‘The 4% Rule Has Not Worked Out So Well:’ Pfau Answers Five Good Questions

Economist Wade Pfau is concerned that retirees are going to find that the 4% rule is unsustainable

Wade Pfau, an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan, does most of his research on retirement-planning issues.

He earned a Ph.D. in economics from Princeton in 2003, under the guidance of professors Alan Blinder and Harvey Rosen. He also earned an undergraduate degree from the University of Iowa, and completed several internships at the U.S. Social Security Administration, the White House and the U.S. Senate.

You have done a great deal of work on retirement withdrawal rates. What does your research into international markets suggest to you about "the 4% rule"?

In the United States, there is a popular rule-of-thumb that it is safe to withdraw 4% of your accumulated wealth during the first year of retirement and then adjust this withdrawal amount for inflation in each subsequent year.  Historically, your wealth will have lasted for at least 30 years. 

My introduction to researching about retirement withdrawal rates was to look at the data since 1900 for 17 developed market countries.  This paper was published as “An International Perspective on Safe Withdrawal Rates from Retirement Savings: The Demise of the 4 Percent Rule?”in the December 2010 Journal of Financial Planning.

From an international perspective, the 4% rule has not worked out so well. The historical worst-case withdrawal rate was above 4% in only 4 of the 17 countries: Canada, Sweden, Denmark, and the United States. For 30-year retirements, the 4% rule failed in 62.5% of the historical cases in Italy and in 42.5% of the historical cases in France.  Five of these developed market countries experienced maximum sustainable withdrawal rates of 1.56% or lower.

In terms of returns for stocks and bonds, as well as for inflation, the United States enjoyed a rather remarkable run in comparison to other developed market countries in the period since 1900.  This is important, because in planning for retirement in the future, it is not clear whether asset returns in the twenty-first century United States will continue to be as great as in the twentieth century, or whether savers and retirees should plan for something closer to the average international experience.  We should be cautious about treating 4% as the safe withdrawal rate.

You have also looked at safe withdrawal rates in different domestic market environments.  Are there special risks in this regard for today's retirees?

Then I explored more about the United States and wrote two papers which each use a different method to suggest that withdrawal rates for recent U.S. retirees may be lower than for past retirees.

Before discussing this further, one point must be clear.  If you are investigating, for example, retirement lengths of 30 years, then you cannot calculate the maximum sustainable withdrawal rate for any retirees after 1981.  We don't yet know if the 4% rule will work for retirees since 1981. But I am quite concerned that retirees since the mid-1990s are going to find that the 4% rule, as it is traditionally defined, will not be sustainable.

In "Will 2000-Era Retirees Experience the Worst Retirement Outcomes in U.S. History? A Progress Report after 10 Years,"I explore the situation facing various hypothetical retirees who retired in different years up to 2000, to see how they are faring 10 years after retirement.

This can be useful, because it turns out that events in the early part of retirement weigh disproportionately on the final retirement outcome.  I show, in particular, that the wealth remaining 10 years after retirement combined with the cumulative inflation during those 10 years can explain 80 percent of the variation in a retiree's maximum sustainable withdrawal rate after 30 years.

It has now been 10 full years for anyone who retired at the start of 2000.  And generally, for stock allocations above 50 percent or so, the 2000 retiree has depleted more wealth in nominal terms after 10 years than most any other retiree in history.  People who retired at the start of the Great Depression, or just before the stagflation of the 1970s, would still have more wealth after 10 years, and that holds for a variety of assumptions and conditions.

When remaining wealth is considered in real terms after removing the effects of inflation, the situation is not as grim, as the 2000 retiree is in better shape than retirees in the late 1960s and early 1970s. But 10 years after retirement, retirees with less remaining real wealth than the 2000 retiree faced much better market conditions in terms of lower cyclically-adjusted price-earnings ratios, higher dividend yields, and generally higher bond yields.

This leads to the other paper, "Predicting Sustainable Retirement Withdrawal Rates Using Valuation and Yield Measures,"which explores the relationship between retirement withdrawal rates and market valuation levels at the time of retirement.

This study attempts to quantify whether a 4% withdrawal rate can still be considered as safe for U.S. retirees in recent years when earnings valuations have been at historical highs and the dividend yield has been at historical lows. I find that the traditional 4% withdrawal rule is likely to fail for recent retirees. The maximum sustainable withdrawal rate for retirees may continue declining even after the peak in earnings valuations in 2000.

My lowest estimate for a 60/40 allocation between stocks and bonds is 1.46% for new retirees in 2008. The regression framework with variables to predict long-term stock returns, bond returns, and inflation (the components driving the retiree's remaining portfolio balance) produces estimates that fit the historical data quite well.

The study does have limitations, and in reality I am hopeful that retirees can obtain higher withdrawal rates than I estimate. Retirees with flexibility for their spending can start with a higher rate and keep vigilant about their remaining wealth so they can cut expenditures if the need arises. 

