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Should retirees forget about the 4% withdrawal rule?

Forget that absurdly conservative 4% withdrawal rule. Retirees can safely remove 15% of their portfolio’s assets every year, for life. You heard it here first.

Not convinced? See for yourself. Money stashed in a safe-deposit box can pay 15% per year for three decades without being exhausted. And that is the poor outcome. Investors who withdrew 15% annually from the Vanguard 500 Index Fund from 1993 through 2022 would have finished the 30-year period with 20 times more assets than the safety-box strategy.

Well, all right. The truth emerges. Because portfolios can maintain their withdrawal rates does not mean that they can retain their values. Nor, regrettably, can they retain their payment schedules. A constant withdrawal rate applied to a shrinking asset base equals fewer dollars. Consequently, the chart depicting portfolios’ annual distributions looks much like the 'Growth of $10,000' illustration.

Considering the denominators

This admittedly silly example points out an essential truth about investment yields. (Technically, some of the distributions discussed in this column are not 'yields' as they contain capital gains, but the principle holds regardless.) While investors customarily evaluate yield numerators (the higher the better), those amounts only become meaningful after considering the denominators.

Indeed, when the denominator is 'the current amount of the portfolio', the yield percentages are entirely moot. By that measure, all withdrawal rates can be delivered over all time periods. Retirees who located the Fountain of Youth can spend 99.99% of their wealth during each year of the next century. They will eventually die, but their money will survive, assuming the retiree’s financial institution will maintain accounts that are worth only a small fraction of a penny.

Four categories

Denominators for investment yields - or, if you prefer, retiree-withdrawal rates - place into one of four categories.

1) Declining

Declining denominators pay constant distribution rates, as measured in percentage terms, but ever-fewer dollars, owing to the decline in the portfolio’s balance. The latter is sometimes forestalled by an early bull market but eventually performance reverts. The portfolio’s value falls below its starting point, as does the dollar amount of its cash payments.

Real-life example: High-yield bond funds have declining denominators because they distribute all income they receive rather than withhold assets to defray the capital losses that come from their bonds’ defaults.

2) Flat nominal

This category is most easily understood. A 4% yield on a $100,000 investment with a flat nominal denominator means a $4,000 annual payout. End of story. For securities that do not face default risk, the analysis concludes. However, while the cash payments avoid nominal decline, they nevertheless fail to keep pace with inflation.

Real-life examples: Treasuries and bank CDs. In theory, investment-grade bond funds also qualify, because their investments make fixed payments and do not default. However, because their portfolios change over time, their payouts also fluctuate. Bond fund denominators are roughly flat nominal, but not precisely so.

Retirement plans relying on fixed payments that are not adjusted for inflation - meaning nominal bonds, annuities, and (largely) private pensions - have flat real denominators. Of course, most would also be leavened with social security payments, which operate differently.

3) Flat real

A flat real denominator grows with inflation. For those accustomed to thinking in nominal terms, the distributions of such securities seem less predictable than those of the second category. For professional investors, though, flat real denominators represent 'riskless' yields.

Real-life examples: Few securities aside from Treasury Inflation-Protected Securities explicitly offer flat real denominators. In practice, though, allocation funds often approximate such behavior, thanks to gains from their equities.

Research reports on safe retirement-withdrawal rates often assume that retiree spending behaves like flat real yields by tracking the rate of inflation. Distributions from retiree portfolios are not true yields because they are supplemented, when necessary, by returns of the investor’s capital. However, the point remains: The percentages given in such reports cannot be usefully compared against either Treasury or annuity rates.

4) Increasing

Increasing yield denominators outstrip inflation, so that the portfolio’s payments grow in real terms. This, obviously, is the happiest scenario.

Real-life examples: Equities. To be sure, they offer no guarantees, but nevertheless, Australian stocks have provided positive real returns over every 30-year period during the past century. Balanced portfolios also usually manage the task.

Few retirees except the wealthy, who can afford the risk associated with owning stock-heavy portfolios, explicitly target a yield that increases faster than the inflation rate. But such can occur during bull markets, even for those who are relatively conservatively positioned.

Wrapping Up

Percentages can deceive. Dollars do not. For that reason, the fund industry has never much liked the idea of billing shareholders for fund expenses. A $1,000 annual charge on a $250,000 position might raise eyebrows if the fund has recently lost money but fewer shareholders fuss about the cost of profitable investments. In contrast, funds that report 0.40% expense ratios, with no dollars attached, will likely go unnoticed.

