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October 04, 2022 at 10:46 AM
What You Need to Know
- A new paper argues that the historical record of asset-class performance in the U.S. used to develop the 4% rule likely offers a poor reflection of future returns.
- A retired couple willing to bear a theoretical 5% ruin probability may withdraw 2.26% per year, according to the researchers.
- But advisors say rules of thumb shouldn't be relied on for retirement planning.
The 4% withdrawal rule is one of the most broadly cited retirement planning rules of thumb discussed by retirement advisors and their clients.
Defined basically, the rule suggests a given client in retirement should add up all of their investments and simply plan to withdraw 4% of their total wealth during their first year of retirement. The withdrawal amount is then adjusted annually to account for inflation.
In a recent interview with ThinkAdvisor, Wade Pfau, principal and director at McLean Asset Management and RISA LLC, voiced frank concern about the reliability of the rule in the current market environment. Pfau says the very low inflation seen in recent years was the saving grace behind this rule of thumb, because it allowed for a higher sustainable spending rate.
That outlook has changed with substantially higher inflation, such that, according to Pfau and others, it will be very difficult for people to actually follow this rule without depleting their portfolios late in retirement.
Now, a new paper published by researchers at the Universities of Arizona and Missouri offers up a new “safe withdrawal” figure, and it is substantially lower than the traditional 4%.
The authors of the paper include Aizhan Anarkulova, Scott Cederburg and Richard Sias, all of the University of Arizona, and Michael O’Doherty, of the University of Missouri-Columbia. According to the quartet, a 65-year-old couple willing to bear a 5% chance of financial ruin over a 30-year retirement period can withdraw just 2.26% per year.
Faulty Assumptions Behind 4% Withdrawals
As the researchers point out, the 4% rule originates from a 1994 analysis published by William Bengen, whose works suggests that a retirement strategy with 50% in U.S. stocks and 50% in government bonds would have survived each 30-year period in the U.S. historical record from 1926 to 1991 — so long as the asset owner withdrawals no more than 4% per annum during that period.
“The ‘safe’ 4% spending rule is ubiquitous and recommended by financial advisors, brokerages, mutual fund companies, retirement groups and the popular press,” the researchers note.
While exceedingly popular, the researchers suggest, the 4% rule is a leading example of the divergence between finance theory and practice, especially in its lack of consideration of income insurance opportunities purchased via annuities.
“Normative portfolio choice models prescribe full or considerable annuitization of assets at the onset of retirement to address the risk of households outliving their wealth,” the analysis states. “In practice, however, few retirees purchase life annuities, and annuitization has, if anything, declined in popularity in recent years.”
The quartet posits that academic explanations for the “annuitization puzzle” include adverse selection issues, bequest motives, health risks and behavioral factors. Thus, the researchers explain, there is debate regarding the extent to which retirees should annuitize versus self-fund retirement.
Theory aside, current retirement spending practices demonstrate a revealed preference for spending rules over annuitization.
“Retirees must balance the desire to make larger withdrawals to maintain a reasonable standard of living against two risks that can deplete their wealth, which are longevity risk and return risk,” the paper states.
According to the researchers, modeling the impact of longevity risk on withdrawal rules is straightforward for a random retiree from the population, given the depth of actuarial information available on mortality risk. Modeling return risk is a more difficult problem.
“Quantifying the likelihood and severity of left-tail outcomes is particularly important, as poor market performance during retirement can be catastrophic,” they warn.
Sober Spending Conclusions
In their paper, the researchers seek to highlight a few critical facts about the period of market returns used in the original 4% withdrawal analysis. First, evidence suggests that the historical U.S. asset market performance during this period likely exceeded reasonable forward-looking expectations when viewed from a global perspective.
