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December 21, 2021 at 03:13 PM
What You Need to Know
- Fixed withdrawal rates aren’t really that realistic.
- The retiree has to be willing and able to cut back.
- Clients must be prepared to spend less if they invest in risky assets and get unlucky.
A new Morningstar report has resurrected debate about the safety of the 4% withdrawal rate in a world of low bond yields and high stock valuations. Plugging more realistic portfolio returns into a Monte Carlo simulator reduces the safe withdrawal rate (10% failure) to 3.3%.
The report makes the very important point that fixed withdrawal rates aren’t really that realistic. When faced with a bear market, most retirees will cut back. Likewise, if retirees get lucky, they should be able to spend more. Flexible spending, that allows spending a bit higher or lower than a fixed withdrawal rate guideline, seems like a much better approach.
But acknowledging the need for flexible spending is an important caveat to the 4% rule, one that opens the door to a better and more realistic approach to matching investment risk with the amount of spending risk a retiree is willing to accept. Going from spending $40,000 on a $1 million portfolio to $35,000 sounds easy enough, but it means that the retiree has to be willing and able to cut back.
One of the most important questions I’ve heard an advisor ask a client when developing a retirement income plan is simply “how much do you need to live on?” The point of the question is to understand how much of a retiree’s budget each month is inflexible.
This is both an empirical question (I can look at retiree spending data and estimate average essential expenses) and a personal/emotional question (do you consider a gym membership or dog grooming an inflexible expense?). Some retirees may consider 70% of their budget inflexible, while others aren’t willing to budge on 90% of their lifestyle.
This has important implications when creating an investment plan because risk requires spending flexibility. Too often a fixed withdrawal rate rule is portrayed as free of spending flexibility risk.
This cannot be true. If there wasn’t a chance that risky investments would underperform safe investments, advisors could simply short Treasury bonds and invest more in stocks to give their clients a better retirement.
The risk of stocks underperforming bonds, especially in a retirement time horizon where returns in the first decade have an outsize impact on lifestyle, is real. Ignoring this risk or dismissing it based on a small series of historical U.S. returns isn’t the most precise way to plan.
For many traditional financial planning clients, a spending-focused retirement income plan isn’t needed because they’ll likely never outlive their savings. However, a larger number of mass-affluent retirees is truly at risk of outliving savings or making painful spending cuts if their investments go south.
These are the ones who most need a retirement income plan where investment risk matches their spending flexibility.
Risk in Retirement
The 4% rule’s fixed-spending concept is consistent with consumption smoothing, or the idea that humans are generally happiest if we maintain about the same lifestyle over time. Maintaining the same lifestyle means adjusting spending each year by the rate of inflation.
Investors can build a completely safe stream of inflation-protected income using Treasury Inflation-Protected Securities (or TIPS), but at today’s TIPS yields they’ll run out of money by age 86, which represents an 80% failure rate for a healthy couple. If you measure success rates of the 4% rule using the traditional 30-year sustainability yardstick, safe investments have a zero percent chance of success.
So a retiree has two choices. They can spend less or they can take investment risk. The good thing about taking risk is that investors have historically been rewarded with a big return bonus (the equity risk premium) for investing in stocks.
A point made in the original 4% rule article is that historically the stock market has reliably provided enough of a bonus to allow retirees to maintain this safe withdrawal rate even if they begin retirement in a low interest rate environment.
In 2010, my American College colleague Wade Pfau made an important point about the singularity of U.S. 20th century stock returns in an article published in the Journal of Financial Planning. The 4% rule may have worked for a limited number of years in the United States, but it didn’t work in 13 of 17 countries during the prior 109 years.
Stock returns in the United States during the 20th century were so high compared to bonds that they represent a puzzle to financial economists. But the bonus for taking investment risk wasn’t as high in other countries.
The United States might just have gotten lucky — other countries didn’t fare nearly as well, and some countries (Russia, Germany, Japan) had a particularly rough patch.
If we use historical U.S. returns, a 4% withdrawal rate seems pretty safe. By playing around with a Monte Carlo simulator, it’s easy to see how sensitive a fixed withdrawal rate is to both stock and bond return expectations.
In 2013, Pfau, David Blanchett (head of retirement research at PGIM) and I wrote a series of papers describing the impact of lower bond yield and higher equity valuations on safe withdrawal rates.
Historical periods in the U.S. when stocks were as expensive as they are right now and yields on bonds were as low as they are today simply don’t exist in the historical data. That makes it hard to predict whether risky assets can bail out the negative after-inflation yields on bonds.
Blanchett notes that “too many advisors and financial planning tools/calculators still use historical long-term averages. While it’s hard to say how long today’s low bond yield environment will last, I think it’s incredibly important for projections for current and near-retirees to take today’s challenging return environment into account.”