Investors would do well to take that lesson to heart. In this instance, good business for the fund industry is bad business for investors. When evaluating investment yields or portfolio spending rates, consider not just the numerator’s percentage, but also the denominator’s effect. Doing so will lead to the only path that truly matters: the dollar trail.

 

John Rekenthaler has been researching the fund industry since 1988. He is a columnist for Morningstar.com and a member of Morningstar's Investment Research Department. The views of the Rekenthaler Report are his own. This article is general information and does not consider the circumstances of any investor. Originally published by Morningstar and edited slightly to suit an Australian audience.


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22 Comments
Eleanor Martin
May 03, 2023

Please explain the numerators and denominators terminology please.

Mark
April 16, 2023

With many dividend paying companies on the ASX that pay more than 4%, especially when adding Franking Credits, drawing 4% would mean never touching the capital and the likelyhood that the capital will still grow offsetting some of the inflationary affects as well.

In a Superannuation environment, this would likely be tax free for most people and as one ages and the requirement to take more out come into play, if you don't need to spend it you could reinvest it outside Super if recontributions rules were to change.

By the time I'm 60 I could be looking at an 8 figure Super Balance. 4% a year will certainly fund my retirement lifestyle.

Dudley
April 17, 2023

"With many dividend paying companies on the ASX that pay more than 4%, especially when adding Franking Credits, drawing 4% would mean never touching the capital and the likelyhood that the capital will still grow offsetting some of the inflationary affects as well.":

Companies paying 4%+ of my share holding cost base while I live would be good. 4% of market value might be bad.

Eleanor Martin
May 03, 2023

Mark,
I cannot see how you can have an 8 figure super balance and be tax free......it just wont happen.

Mark
May 03, 2023

I never said my Superannuation would be tax free. I said most people investing in dividend paying companies would be receiving that money tax free in their retirement.

Wayne
April 16, 2023

I struggled to understand this article

Richard
April 23, 2023

me too

John
April 16, 2023

Maybe retirees could eliminate all the worry about running out of money and instead work out if they can live off the aged pension. Once they have worked out that they can, like 60% of current retirees, anything more is cream on the cake. No worries.
As for the cream on the cake, as has been shown in past editions of Firstlinks, a couple can have up to $419,000 of assets outside the family home and still get a full (indexed) aged pension. The combined aged pension and income generated on $419,000 of investment assets could result in a total income for a couple of approximately $65,000 pa, which makes for a comfortable retirement.

Dudley
April 16, 2023

A different 4% rule:
= (4% * 419000) + (26 * 1604)
= $58,464 y
The problem then being what to do with the excess after expenses to avoid losing 7.8% / y to Age Pension taper on each saved $; Home improvement.

With necessities funded by Age Pension, the betting person could indulge in flutters with a higher return:
= (10% * 419000) + (26 * 1604)
= $83,604 / y
Spending the excess on fancies. Losses covered by Age Pension and profits in excess of Age Pension.

Terry
April 17, 2023

Icing goes on top of the cake-cream goes in the middle

Julian
May 21, 2023

and if one is unfortunate enough to have $419,001 the marginal effective tax rate on that extra $1 is about 150%. Have to have about $1,200,00 @5% to have same income as with $419,000 assets.
The cream is stale and the icing hard.

Mark
April 14, 2023

I've treated the 4% rule as just a guide.

When I retire at 60 and start drawing a pension from my Superannuation, 4% will be more than I need, what I don't spend I'll invest outside of Superannuation and it will be there if I ever need it. Each year that amount will grow. I can splurge on something nice or gift it to the kids tax free.

Peter Vann
April 14, 2023

John

William Bengen’s 1994 paper describing the 4% rule states that one can very safely commence withdrawing 4% of portfolio value and then adjust that dollar amount each year for inflation if the asset allocation is between 50:50 and 75:25 equities and bonds (the exact market exposure is in his paper).

The denominator referred to above is only used once, at the start of many years of withdrawing money to funds retirement. Thus there is no problem regarding “Percentages can deceive. Dollars do not.” when following the 4% rule.

The article’s title “Should retirees forget about the 4% withdrawal rule?” has been visited a few times since Bengen’s paper. A colleague and myself have explored this with an approximate closed form solution we developed to calculate the probability of running out of money over retirement given a withdrawal rate (or a withdrawal profile) and stochastic returns.

We found that starting with total withdrawals over the first year at 4% of assets and then changing that dollar amount by inflation was very safe. Withdrawal rates based on 5% or a bit higher of initial assets had low probability of running out of money. I should also add that Including the benefit of mean reversion of equity valuations due to market booms and busts further strengthened this result; note that Bengen’s analysis includes this aspect but many researchers don’t.

