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Can investors rely on return on investment as a means of generating income?

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For decades, investors have sought to use return on investment as a means of generating income, including retirement income. 

Historically this worked, in large part because before the mid-1990’s, market returns experienced relatively minor short-term fluctuations in value and were fairly predictable over time horizons as short as three to five years. 

In 1994, William Bengen suggested that an average investor could safely withdraw up to 4 percent of a portfolio without risk of outliving the principal. Four years later, Cooley, Hubbard and Waltz (“The Trinity Study”) affirmed Bengen’s conclusion. This paradigm became known as “The 4 percent Rule.”

However, Bengen’s model assumed an investment portfolio that consisted of 50 percent stocks and 50 percent bonds and was derived from market conditions prevalent in the latter half of the 20th Century prior to 1995. 

But January 1995 introduced a period of unprecedented market volatility in which the oscillations in market value increased by hundreds if not thousands of times more than ever previously recorded. So great were these changes, they prompted Nobel Laureate William Sharpe and colleagues to re-examine Bengen’s hypothesis. 

Sharpe’s conclusion was the 4 percent Rule had a 53 percent chance of failure. By 2014, other researchers, most notably Rex Voegtlin and Wade Pfau not only confirmed Sharpe’s conclusions, but alternately suggested that the “4 percent Rule” carried a higher (57 percent) chance of failure than predicted by Sharpe, and reported the general assumptions of the “4 percent Rule” would be more accurate if 2.8 percent. 

Based on the realities of the 21st century, there are several errors with the 4 percent Rule:

    1. Unprecedented market volatility: 
      From January 3, 1995 through March 24, 2000, the S&P 500 Index® roared upward at an enviable average rate of 21.21 percent per year. Then, over the next 2½ years, it plummeted 45.47 percent, reaching a new low on October 4, 2002. Then, for the next five years, it roared upward again at 14.29 percent per year, reaching an all-time high by October 12, 2007. Sixteen months later, on March 9, 2009, it crashed, bottoming out with a total loss of 56.72 percent. Then it again climbed 22.95 percent per year through December 31, 2014. The net result of those huge swings which included two of the three largest bull markets in US history was that from January 1, 2000 through December 31, 2014, the total average return was just 2.15 percent, BEFORE deducting investment fees and taxes.

    2. Historically low bond rates: 
      Normally bond rates improve when stock markets are weak but that didn’t happen with the financial crisis of 2008. Yields on the 10-year Treasury Note (bonds) fell from a high of 5.19 percent on July 6, 2007 to 2.17 percent by December 31, 2014. Bergen’s 4 percent Rule that assumed a portfolio of 50 percent Bonds, was derived from a time when typical bonds paid two to three times what they pay today.

    3. Increasing human life expectancies: 
      Increased longevity raises the demand on return to sustain income. In 1950, the average life expectancy of a 65 year-old male was 12.8 years with half dying before age 78. Today the average life expectancy of a 65 year-old is 85 and current projections are that the probability of a person living into their 90’s will quadruple.

    4. Sequence of returns risk: 
      For those people who are “lucky” and start their retirement (based on 4 percent withdrawal) at the beginning of the “bull markets,” the probability of success is far greater than those who start their retirement when the markets are at (or past) their peaks. But analysis from T. Rowe Price showed that a retiree who starting taking income as 4 percent of portfolio value on January 1, 2000 would, by 2010 have lost a third of their total portfolio.

    5. Inflation risk: 
      According to the U.S. Bureau of Labor Statistics, from 1995 through 2014, the average rate of inflation was 2.2 percent per year. Many people popularly doubt inflation was actually that low, but even taking the BLS statistic at face value, it’s easy to see how an inflation load equal to if not greater than the net average annual return defeats any ability to preserve principal while withdrawing income. 

Nobel Laureate, distinguished professor of finance at the MIT Sloan School of Management and Professor Emeritus at Harvard University, Robert C. Merton writing in the Harvard Business Review, strongly criticized corporate America for their away shift from traditional pension plans (known as Defined Benefit Plans) to Defined Contribution Plans (IRAs and 401(k)s).

Essentially, this shift converted the former corporate promise of a “we’ll take care of you for life” plan to a “good luck in your retirement” plan. Merton’s central message is that when it comes to retirement planning, people “need to think about monthly income, not net worth” and he is sharply critical of corporate America for this error.

But the sins of corporate America are no worse than what many personal investment advisors tell their clients. Those advisors want you to believe – because they believe, that markets are sufficiently predictable to be relied on for income generation or (worse) that the advisor’s advisory skills are so advanced, they can insulate an investor from what will happen when markets correct. In other words, they continue to believe in the 4 percent Rule.

Mandatory liquidation:

Within the United States, the largest single block of moneys is qualified retirement funds (IRA, 401(k), etc.). According to the Employee Benefit Research Institute, by year-end 2012, qualified retirement money totaled approximately $23.7 Trillion. Of that, more than $4.0 Trillion (17 percent) was in Defined Contribution Plans and nearly $5.7 Trillion (24 percent) in traditional IRAs.

Current tax code mandates that a retiree who reaches the age of 70½ must begin a schedule of Required Minimum Distributions (RMDs) from a Qualified Retirement Plan (such as IRA and 401(k) plans). The amount of that mandatory liquidation changes every year, starting at approximately 3.65 percent for a 70 year-old and rising steadily from there, topping out at more than 52 percent for anyone fortunate enough to live to at least age 115.

However, according to the IRS, the average life expectancy of a 70 year-old (unisex) is 17 years. At that rate, the average RMD is 4.88 percent per year, with a range of 3.65 percent at age 70 to 7.09 percent at age 86. But, for someone who lives to age 90, that average RMD jumps to 5.28 percent. Note that all of these required distribution demands are well in excess of the 4 percent Rule.

Put another way, an IRA owner who turned 70 in January 2000 and on January 1, 2000  had and IRA worth $100,000 (based on the S&P 500 ®) would, by January 1, 2015 have only $65,962.19 left; a net loss of 34 percent to volatile markets and the relentless erosion of mandatory distributions. Even adding back their $49,370.68 paid in combined Required Minimum Distributions, their net return would be only 0.96 percent per year.

In short, the schedule of Required Minimum Distributions – in the face of volatile markets such as have typified the early portion of the 21st Century, spells a formula for disaster for this, the largest single block of money in the United States.

As such, anyone hoping to preserve the principal value of their IRA through the schedule of RMDs, should give serious consideration to moving those moneys away from markets and into accounts free from the risk of market downturns. There are but two sources of such funds: fixed bank accounts (short-term CDs and money market accounts) and fixed insurance products (annuities).


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