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Retirement Planning > Retirement Investing

Finke, Blanchett on 4% Rule: Retirement Success Is Flexibility, Not Fixation

By Jeff Berman

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As the COVID-19 pandemic and market volatility continue, advisors need to speak to clients about shifting withdrawal rates, according to two retirement experts who spoke during a recent ThinkAdvisor webcast.

“The first quarter was really a wild ride for equity investors,” David Blanchett, head of retirement research for Morningstar’s Investment Management Group, told listeners, adding “we’re in a really unique time” right now.

Clients who have been accumulating their wealth for 30 or 40 years are those who are most affected by the current turmoil.

Blanchett and Michael Finke, director of the Wealth Management Certified Professional program at the American College of Financial Services, explored how buffer assets can affect retirement income success and why retirement specialists now are taking a more nuanced view of “safe” initial withdrawal rates than in past years.

Risk and the 4% Rule 

The pandemic has highlighted one portfolio weakness — namely, it “almost seems as if risk is not a real concept” to many clients anymore, according to Finke. After all, for the past decade, “the market’s pretty much” done nothing but “go up,” he noted.

When many clients see analysis claiming they have a 94% chance of success in retirement, they think that means there’s a 94% likelihood they can maintain their lifestyle throughout retirement, Finke explained.

Also, many believe that if they’re relatively conservative at the start of retirement, they’ll be relatively fine through retirement — no matter what. 

“But the reality is you get unlucky, and that’s what risk means,” he pointed out. “If you’re going to take risk in retirement with your investment portfolio, then that means that there’s a possibility that you could draw the wrong card the first year.”

As an example, Finke pointed to a Monte Carlo simulation in which a client retired Feb. 20 and chose a 3% withdrawal rate under the 3% rule. “You would have had a 94% chance that you could maintain, say, $30,000 plus inflation each year in retirement from a million-dollar portfolio” at that point, he said. 

However, by the time that client got to March 12, he or she would have had only a 64% chance to maintain that same $30,000 plus inflation each year in retirement, Finke explained.

That underscores why the traditional methodology of thinking about retirement withdrawals from a risky portfolio to fund a safe and stable income in retirement is “not exactly realistic,” Finke said. 

In reality, there are many events that happen during the course of one’s retirement that affect this scenario. “Those events will change your reality every year, and you have to adapt to the new reality,” he noted.

The traditional 4% rule is a “fluke” of the United States in the 20th Century, Finke said. Failing to adjust one’s spending each year in retirement hasn’t worked well in other countries, and it might not work well anymore in the United States either.

This is because of the current “globally diversified marketplace,” he explained, predicting that lower returns across the globe are likely to be the norm in the 21st Century.

Buffer Assets, Other Options

To better manage volatility and longevity in retirement, clients have basically four options, according to Finke:

  • Spend conservatively,
  • Spend flexibly,
  • Reduce volatility and
  • Use buffer assets and avoid selling at losses.

Retirees often decrease their spending, some of which is more flexible than it was in their pre-retirement years, Finke explained. Financial advisors shouldn’t assume retirees’ spending will be the same each year, though about 70% of a retiree’s budget is inflexible (as it is tied to food, healthcare, etc.). 

Delaying Social Security is an option that can give clients more to spend in retirement, he noted. Clients who have pensions also can withdraw more money safely from the portfolio than those who do not.

A buffer-asset strategy, meanwhile, could have helped counter what happened in March, when bonds fell at the same time as stocks, according to Finke.

A client with a $2 million portfolio containing S&P 500 stocks and intermediate bonds saw a 19.4% decline on March 19, he said; but if that client had owned a cash-buffer asset instead of the intermediate bonds, the amount would have declined much less — only 11.2%.

“The key for us and the key for investors is to ask the question, what is the right thing to invest in now?” Blanchett said. “As the markets rose, risk aversion fell. Then as the market fell, risk aversion rose for older investors.” 

Advisors have a key role to play in this context, because they are “helping investors stay the course,” he said. On their own, investors are more likely to make changes to their equity allocations based on volatility; plus, older investors tend to make the largest changes.

Time Diversification Debate

“Time diversification is the idea that if you have a longer-term time horizon, stocks are a more attractive investment,” Finke said.

However, some economists believe risk and time horizon shouldn’t matter when deciding on a portfolio, while others view stocks as somewhat less risky when held over a longer period of time, whether the client is risk averse or not.

“How you invest is critical for long-term outcomes,” Blanchett said. “In theory, you need to take on more risk if you want a portfolio to last 30 or 40 years.” But the important question remains: How should the right level of risk in a portfolio be defined?

“If you’re going to overreact to the market, like a lot of investors do… then maybe you have to be more conservative,” Blanchett said. “The benefit of being more aggressive for longer time horizons has been increasing throughout the 20th Century.”

Advisors should let clients see their assets as different pools of money, in separate cash, portfolio and annuity buckets, so they can better understand the true impact of market shocks, Blanchett suggested.

Finke agreed, pointing out: “Older investors tend to underperform the market” for reasons that include “they tend to do the wrong things at the wrong time.”

For example, “In March, they were far more likely to pull their money out of stocks at the bottom of the market,” he said. “They also become more risk tolerant after stocks have risen in value. So essentially what they’re doing is they’re buying stocks when they’re more expensive and they’re selling them when they’re cheaper. That leads to consistent underperformance.”

As a result, investors over age 70 have an average stock returns that are 3% less than those in their 40s and 50s, Finke noted.

Importance of Annuities

Annuities, meanwhile, are a “more efficient way of funding the safe spending” that investors have in retirement, according to Finke.

“The time to have bought annuities was back in December or January — back when your equity portfolio had gone up in value for the better part of a decade,” he said. Also, it would have made sense to “take some of those gains off the table and buy yourself a guaranteed income with it.”

However, older investors tend to look too much at recent performance when making decisions “such as buying guaranteed income for a lifetime,” Finke explained. “That means that annuities become less popular during periods when the market is going up, and they become more popular in periods like now, when the market has fallen.” 

It seems that older investors “need to be reminded of what risk means before they invest in products that give them a measure of safety, such as an annuity,” he said. “So part of the advisor’s job is to get clients to remember that risk is real — even when risky assets seem like they can only go up in value.”

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Jeff Berman

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