Peter

Dudley
April 14, 2023

Simple calculation of average outcome:
FutureValue in real % of initial capital of 100% (= 1) with 10% average return, 8% inflation, 30 year term, 4% of initial capital withdrawals per year:
= FV((1 + 10%) / (1 + 8%) - 1, 30, 4%, -100%, 0)
= 14.85%

Negative result: capital exhausted before term.

Convert % to $: multiply % by initial capital. No deception.

Adding stochastic returns useful for estimating probability of earlier or later exhaustion than the average.

Peter Vann
April 14, 2023

A 1.85% expected average real return for retirement assets with good growth exposure is very low over cycles!

Dudley
April 14, 2023

"A 1.85% expected average real return for retirement assets with good growth exposure is very low over cycles!":

Choose a less topical inflation rate; 2.5%?

What is the nominal rate of return required for FV = 1 (= 100% if initial capital), 4% withdrawal, 2.5% inflation?

= (1 + 4%) * (1 + 2.5%) - 1
= 6.6%

= FV((1 + ((1 + 4%) * (1 + 2.5%) - 1)) / (1 + 2.5%) - 1, 30, 4%, -100%, 0)
= 100%

Peter Vann
April 15, 2023

Hence a constant real return of 4% will forever fund an inflation linked withdrawal that is initially 4% whereas a 1.85% real return will result in ruin a bit past 30 years.

Include volatility and you need higher real returns hence exposure to growth assets are required as Bengen showed in his 1994 paper.

BTW, Your last formula is independent of inflation.

Steve
April 13, 2023

It's pretty clear the equities/growth biased portfolio is the no-brainer. Cash like investments are GUARANTEED to lose value over time as they never match inflation (ala Peter Thornhill). If you take $1.6MM as a portfolio (easier maths than 1.7....) with 75-80% in equity/growth investments you can take 5% ($80,000) as a starting withdrawl. If you have 20% in cash/TD/Fixed interest, and assuming the income from the portfolio is around 4% (incl franking credits) you should outlast most downturns before you need to think about selling growth assets at reduced prices (net cash withdrawal is 5% payout - 4% income = 1%) so 20-25% cash buffer is good for many years. OK, it reduces maximum potential return having cash, but reduces the risk of selling in a down market and smooths out incomes. Of course in downturns the income may fall as well as the balance but if you can adjust your expenditure accordingly you should be OK. Lets face it most self employed have no certainty of the same income every year but manage to smooth out expenses, retirees should be no different.
Why 5%? It seems about right for historical returns from equities and inflation (4.5% growth + 4.5% income = 9%). Take off say 3% for inflation you get about 6% real. If this is 75% of your portfolio you get 4.5%, assuming the other 25% can get around 4% in cash/TD/FI this adds around 1%. Total 5.5%. Of course these are give or take numbers but not way off the mark.
Now if we can find a way to actually spend some of the capital without the fear of running out we would be in a whole other world; you could be looking at 7-8% of more annual withdrawls (depending on timeframe). Going from 4% to say 7 or 8% as income has major ramifications to say the least!! To me this is still the biggest elephant in the room re retirement spending - how to get annuity like security without being locked into Fixed Interest like investments. Answer - pooling risk as per normal insurance as this removes the number one unknown - how long you will live. Unfortunately the govt wants annuities to be invested in a "safe" ("less risky") manner so they miss the boost you get from growth investments, hence reduced income. Perhaps Peter Thornhill can help explain risk from a multi-decade timeframe for them.

filip
April 13, 2023

yeah, needed a couple of reads as well to understand, i think, not sure

Dudley
April 13, 2023

Never run out of money withdrawing 15% / y:
Starting with $10,000 at start of year 0, withdrawing 15% of remaining capital at end of each year, at end of 29th year the remaining pot will be:
= 10000 * (1 - 15%) ^ 29
= $89.77
and the withdrawal at end of year 30 will be:
= 15% * 89.77
= $13.46
leaving :
$76.30
= 10000 * (1 - 15%) ^ 30
= $76.30

Starting with $10,000 at start of year 0, withdrawing $1,500 (15% of initial $10,000) at the end of each year, the capital will be exhausted in:
= NPER(0%, 1500, -10000, 0, 0)
= 6.67 y.

Jack
April 13, 2023

Took me a couple of reads but is he saying that if you have a retirement pot of $100 and you withdraw $4 every year, everyone thinks about the $4 (the 4%) when they should be paying just as much attention to the $100. He then relates it to dividend yields. Everyone focuses on the dividend and the yield when they should be paying more attention to the earnings which drive them.

Rick
April 14, 2023

Thanks Jack!

 

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