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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.

The 4% Retirement Income Solution

What is your plan for retirement income? Traditional asset management with a 4% annual distribution is a popular idea with professional advisors and consumers alike. New research from the Merrill Lynch Wealth Management Institute suggests this approach to be far too simple. An article published last week in Smart Money covers many of the potential problems with the 4% solution. Read the article here.

The author claims the biggest issue with the 4% distribution rule is that it doesn’t address the major risks retirees actually face. Longevity risk, sequence of returns risk(reverse dollar cost averaging) and asset allocation risk are just a few of those mentioned. If you’ve been following us for long you’ll know that we tend to agree with the assertion.

When you consider that age and gender are significant factors when devising an income strategy, it’s easy to see why there is no such thing as single plan or rule that can work for everyone, as mentioned in the Merrill Lynch study. Additionally there are a multitude of other factors that will affect your strategy so designing a plan that works will cost a lot of time and money. And even so there are no assurances offered.

I’m not going to rewrite the article but I do suggest you take a look at it to see what the exact risk factors are and how changing one can substantially affect the others. Education and understanding are critical to making decisions that will last a lifetime. There’s no way anyone can afford to make a mistake here.

We are obviously fans of guaranteed income. I personally think that keeping income and growth assets separate is a pretty dang good idea. Why worry about it for the rest of your life? When you’re ready for a discussion about the difference between asset management and income planning, simply contact us so we can help make sense of it all.

Have a great week!

Bryan J. Anderson
800.438.5121
[email protected]

On Cashing Out In Retirement

Retirement Annuities

Retirement Annuities

The tools used to maximize pre-retirement asset accumulation are not the tools of retirement  income generation.  Maximizing retirement income is just outside the scope of expertise  for most traditional advisors and individuals because  of the biggest unknown: life expectancy.

An  individual seeking to maintain full control over their money, and setting their own withdrawal rate,  is carrying their entire longevity risk on their shoulders.  And an advisor that recommends a withdrawal rate or a stock / bond allocation to a client is making that client shoulder their entire longevity risk perhaps unknowingly.

This excellent article looks at various ways people consider using their assets in retirement.  It’s worth reading in its entirety, but what is fascinating is that annuities rightfully get their mention at the top of the list as a smart allocation for a portion of your assets.  This is uncharacteristic for main stream media, which  usually scoffs at annuities.

How to Cash Out in Retirement

A look at four strategies that could help make a retiree’s savings last a lifetime

By ELEANOR LAISE

There’s no rest for retirement investors. They spend decades worrying about the best way to put money into their accounts—and then they have to find the best way to take it out.
While saving for retirement can be tough, finding the right way to spend down your nest egg may be an even bigger challenge. Francis Kinniry, a principal at Vanguard Group, discusses some spending strategies with WSJ’s Eleanor Laise.

It’s a problem that’s starting to hit home for the oldest baby boomers, who turn 65 this year. Many don’t have traditional pension plans to dole out steady paychecks for the rest of their lives. They have to figure out the best way to pull money from retirement accounts so that they get a livable income each year—and the money doesn’t run out too soon.

And that means they have to account for a host of factors that are impossible to predict. “You can’t control how long you’ll live, which is a huge determinant of retirement income,” says Francis Kinniry, a principal at Vanguard Group. “And you can’t control the markets.”

Many people are dealing with the uncertainty by simply working longer. But for those who were looking forward to a more retiring retirement, there’s fresh hope.

Financial advisers are rethinking retirement-spending rules of thumb and coming up with new withdrawal strategies that help clients maintain their standard of living regardless of the stock market’s ups and downs. And financial-services firms are introducing new products to turn lumps of retirement savings into steady income without requiring people to lock up their money in an annuity. (Annuities, of course, may still be a good retirement-income solution for some people.)

Making the Case to Buy an Annuity

Below, we explain various strategies for spending down retirement savings. But don’t feel compelled to choose one and follow it for a lifetime. The key to developing a successful strategy is flexibility, retirement experts say. Given all the variables in retirement spending, advisers suggest that investors regularly revisit their approach rather than religiously following a preset path. Those who are willing to make small adjustments along the way will run the smoothest course through retirement.

Regular readers of Annuity Straight Talk should smile at this line, above. Flexibility has always been one of our guiding principles, together with Profitability and Safety.

Reviewing the 4% Rule

Faced with the question of spending in retirement, many financial advisers fall back on “the 4% rule.” With this approach, investors withdraw 4% of their retirement balance in the first year of retirement, or $40,000 from a $1 million portfolio. The dollar amount of the withdrawal is adjusted each year to keep up with inflation, and the remaining portfolio is rebalanced to the desired mix of stocks and bonds.

See how long a $2 million portfolio might last.

