Smarter retiring: Rethinking the 4-per-cent rule
If you want to see a group of financial experts brawl, ask them how much it’s safe to withdraw from your investment portfolio each year in retirement.
One of the most common answers is to suggest some variation of the 4-per-cent rule. Under this guideline, a retiree would take out 4 per cent of his or her original portfolio in the first year and continue to withdraw the same amount – but adjusted for inflation – each subsequent year.
The 4-per-cent rule offers the undeniable attraction of simplicity. But the more you examine it, the more unsatisfactory it becomes.
One flaw – a rather major one – is that it doesn’t work for everyone, everywhere. The rule was based on a landmark 1994 study by William Bengen, a U.S. financial planner, who looked back at several decades of U.S. market history to gauge a safe withdrawal rate for a retiree with a conventional balanced portfolio. Mr. Bengen wanted to establish a spending rule that would have allowed a retiree to survive even a Great Depression or a world war without running out of money.
The rule has since become embedded in the public mind as the correct withdrawal rate for every situation. But it’s not.
Among other restrictions, it’s based on someone planning for a 30-year retirement. If you’re planning to quit work in your early fifties and think there’s a good chance that you or your spouse may make it into your nineties, all bets are off. In such a case, it makes sense to begin your retirement by being even more cautious than the 4-per-cent rule would dictate.
Conversely, if you’re 90 and still have a hefty portfolio, it’s not clear why you should stick to a 4-per-cent annual cap on your spending. It’s time to indulge.
Barring a breakthrough in human longevity, you should feel free to spend more lavishly than the rule would suggest.
As these examples demonstrate, the 4-per-cent rule is about establishing a safe withdrawal rate, not the optimum one. Mr. Bengen wanted to ensure that people would not run out of money no matter what, so he sought a guideline that would have avoided regret, not maximized pleasure, during recent decades. One of the frustrating aspects of his rule is that in many cases it would result in a retiree dying with a mountain of money still left unspent.
Yet, another drawback to the 4-per-cent dictum is that it assumes that what worked in the United States during a certain historical period will also hold true in other countries and during other times.
Wade Pfau, a professor at the American College in Philadelphia, recently examined how the 4-per-cent rule would have fared in 20 developed countries between 1900 and 2015. Assuming that investors held portfolios evenly divided between stocks and bonds, Prof. Pfau found the rule would have failed in every country, although it came very close to working in the United States and Canada.
In eleven of the 20 countries, the safe withdrawal rate was below 3 per cent. German, Australian, Japanese, Austrian and Italian investors were among many global investors who would have gone bust following the 4-per-cent guideline.
Canadian investors tempted to stick to the time-honoured rule should consider those global examples. “In planning for retirements in the future, it is unclear whether asset returns of this century will continue to be as favourable [for North American investors] as they were in the 20th century, or whether savers and retirees should plan for something closer to the average international perspective,” Prof. Pfau says.
Today’s rock-bottom interest rates offer the most obvious threat to Mr. Bengen’s rule. The near-zero yields on many government bonds are an anomaly compared with past centuries and substantially reduce the payoff one can expect from the fixed-income portion of a portfolio. They suggest that history may not be a great guide to what we can expect over the next few decades.
So can we do better? A couple of recent papers suggest alternative approaches.
The first is from ReSolve Asset Management in Toronto, a firm that specializes in applying quantitative research to building client portfolios. Among other findings, the crew at ReSolve conclude that there’s not just one safe withdrawal rate. Much depends on what interest rates and stock market valuations are like when you retire. The researchers suggest that it makes sense to take these factors into account when you choose a withdrawal rate.
Given today’s dismally low interest rates and lofty stock valuations, wise retirees will ratchet down their expectations. Based on ReSolve’s own valuation model, “current estimates for optimal withdrawal rates are near the bottom of the historical range: 3.23 per cent to 3.87 per cent, to be precise.”
Many people will find that math disappointing. At such low withdrawal rates, a million-dollar investment portfolio can be counted on to generate only an inflation-adjusted $35,000 or so a year in retirement. That’s not exactly what most of us mean when we say we want to live like a millionaire.
So maybe it’s time to look at the problem from a different angle. Rather than picking one fixed withdrawal rate, perhaps we should view retirement in actuarial terms, as a matter of matching the present value of assets to the present value of liabilities and adjusting regularly based on actual experience.
Ken Steiner, a retired actuary living in California, is the most articulate exponent of this approach. He offers free spreadsheets on his website, How Much Can I Afford to Spend in Retirement? They allow both retirees and pre-retirees to create detailed scenarios for their golden years.
Mr. Steiner explains his approach more fully in a recent essay, Using Sound Actuarial Principles to Enhance Financial Well Being, available on the Society of Actuaries website, or you can Google it. It’s good reading if you’re interested in the broad strokes of how you should plan for your retirement.
On a more practical level, his spreadsheet allows you to update your plans, year by year, for unexpected spending needs as well as actual market returns and desired legacies. Spend some time on Mr. Steiner’s website and with his spreadsheets and you’ll be far better prepared to navigate retirement than by simply sticking to an unbending 4-per-cent rule.
Edited on 8 November 2017