4% Rule Under Fire- Again

4pctThe often-quoted ‘4% withdrawal rule’ that mainstream investment managers use as a guideline ‘safe’ withdrawal rate for a portfolio has come under fresh fire.

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.

Written By

Bryan Anderson

4 thoughts on “4% Rule Under Fire- Again

  1. While this is a great inroduction to the failure rate of the 4% rule and the potential need for an annuity. It would be very helpful to show the numbers. That is, if someone has a single premium immediate annuity, what are the failure rates at 4% over 30 year retirement. In addition, what would be the right withdrawal rate with an annuity. I know the amount of the annuity will matter as it compares to the total nest egg…give us an answer!

    1. Hi Dave- the whole point of using an annuity is that you have a 0% probability of failure due to market forces. You’re transferring the investment risk to the annuity carrier in exchange for their guarantee of an income stream. If they invest and lost the money, they are on the hook for it, which is why we look for strength in the carrier. With a SPIA, and other types of lifetime income annuities like hybrid indexed annuities, you have an income stream- you do not have a variable withdrawal rate subject to fluctuations or risk.Give us a call if you need further clarifications about what these products do.

  2. I am 73 years old and my husband is 83. We are thinking about an annunity in which we would have a fixed income for the remainer of our lives. At the present time we have approx. $400,000. to invest.
    My goal is to use the income and also to leave the remainding monies in tact for our children.
    Which would be the safest annunity in which to invest under my name?
    Sandra Moore

    1. Sandra-

      To answer appropriately, we would need to know the amount of fixed income you need. The best bet would be to call us and speak to me or Bryan so we can understand your situation a little more fully. Give us a call- 800 438 5121

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