Different investors may follow different versions of the rule, such as initially withdrawing 5% or 6%. That initial withdrawal amount can have a major impact on the strategy’s success. Assuming a mix of 60% stocks and 40% bonds, an investor initially withdrawing 4% has a 10% chance of running out of money at age 97, according to T. Rowe Price Group Inc. With a 6% initial withdrawal, he has a 10% chance of running out of money at age 82. Many advisers have settled on 4% as the “safe” initial withdrawal rate.

The 4% rule helps manage two big risks in retirement: longevity and inflation’s tendency to gnaw away at your purchasing power, says Stuart Ritter, a financial planner at T. Rowe Price.

The rule also has the allure of simplicity, and at least in the short term, it gives investors steady amounts of spending money each year. The problem, critics say, is that this approach matches a rigid spending rule with an investment portfolio that can bounce all over the place. Given strong markets, investors may wind up with lots of money to leave their heirs. Given weak markets, they could run out of money halfway through their retirement.

“This is a prescription for getting people into serious trouble,” says Laurence Kotlikoff, economics professor at Boston University.

The 4% rule should be viewed as “a starting point,” Mr. Ritter says, adding that it “gives people the ability to adjust along the way.”

Getting Flexible
Another simple approach to retirement spending is to withdraw a set percentage of the portfolio each year.

Unlike the 4%-plus-inflation rule, this approach automatically adjusts an investor’s spending in response to market performance: If the portfolio grows, the withdrawal is larger; if the portfolio shrinks, the withdrawal is smaller. And investors will never completely run out of money.

Of course, that means there can be major fluctuations in the amount of spending money from one year to the next. Given that many people want to maintain a steady standard of living in retirement, those ups and downs can be stomach-churning.

Vanguard suggests a more flexible version of this strategy. Aim to withdraw a set percentage of the portfolio each year, but place upper and lower limits on the dollar amount, based on the prior year’s spending.

For example, an investor may decide that he’ll withdraw 4% of his portfolio each year, but he doesn’t want his spending amount to change more than 5% from one year to the next. Let’s say he took out $40,000 from his $1 million balance last year, and this year strong markets have boosted his portfolio to $1.1 million. A strict 4% withdrawal would give him $44,000 in spending money this year, but given his 5% spending band he’ll limit his withdrawal to $42,000.

This is “a middle-of-the-road approach,” says Vanguard’s Mr. Kinniry. Spending levels remain relatively steady year to year, but the strategy also responds to changes in investment performance, helping the portfolio last through retirement.

The bands around the dollar amount of spending don’t have to be symmetrical, of course. Mr. Kinniry suggests allowing for more flexibility on the downside than on the upside. For example, you might cap the year-over-year increase in the withdrawal amount at 3%, so that in a good year you keep more of your profits in your portfolio—but if your investments take a beating allow withdrawals to fall as much as 5% or 10%. If markets perform poorly, “you don’t want to compound” the effect on your portfolio by taking a large withdrawal, he says.

Let’s again assume that the investor took $40,000 last year from his $1 million portfolio. But this year his investments fell in value to $850,000. A strict 4% withdrawal would be $34,000. With a maximum 5% drop in the dollars he withdraws compared with last year’s $40,000, he would take out $38,000. With a 10% maximum drop, he would take out $36,000.

Build a Solid Foundation

To build confidence that a portfolio will sustain a lifetime of spending, it helps to take a page from the playbook of defined-benefit pension plans, advisers say. With this approach, investors should think of each year’s spending as a liability that must be matched with a chunk of your portfolio.
The best match for those liabilities is a bond ladder, advisers say. With high-quality bonds such as Treasurys maturing in each year of retirement, creating a “spending floor,” investors can feel confident their future spending needs will be met.

Umm…. Might I introduce Secondary Market Annuities??? These fantastic fixed income investments are of comparable credit quality as the best bonds, yet with yields in the 5-6 and even 7% range….  Hello!! Opportunity is Knocking!

Pouring all your money into bonds, of course, can reduce your portfolio’s growth potential. But it’s possible to create a mix of steady income, upside potential and some longevity protection by starting retirement with a blend of 80% bonds and 20% stocks, says Jason Scott, managing director of the retiree research center at investment advisers Financial Engines Inc.

With bonds to meet your basic spending needs, “you’re not subject to the vagaries of the [stock] market for that spending,” Mr. Scott says. And if the equity allocation does well, investors can use the stock-market proceeds to extend their bond ladder further into retirement or raise their spending floor. So payouts won’t drop when the stock market falls, but they can rise when stocks are rallying.

You can read the rest of the article here.  Annuity Straight Talk focuses on the maximum profitability portion of your Safe Money allocation- get the most income with the least risk.  Come talk to us and see what we can do for you.