bond prices shows the probability of failure – meaning, the chance of running out of money in a 30 year retirement, at an acceptably low probability of about 6%.
Where It Falls Apart:
In its day, the “Rule” made sense, but that day was 1994. The US had strong market performance year over year in the preceding decade, and portfolios grew at a solid rate even with withdrawals.
Well along comes the Tech Bubble, a Black Swan event, and then a Flash Crash, computerized trading, the lost decade of the 2000’s, the banking crisis, international currency crisis, and the real estate crash. Oh yeah, THAT awful decade….
Retirees looking to their assets for income, and carrying their own longevity risk, saw portfolio values decimated, and at the same time were forced to sell securities while they were down for income.
Welcome to Reverse Dollar Cost Averaging- Getting kicked while you are down.
Well in case you didn’t already know from common sense, you can’t pull money out of a depreciated portfolio and expect it to bounce back and stay on track indefinitely.
The Case for Annuities:
I probably don’t need to belabor the point that annuities are MADE for times like this- quite simply, you buy security and safety of income, and offload major risks like longevity and loss of principal on a strong insurance institution. That’s all there is to it. How we put together a plan for you depends on your needs and assets, so get started by giving us a call today.
4% Rule- New Research
New research from a distinguished trio of academic and research economists has driven a new nail in this coffin. Michael Finke, Wade Phau and David Blanchett have re-run the economic simulations that Bengen initially based his finding on with TODAY’s actual reality of low to negative real (after inflation) bond yields.
Instead of a 6% probability of failure, today’s rate environment produces an astounding 57% probability of portfolio ruin. Remember, ruin means running out of money- kaput, no groceries, no roof over your head. Does that sound a like a good way to spend your final years? At 57%, this is almost a certainty of failure!
Here are several quotes from the Author’s excellent new study (Available Here):
The safety of a 4% initial withdrawal strategy depends on asset return assumptions. Using historical averages to guide simulations for failure rates for retirees spending an inflation-adjusted 4% of retirement date assets over 30 years results in an estimated failure rate of about 6%. This modest projected failure rate rises sharply if real returns decline.
As of January 2013, intermediate-term real interest rates are about 4% less than their historical average. Calibrating bond returns to the January 2013 real yields offered on 5-year TIPS, while maintaining the historical equity premium, causes the projected failure rate for retirement account withdrawals to jump to 57%. The 4% rule cannot be treated as a safe initial withdrawal rate in today’s low interest rate environment.
Some planners may wish to assume that today’s low interest rates are an aberration and that higher real interest rates will return in the medium-term horizon. Although there is little evidence to support this assumption, we estimate how a reversion to historical real yields will impact failure rates.
Because of sequence of returns risk, portfolio withdrawals can cause the events in early retirement to have a disproportionate effect on the sustainability of an income strategy. We simulate failure rates if today’s bond rates return to their historical average after either 5 or 10 years and find that failure rates are much higher (18% and 32%, respectively for a 50% stock allocation) than many retirees may be willing to accept.
The success of the 4% rule in the U.S. may be an historical anomaly, and clients may wish to consider their retirement income strategies more broadly than relying solely on systematic withdrawals from a volatile portfolio.
As Pfau (2010) showed, the success of the 4% rule is partly an anomaly of the US historical data. In most other countries sustainable initial withdrawal rates fell below 4%. We find there is nothing inherently safe about the 4% rule. When withdrawing from a portfolio of volatile assets, surprises may happen. This study demonstrates that when we recalibrate our assumptions for Monte Carlo simulations to the current market conditions facing retirees, the 4% rule is anything but safe.
We also show that a 2.5% real withdrawal rate will result in an estimated 30 year failure rate of 10 percent. Few clients will be satisfied spending such a small amount in retirement. It is possible to boost optimal withdrawal rates by incorporating assets that provide a mortality credit and longevity protection. Pfau (2013), for example, estimates that combining stocks with single premium immediate annuities, rather than bonds, provides an opportunity for clients to jointly achieve goals related both to meeting desired lifestyle spending, and to preserving a larger reserve of financial assets. In the absence of some added income protection, there is a high likelihood that low yields will require planners to rethink the safety of a traditional investment-based retirement income plan.