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Is the '4% rule' for retirement broken?

Retirement researchers have been sounding the alarm about the 4% guideline for a while. They've noted that the combination of very low bond yields and not-inexpensive equity valuations mean that a starting withdrawal of 4%, with that dollar amount adjusted for inflation in each year thereafter, could cause a retiree to prematurely deplete his or her funds over a 25- to 30-year horizon.

The fact that the current pandemic has forced yields lower still - to just 0.7% on the 10-year Australian Government Bonds as of 21 July 2020 - imperils the 4% guideline even further.

In an interview on The Long View podcast, recorded in the US in March 2020, retirement researcher Wade Pfau discussed the case against the 4% guideline. He also shared some thoughts on withdrawal strategies that retirees should consider instead.

Pfau is a Professor of Retirement Income at The American College of Financial Services. This excerpt from the interview has been lightly edited. The entire transcript covers other aspects of retirement planning, including long-term care and what Pfau calls “buffer assets”.

Christine Benz: Wade, withdrawal rates are an important component of retirement planning. The obvious adjustment to make in the face of a declining market would be to reduce withdrawal rates. In fact, you wrote this week that it's important to understand that the 4% rule does not apply today. Why is the rule broken now?

Pfau: Well, there are a number of factors. People are living longer and the 4% rule ignores taxes, it assumes investors are not paying any fees on their investments, and so forth. But the biggest driver for what I'm talking about right now is the low-interest-rate environment.

Low bond yields mean low bond returns in the future. And there's not really any controversy about that. If interest rates don't change, today's bond yields will be the bond returns. And then, of course, if you're holding bond managed funds, well, if interest rates go up, you're going to have capital losses, which make things even worse. Or vice versa, if interest rates decrease further, you could have capital gains. But effectively, future bond returns are going to be close to today's bond yields. The 4% rule is based on historical data, where we've never seen interest rates this low. 

We're also dealing with this high-valuation environment and historically low interest rates, lower than the 4% rule ever had to be tested by. And so, it's not as clear how stocks can come to the rescue of bonds in a diversified portfolio. If you just take historical average data and plug that into some sort of financial planning calculator, which is kind of the naive approach that still gets used today, that will be assuming you're going to have 5% to 6% bond returns in the future. The 4% rule looks like it's going to work 95% of the time.

But if you just lower returns to account for lower interest rates, and because of this idea of sequence-of-returns risk, even if interest rates normalise later to their historical averages, that's kind of too late if you're retiring today. Based on those kinds of projections, you're going to be looking at the 4% rule working more like 60% to 70% of the time. And that's usually not the amount of safety people want. 

If you want the kind of safety of at least getting your strategy to work 90% of the time, the lower interest rates are going to push you toward something like 3% being a lot more realistic than 4% as a sustainable strategy in a low-interest-rate environment.

Benz: You mentioned variable spending, Wade, as a way of potentially addressing these conditions. So, a very crude way to do that would be to simply use a fixed-percentage withdrawal and take the same percentage out of a portfolio every year regardless of what the portfolio value is. But that's obviously not ideal from a quality-of-life standpoint. So, let's walk through how one could create a sensible variable withdrawal strategy.

Pfau: What you explained is the opposite end of a spectrum of extremes. The 4% rule is the other extreme. It's 4% of your initial retirement assets, which tells you how much you can spend. And then you just keep spending that same dollar amount every year (adjusted for inflation) and you never adjust based on market performance. There's always going to be a withdrawal rate, but you don't care what it is, you just keep spending the same amount.

Then what you described is the opposite end, where you just spend a fixed percent of what's left every year. So, you're always using the same withdrawal rate every year, but your spending will fluctuate, and it could fluctuate quite dramatically just based on how your portfolio is doing. Those are the two ends of the spectrum.

There's a host of strategies in between that try to develop some sort of compromise between thinking you should make some adjustments to your spending. And that does help manage sequence risk. But you don't necessarily want to adjust your spending too much. In practical terms, just following the required minimum distribution rules to define spending in retirement, that's going to be related to the fixed-percentage strategy, but it actually is pretty closely aligned with what academic research shows is the optimal way to spend beyond that as well.

Different advisers have proposed different types of variable spending strategies. One of my favourites is from Bill Bengen who created the 4% rule initially. But he talked about a 'floor and ceiling' approach, where you spend a fixed percentage of what's left every year but you decide you're going to have a floor that you don't want your spending to fall below a certain dollar amount, and then you have a ceiling where you're not going to let your spending go above a certain dollar amount. So, as long as you're within that range, you just spend a fixed percent, but you apply the floor and the ceiling.