Also, including TIPS and international assets could help. Retirees can also consider annuitizing a portion of their wealth at retirement, which with Social Security would help provide a minimum income floor in order to allow for more aggressive withdrawals from non-annuitized wealth.

You have a fascinating paper which turns the "4% rule" on its head and looks at savings rates over time.  What's your best advice arising from that research?

I have noticed that a lot of literature about retirement planning treats the accumulation and retirement phases separately. On the retirement side, research is mostly about finding a "safe withdrawal rate," which is then used to compute a "wealth accumulation target" so that desired retirement spending can be funded from this wealth at the desired withdrawal rate. On the accumulation side, research is mostly about how to achieve this wealth accumulation target.

But I've not seen so much that links the accumulation and retirement  phases together in an integrated whole. I address this in "Safe Savings Rates: A New Approach to Retirement Planning over the Lifecycle," in the May 2011 Journal of Financial Planning. When linking the accumulation and retirement phases together, the concepts of "safe withdrawal rates" and "wealth accumulation targets" end up serving as almost an afterthought.  Focusing on them may not be the best way to think about retirement planning.

When considered together, the lowest sustainable withdrawal rates (which give us our idea of the safe withdrawal rate) tend to follow prolonged bull markets, while the highest sustainable withdrawal rates tend to follow prolonged bear markets. Investors will likely tend to have also accumulated more wealth after bull markets and less wealth after bear markets.

So what really matters instead is the "safe savings rate," which is the maximum of all the minimum necessary savings rates from overlapping historical periods needed to build up enough wealth so that you can afford your desired retirement expenses. Put another way, someone saving at her “safe savings rate” will likely be able to achieve her retirement spending goals regardless of her actual wealth accumulation and withdrawal rate. The difference in this approach is that it makes some account for the level of market valuations at the retirement date.

An important point of the research is that the savings plan should be adhered to regardless of whether it seems one is accumulating either more or less wealth than is needed based on traditional criteria. New retirees in the 1990s may have not saved enough or retired early because an outstanding market performance may have brought them to their traditional wealth accumulation goals earlier than expected, when the reality is that they may end up needing more than expected to fund their retirements.

At the same time, someone saving during a bear market who is nowhere near reaching a traditional wealth accumulation goal may have given up saving or needlessly delayed their retirement, when it is precisely such individuals who could have enjoyed higher withdrawal rates and, therefore, less accumulated wealth.

What research are you currently working on and how might it impact financial advisors and their clients?

I am hoping to make some improvements to my past work, such as allowing asset allocations and savings rates to vary over time in my “safe savings rates” analysis, looking more at the role of international diversification in retirement portfolios, accounting for taxes in retirement withdrawal studies, and investigating more about lifecycle or target-date funds for both the accumulation and retirement phases. 

I’m also investigating how long-term conservative investors may possibly benefit by changing their asset allocations in response to extreme market valuation levels, and one paper I recently finished on this topic is "Revisiting the Fisher and Statman Study on Market Timing."

Also, I’ve seen a number of studies which argue that those near retirement should maintain high stock allocations in order to maximize their expected wealth.  I’m exploring whether these findings hold when one accounts for the fact that people experience diminishing marginal returns from having additional wealth.  My paper, "The Portfolio Size Effect and Lifecycle Asset Allocation Funds: A Different Perspective,”in the Spring 2011 Journal of Portfolio Managementis about this.

More generally, I am now studying for the CFA Level III examination, and included in the curriculum is  Dan Nevins’ article, "Goals-based Investing: Integrating Traditional and Behavioral Finance."I thought this article ties together the approach I had been taking in various strands of research, but which I hadn’t articulated before.

I hope that in the future I can do research more along these “goals-based” lines. Telling someone the standard deviations of their portfolio returns probably isn't too helpful, but telling someone the probability of reaching their goals can help a lot. The long-term perspective also really highlights the important impacts of fees.

I maintain a blogwhere I try to provide updates about my research progress.

You live in Japan.  What insights should American advisors and investors take from the Japanese experience?

Both for Japan’s lost decades and for the recent crisis triggered by the earthquakes and tsunami, I think the best lessons are to keep flexible with both your human capital and your financial capital. 

For human capital, you never know when you may unexpectedly find yourself in need of a new job, and so you should keep your skills up to date. Keep a liquid emergency fund so that you don’t have to liquidate your savings for unexpected expenses.  And consider including an important role for international diversification in your investment portfolios.  I think these are lessons that advisors and investors already understand, but a friendly reminder never hurts.

As well, I have reported on my blog about whether the extreme market valuations Japan experienced in the late 1980s work for or against the idea of reducing stock allocations when valuations become extremely high.

I have heard that the case of Japan argues against deviating from a buy-and-hold strategy and instead changing one’s strategic asset allocation in response to extreme market valuation levels. But my reading of the evidence supports the role for this limited type of “market timing” for the case of long-term investors. 

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