Until recently, it has been conventional wisdom that retirees can safely withdraw 4% of their retirement funds every year and not outlive their financial capital. Now, many financial advisors say, the 4% rule doesn’t meet the realities of 2012 and beyond.
With major events such as the bursting of the dot-com bubble and the financial crisis of 2008 still very present in people’s minds, advisors and clients alike will have to come to grips with the realization that the 4% rule, while providing some discipline in savings, is no longer a valid rule of thumb.
“We have a generation of advisors and a generation of clients who have mastered the accumulation part of money very well,” says Gordon Gibson, senior vice president and managing director with National Bank Financial Ltd. in Montreal. “We are just entering the front end of the boomers who are retirement age, so people now have to find their way. We don’t pretend that we know all the secrets, and it’s something our advisors and clients have to wrap their minds around fairly quickly because it’s been such a big shift. However, we can’t afford not to get it right.”
The 4% rule was first coined in the 1990s, following a study that had looked at the previous 30 years of the U.S. economy and markets and concluded that retirees could withdraw 4% of their portfolios, adjusted for inflation, each year and still have enough money to last for at least 30 years.
“I think that going by just a percentage is a little bit short-sighted,” says Monique Madan, a fee-for-service financial planner with Monique Madan Consulting Inc. in Toronto.
A set percentage can provide some discipline to help ensure clients stay within certain limits. But, Madan says, a more practical solution to the 4% rule is for clients to calculate the things they must pay for – bills such as property taxes, utilities and basic food. These should be paid out of income clients know they can count on, such as Canada Pension Plan, old-age security, employer-sponsored pension plans and other guaranteed income such as annuities.
All discretionary spending should then come from a portfolio of diversified investments, with clients adapting themselves to lower markets by tightening their discretionary spending. “You are going to have some of your retirement income prone to the fluctuations of the markets,” Madan says. “I would cover non-essentials with investment income.”
(Income from registered retirement income funds is not taken into account in this scenario, Madan adds, because RRIFs are subject to minimum withdrawal rates.)
Gibson takes a similar view, saying it’s virtually impossible to come up with a set figure for safe withdrawal every year.
“I don’t think that models real life,” says Gibson. “What happens in real life is that you’re withdrawing and, all of a sudden, markets take a big dive and you will have to try to compress your lifestyle somewhat and cut back on what you withdraw to the extent that you can.”
Gibson subscribes to a theory similar to Madan’s, dividing the essentials and discretionary spending into separate “buckets.”
A variation of this theory is to separate the money into time frames, says Gibson: “So, I will have a bucket in which I’m going to have enough capital to cover me for the next three to four years in the absolutely most secure way I can. Then, I will have a longer-term bucket, with a 60% bonds/40% equities mix because I know that even if the market falls out of bed, I have four or five years before I have to start drawing on that, and I won’t be stuck selling those [investments] at the bottom of the market.”
Gibson says one of the problems with the 4% rule is that it doesn’t take into account “sequence risk.” Citing the theory penned by Moshe Milevsky, a finance professor at the Schulich School of Business at York University in Toronto, Gibson offers the example of two identical portfolios with the same asset mix. If the market tumbles at the beginning of a 30-year sequence, the client will run out of money faster than if the market drop had been spread out equally throughout the 30 years or loaded at the end of the period.
“So, if you had the misfortune to retire at the end of 2007 and you had a 50/50 portfolio and the equities markets went down by 50%,” explains Gibson, “you may withdraw 4% in your first year of retirement. But then, all of a sudden, you’re down by 29%. You’ve lost 25% of your capital, plus the 4% you have withdrawn. So, that’s what has gotten everyone thinking about the 4%.”
Clients tend to be too passionate about their investments, Madan says. They romanticize previous successes they might have had while failing to remember the bad times. Clients also have a tendency to overspend when times are good, without enough care for the future, she adds: “There are a lot of people living like rock stars, and rock stars go bankrupt.” IE
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