Beyond the 4% Rule: How Should Retirees Withdraw Their Funds? – ThinkAdvisor

Another potential problem with literature on the 4% rule is that the analyses often do not include asset management fees and investment expenses. Even after the longest bull run in U.S. stock history, according to calculations by Blanchett, someone who retired with $1 million on Jan. 1, 2000, would have just $462,282 left today if they’d followed the 4% rule while paying 1% AUM fees and a low 0.25% on invested assets.

In other words, a year 2000 retiree would need to fund $61,707 plus inflation per year (up to $65,000 in 2022) for the next nine years with $462,282 in savings. Invest in TIPS and you fail (in less than seven years). If the bull market doesn’t continue, you fail.

In fact, Americans who retired in the worst 99 months between 1926 and 1991 would have run out of money before 30 years if they’d followed the 4% rule with 1.25% in total asset fees with a 60% large stocks/40% Treasury portfolio. At 1% AUM and 75bps average fund fees, retirees in the worst 160 months would have failed before 30 years.

All this pessimism about the 4% rule isn’t merely a buzzkill to those who believe in the power of U.S. equities to overcome historically low real bond yields. It should remind advisors that risk is real and that the downside of risk is that clients must be prepared to spend less if they invest in risky assets and get unlucky.

As an example, someone who retired on Feb. 17, 2020, with an initial $1 million portfolio faced a 94% probability that they could spend $30,000 plus inflation each year to the age of 95 using projected capital market return expectations. Three weeks later, that probability had fallen to 65%.

The market recovered, but a retiree can’t bet their lifestyle on the certainty of immediate recoveries from future bear markets. The implication is that when asset returns don’t meet expectations, a retiree must be willing to spend less each year.

And not all retirees can make deep cuts in spending to maintain a comfortable probability of success. Beginning the retirement income planning process with a conversation about the lifestyle a client hopes to lead and the amount of spending flexibility they’re willing to accept is more important than hitching their lifestyle to a faith in the market’s ability to consistently deliver a return on risk when they need it most.

Matching Investments to Spending Flexibility

“How much do you need to live on?” or “How much of your monthly spending is essential?” should be the first step in a goal-based retirement planning process. For most mass-affluent retirees, this number is a relatively high percentage of their pre-retirement lifestyle — around 70%, according to my own unpublished research based on the Consumer Expenditure Survey (CEX).

Consider the following example, also based on CEX research. A worker earns $120,000 before retirement. A close look at their spending reveals that consumption is about 60% of their gross salary, or about $72,000. Fifty thousand dollars of this amount is inflexible. They have $30,000 in Social Security, leaving a $20,000 gap in basic spending needs and a $22,000 gap in more flexible spending needs.

Stocks aren’t appropriate for funding the first $20,000. This is where things get interesting. Are bonds truly the best way to fund the $20,000 gap?

Researchers like Blanchett and me are OK with funding the $20,000 using nominal dollars since $25,000 of basic expenses are funded using inflation-adjusted Social Security payments (we also don’t believe that Social Security benefits will be cut) and a portion of essential expenses is fixed (such as property taxes for retirees in many states, a mortgage, etc.) or declines in real terms with age.

Creating a smooth income from bonds can be achieved with bond funds, or with greater precision using a liability-driven investing approach that matches the duration of the cash flow with the duration of the bond investment. This approach will require significantly more capital to implement than an approach that mixes bonds with annuitization.

For example, a 65-year-old healthy man could buy a 25-year PIMCO ZROZ zero-coupon bond today for about $13,000. But he has a 41% chance of being alive at age 90. By pooling mortality risk with other retirees through, say, a deferred income annuity, he could instead pay 0.41*$13,000 = $5,330 to get an insurance company to promise a $20,000 payment at age 90 if he’s still alive. That gives him more money early in retirement to spend on fun stuff.

The remaining $22,000 of spending can be funded using a traditional portfolio of stocks and bonds. The asset allocation of this portfolio, again, should match a retiree’s willingness to trade off the likelihood of more spending from accepting investment risk with the possibility of spending less if markets don’t cooperate.

Still Think the 4% Rule Isn’t Risky?

Advisors who still prefer a portfolio-based to a goal-based approach to creating retirement income should reflect on the amount of risk they are asking their clients to accept.

An interesting thought exercise may be to ask a financial advisor or their parent firm: “Would you be willing to accept the risk of making income payments adjusted for inflation to any client who outlives their savings?”

This might motivate these advisors and firms to revisit their confidence in the safety of a 4% withdrawal rule. If the advisor assures the client that the rule is perfectly safe, she should be willing to put her own wealth on the line as a backstop.

This is a thought exercise because, as we know, no investment firm would be willing to provide this guarantee. To do so would require that they set aside a portion of profits every year and invest this money in a mix of assets that can be used in the future to protect against the risk that many clients will outlive their savings (for example, by buying bonds and interest rate or longevity swaps and put options).

It is expensive to hedge long-term portfolio and longevity risk, which is why insurance companies charge a fee to provide the protection of a guaranteed minimum lifetime income benefit on a risky portfolio. If asset managers had to provide this same lifetime income protection, they’d charge a fee, too.

A final benefit to following a goal-based retirement income approach is clarity. Retirees want to know how much they can safely spend each month. They don’t want to worry about cutting back on the most important part of their lifestyle if the stock market has a bad month, a bad year or a bad decade.