Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 54

The 4% Rule for retirement withdrawals may be too high

An Australian paper on safe withdrawal rates from capital at retirement concludes that over 30 years, a 50/50 portfolio with a withdrawal rate of 4% a year would run out of money about 18% of the time. This is despite the excellent returns from Australian equities over the sample period. The study has important implications for financial planning over long retirement periods.

In contrast to academic work on the accumulation phase of investing, a trifling amount of research has been done on the decumulation phase of investing, where accumulated wealth must be managed to fund retirement needs for potentially 30 years or longer.

Twenty years ago, William Bengen, a practising financial planner with an aeronautical engineering degree, set about calculating the rate at which capital could be drawn for a US retiree with a high probability of the portfolio lasting 30 years. Bengen used US investment return data from 1926 to compute a safe maximum withdrawal rate (which he called SAFEMAX) of 4.15% per annum for a 50/50 portfolio of US shares and bonds. He thus suggested that if a US retiree commenced a systematic withdrawal plan drawing 4% of the initial portfolio value, and thereafter that same dollar amount (adjusted for inflation each year), a 50/50 ‘balanced’ portfolio would last for at least 30 years. Subsequent studies confirmed Bengen’s findings, and thus the ‘4% Rule’ was born.

Finsia safe withdrawal rate report

The 4% Rule has come to be the default safe withdrawal rate in retirement planning assumed by planning professionals.  It relies on historical data for the US. How safe is it for other countries? A recently released Finsia report seeks to shed light on the matter.

Finsia’s report is the latest contribution in its Retirement Risk Zone initiative, focussing on the risks in the last two decades of work and the first fifteen years of retirement. The report was authored by Professor Michael Drew and Dr Adam Walk of Griffith University.

In an important departure from previous US-centric studies the authors used a global database of real (after inflation) investment returns for 19 countries spanning a period of 112 years. They focussed their analysis on Australia and a selection of other countries representing the quartile performers (Japan 25th, Netherlands 50th and New Zealand 75th) as well as the worst performer, Italy. The table below provides details of these nations (with the US and UK added for comparison):

HC Snip1 210314

HC Snip1 210314

Drew and Walk used a simulation process to model the probability of portfolio ruin (retirement capital exhausting) for various retirement timeframes, and for various growth/defensive asset allocations. The results for a 30 year retirement for Australia appear below:

HC Snip2 210314

The highlighted row indicates that using a 50/50 asset allocation, the Australian safe withdrawal rate is 3.62% p.a. (real) at a 10% chance of portfolio ruin (SAFEMAX90) over a 30 year retirement.

Whilst Australia has enjoyed the highest equity returns of all 19 nations over the 112 years analysed, its 50/50 SAFEMAX90 real rate of 3.62% p.a. is not the highest. Both NZ (3.97% p.a) and the Netherlands (3.67% p.a.) had higher safe withdrawal rates, owing to superior risk-adjusted returns from their respective bond markets. The two laggards were Italy with a SAFEMAX90 rate of 1.23% p.a. and Japan with a rate of 0.29% p.a.

What conclusions can be drawn from the report?

The report’s authors conclude that there is no ‘silver bullet’ when it comes to retirement planning.  They warn against using the 4% Rule in a deterministic way, instead suggesting that the underlying philosophy of the Rule can be a useful tool in framing retirement conversations and in forming expectations. They note that a retiree couple with a $1 million starting pension balance would need to draw in excess of 5.6% to generate the ASFA comfortable retiree budget.

Perhaps more importantly, the report suggests that asset-liability management needs to be considered more thoroughly in retirement planning. The authors note that, “The conversation is a difficult one in that, for many investors, their focus is on the asset side … of the equation, not the liability. We posit that the first challenge in tipping the scales in the retiree’s favour is to get the framing right, moving from a ‘pot of gold’ (asset) mindset to an ‘income replacement’ focus (liability).”