This helps to manage sequence risk by adjusting your spending. That floor might not be all that much less than what the 4% rule logic - always spend the same amount every year no matter what - would have had you spending. So, you have the potential to spend more on average, and even on the downside, you're not really spending all that much less. That's a pretty easy strategy to implement. 

Jonathan Guyton developed his decision rules with William Klinger that are a lot harder to implement in practice and do call for occasional 10% cuts to the distribution that are permanent. But that could be another option as well.

Benz: Before we leave required minimum distributions as maybe a benchmark that someone could use, what are the virtues of that. It updates with my age and my portfolio value, and so that is valuable?

Pfau: The academically optimal way to spend is, you're going to adjust your spending every year to reflect your portfolio value and your remaining longevity. As people age, their remaining life expectancy gets shorter. And so, naturally, people can spend a higher percentage of what's left as they age.

The required minimum distribution rules guide that sort of spending. You could play around with making them a little more aggressive if you want to spend a bit more aggressively. But generally speaking, that's what academics are saying: spend an increasing percentage of what's left every year as you age. And that can be the most efficient way to spend down your assets in retirement. 

 

Christine Benz is Morningstar's Director of Personal Finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. This article does not consider the circumstances of any investor, and minor editing has been made to the original US version for an Australian audience.


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6 Comments
Peter Scully
August 09, 2020

I have served 10 families as their financial adviser for over 45 years. An actuarial consultant in 1975, who was a Ben Graham advocate, used 6% in earnings as the safe draw down number.
In the late 70s and 80s case study analysis showed me that in financial terms Early Aged started at 60, Middle Aged financially was 75 +/- 5 years and Elderly was 85 +/- 5 years.
Increased aged obtained life expectancy will have moved the midpoint of the Middle and Elderly financial sets.
The transition period from both sets is different and this is causal.
We have encouraged postponement of “retirement” given the impact of this on sense of purpose and length and quality of life.
The introduction of Early Retirement at 55 was an abuse of government policy in prioritisation of constructive social improvements in Australia.
Earnings from capital stable securities should underpin all portfolios so that two things are achieved.
First other sectors are not exposed to have a “have to sell imposition” and secondly the capital stable securities provide the hurdle rate to answer the two critical questions.
What reward should I seek for a given risk exposure and what risk exposure is affordable and advisable?

Dudley.
July 24, 2020

Currently I'm using the 0.4% rule.

Interest rates are small because if they were any bigger capital losses would, like a tsunami, swamp the negligible earnings from interest and dividends - and turn the wealth effect into the poverty effect.

David
July 23, 2020

Anyone tell our Government ! The compulsory drawdown percentages of super in retirement negate this article .

Rob
July 23, 2020

You should not import US thinking into Australia without qualifying the differences.

Reality in Australia, is that in retirement, income and capital gains are tax free inside Super - income "per se", is irrelevant, PROVIDING capital growth continues. For many retirees and advisors, that requires a mindset change, not to rely totally on interest or dividend income, but to re weight to more growth, and inherently more volatile, assets.

Will not be an easy transition

Aussie HIFIRE
July 23, 2020

I certainly agree that with bond yields being lower it's likely going to be more difficult for the 4% rule to work in the future. The original 4% rule from the Trinity Study was based on the US though rather than Australia, and based on a 50% equities 50% bonds portfolio. Most people looking at using the 4% withdrawal rate in Australia are likely to have a higher percentage of their assets in equities and thus lower amount in bonds. From my research into how it's played out historically around a 75% equities and 25% bonds portfolio has in almost all cases worked out fine for retirees. https://aussiehifire.com/2018/11/21/sequencing-risk-the-trinity-study-and-the-4-rule-in-australia/

There's also the issue of real returns. Yes bond yields used to be much higher, but so did inflation, so the real return was much lower although still higher than what can likely be achieved currently.

And then with bond yields being so low, will more funds go into equities and push those returns up which might compensate for the lack of returns from bonds?

I think the key is to be flexible with your spending to the extent possible, bearing in mind that a lot of your costs such as rates, various insurances etc in retirement are likely to be fixed in nature. Having a buffer would obviously make this a lot easier, whether this be through a large amount of excess cash, some spending that can be cut if necessary, using a 3% rule instead or any combination of the above.

Mark Hayden
July 23, 2020

This is a fascinating area and I will continue to research this field. I have designed my investment model to maximise the safe withdrawal rate and am continuing to tinker with the components of my model including the asset mix. I published my book in 2013 addressing sequencing risk etc and I am convinced my model can do better than the models used by Wade and others. I also welcome readers of FirstLinks to recommend other articles in this area.

 

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