Web exclusive: Rethinking the 4% rule

“I have issues with that rule,” Milevsky says. “It’s a problematic rule, and there are many challenges in implementing it.”

Many advisors agree that idea of a general guide to determine the longevity of a client’s portfolio and whether clients are saving enough for retirement has value. But the 4% rule — devised 20 years ago by American advisor William Bengen — is no longer valid because of changes in the economic environment. Specifically, the rule states that a client would withdraw 4% of his or her portfolio during the first year of retirement. That amount is then adjusted for inflation for subsequent years, and earnings and interest would cover most of the withdrawals.

Milevsky points out that the 4% rule was developed at a time when interest rates were much higher, stock markets were more stable and life expectancies were shorter. At the very least, he says, the rule should be modified to take into account clients’ other investments and assets.

“The rule of thumb is probably not a bad idea,” says Gaétan Ruest, assistant vice president, product and corporate research with Investors Group Inc. in Winnipeg. But it’s more as a guide than as a hard and fast rule, he says.

“It’s fine to use for looking at how much assets you’re looking to target for your retirement,” Ruest says, “but it’s not really a good rule to use for your day-to-day financial planning. A retiree starting to draw assets shouldn’t be using a rule of thumb; they should be looking at their own particular financial situation.”

Concerns about how long the money will last are understandable, as life expectancy in Canada keeps going up. At age 65, life expectancy for men is 84; it’s 87 for women. And many more will live well beyond these estimates. What happens to people who live into their 90s?

“I do a lot of speaking to financial advisors,” Milevsky says. “One of the things that I find resonates with advisors is the idea of portfolio longevity.”

The longevity of a portfolio will vary depending on the client’s individual situation, Milevsky says, but there are common factors that can help advisors determine how funds will hold up.

“When someone asks me, ‘How much can I afford to withdraw?’,” Milevsky says, “I want to know whether they have a good pension to fall back on if things go poorly [with their portfolio].”

If, for example, the client has a good defined-benefit (DB) pension, Milevsky says, he or she might be able to withdraw 6% per year.

“If worse comes to worst,” Milevsky says, “they can fall back on the pension. On the other hand, if they do not have a good pension to fall back on, they might be able to withdraw only 2%.”

Younger clients are less likely to have generous DB pensions, but many people over 50 still do — teachers and government workers for example. So, we have to be careful not to “brush everyone in the same colour,” Milevsky says, when it comes to the amount they should withdraw annually from their savings.

The erosion of savings that retirees need for yearly withdrawals is a bigger problem for clients who are invested in fixed-income products, which have lower risk but also lower returns, Ruest says. “It can really erode the value of your portfolio,” he says. “The long-term returns on government bonds are less than 2%.”

Some advisors have suggested that retirees should consider a lower withdrawal percentage — for example 3% — which means living on less, says Jonathan Waye, senior wealth advisor with ScotiaMcLeod Inc. in Halifax. And omitting the inflation adjustment on the withdrawals is not the answer.

“If inflation is 2.5%,” Waye says, “in 30 years, [the purchasing power of the yearly withdrawal] is going to be cut in half.”

Every retiree is different, and each client needs to balance two factors: the need for principal to remain secure; and the need to generate better returns, which means assuming higher risk through investments in equities. Those who don’t have enough to retire on face difficult and often unpleasant choices, says Waye: “Die early, eat cat food or assume some risk.”

Like virtually all advisors, Waye agrees that the key is to know your clients, their needs and their risk tolerance.

Ted Rechtshaffen, president of TriDelta Investment Counsel in Toronto, recognizes the challenge of maintaining a stable withdrawal rate at times when investment portfolios are volatile.

“If I have $1 million,” he says, “the rule says that I can take out $40,000 a year and preserve my capital. But if I’m 70 years old, why wouldn’t I take down that capital during my lifetime. That’s what it went in there for.”

There are many factors that go into determining the percentage, Rechtshaffen says, such as the client’s age, health and estate goals. Another important consideration is whether the client wants to give money to their heirs while alive.

Rechtshaffen’s advice to clients: “If you’re 63 and you retire this year, enjoy life [and draw out enough to do so], because the odds are that when you’re 87 you won’t be spending as much. You’re going to draw out more money in your first 10 years of retirement.”

Milevsky recommends clients ask themselves: How long will my money last? He recommends advisors determine the longevity of clients’ portfolio is under various scenarios, including different withdrawal rates.

This web-exclusive article is part of an Investment Executive special feature, The challenges of retirement.