Scope for future research

Whilst the report is an important step, especially given its Australian context, much more needs to be done to further our understanding of the decumulation phase. The report does not consider, for example, the interaction between personal retirement assets (superannuation), other assets and the age pension. It ignores important personal planning issues such as mortality risk, taxes, franking credits or the bequest motive. Current government statistics indicate that less than 20% of retirees are fully self-funded, and that most Australians will be dependent on some level of government assistance in retirement. With those aged 65 plus estimated to grow in number from the current 3 million to some 4.2 million by 2020, and with pension assets expected to exceed $1.4 trillion (2011 dollars) by 2026, there is a lot at stake. This report shows that even if the future repeats the excellent past returns, the old 4% Rule is little more than a conversation starter.

 

Harry Chemay is a Certified Investment Management Analyst, a consultant across both retail and institutional superannuation and Fellow member of FINSIA. He has previously practised as a specialist SMSF advisor, and as an investment consultant to APRA-regulated superannuation funds.

The full study is, “How Safe are Safe Withdrawal Rates in Retirement? An Australian Perspective”, FINSIA Research Report, Professor Michael Drew and Dr Adam Walk. Available on the FINSIA website.

2 Comments
Peter Vann
March 25, 2014

Is 4% too much?

Well a Challenger CPI indexed Lifetime annuity at age 65 pays more, 4.447% (BTW, I have no affiliation with Challenger).

I would say that is a base from which one can assess the financial longevity risk from drawing higher rates.

Kevin
March 22, 2014

It seems to me that the competing demands of passive income requirements during retirement and minimising draw down rates from superannuation will soon become a significant issue for Australians. I find it very frustrating that, on the one hand our government rightly states that as many retires as possible should become self-funded to minimise the cost to tax payers (potentially allowing more funds for education, health etc) yet on the other hand actively discourages workers from becoming self-funded retirees!
As example, we are encouraged to save more in super by the lower tax treatment, but then we are penalised if we try to save too much. Even worse if (like my parents) you are one of the very few who manage to become a fully self-funded retiree (by working hard, living frugally, and making a couple of good investments) the government then “taxes” you via Aged Care Fees.
Whilst I’m all for paying taxes, where those more fortunate help those less so, and I’m certainly all for paying for services provided by the government. But it does seem to me that the asset/income (means) tested Aged Care fees are a tax designed to reduce the independent retiree’s assets and force them to significantly increase their superannuation withdrawal rate.
In fact, during a recent Aged Care fee assessment, we were told by Centrelink not to worry about my parent’s steadily reducing assets (due to the requirement to pay the Centrelink assessed Aged Care fee) as once their assets got below a certain point they’d be eligible for the pension! Is it just me or does this seem like a way of reducing self-funded retiree’s assets prior to their estate transferring them tax free to their beneficiaries?

 

Leave a Comment:

     

RELATED ARTICLES

Age pension reform and its consequences for financial plans

Putting off that retirement speech

Retirement adequacy: COVID means we need to work longer

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Superannuation

The 'Contrast Principle' used by super fund test failures

Rather than compare results against APRA's benchmark, large super funds which failed the YFYS performance test are using another measure such as a CPI+ target, with more favourable results to show their members.

Property

RBA switched rate priority on house prices versus jobs

RBA Governor, Philip Lowe, says that surging house prices are not as important as full employment, but a previous Governor, Glenn Stevens, had other priorities, putting the "elevated level of house prices" first.

Investment strategies

Disruptive innovation and the Tesla valuation debate

Two prominent fund managers with strongly opposing views and techniques. Cathie Wood thinks Tesla is going to US$3,000, Rob Arnott says it's already a bubble at US$750. They debate valuing growth and disruption.

Shares

4 key materials for batteries and 9 companies that will benefit

Four key materials are required for battery production as we head towards 30X the number of electric cars. It opens exciting opportunities for Australian companies as the country aims to become a regional hub.

Shares

Why valuation multiples fail in an exponential world

Estimating the value of a company based on a multiple of earnings is a common investment analysis technique, but it is often useless. Multiples do a poor job of valuing the best growth businesses, like Microsoft.

Shares

Five value chains driving the ‘transition winners’

The ability to adapt to change makes a company more likely to sustain today’s profitability. There are five value chains plus a focus on cashflow and asset growth that the 'transition winners' are adopting.

Superannuation

Halving super drawdowns helps wealthy retirees most

At the start of COVID, the Government allowed early access to super, but in a strange twist, others were permitted to leave money in tax-advantaged super for another year. It helped the wealthy and should not be repeated.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.