Financial advisors who rely on the standard “4% Rule” as the template for their clients’ retirement income planning need to factor in a better than even chance of failure, according to a recent study.
The report on the study, entitled The 4 Percent Rule is Not Safe in a Low-Yield World, cautions advisors about basing clients’ retirement plans on historical returns that simply may not be repeated in the future. According to researchers Michael Finke, Wade Pfau and David Blanchett, their Monte Carlo-style simulations based on historical returns for a 30-year retirement using a 4% withdrawal produced a success rate approaching 94% – a threshold that, at first glance, would seem adequate.
However, that success rate drops sharply if real returns decline even slightly from historical norms, the study’s authors warn. Based on current low yields (intermediate-term real interest rates are about four percentage points less than their historical average), the report says: “If we calibrate bond returns to the January 2013 real yields offered on five-year [treasury inflation-protected securities] while maintaining the historical equit[ies] premium, the failure rate jumps to a whopping 57%.”
This is problematic because below-average returns cause retirees to consume a larger percentage of their portfolios earlier in retirement, leaving fewer assets available with which to capture any subsequent market rebounds. As a result, the report concludes: “The 4% rule cannot be treated as a safe initial withdrawal rate in today’s low interest rate environment.”
To answer critics who would dispute this conclusion on the assumption that today’s low rates are an aberration, the researchers looked at how a reversion to historical real yields would impact failure rates. They simulated scenarios in which today’s bond rates return to their historical average after either five or 10 years and found that failure rates are still high – 18% and 32%, respectively, for a balanced portfolio of 50% stocks/50% bonds – than many retirees may be willing to accept.
Even these results were really best-case scenarios, as the researchers did not account for any potential capital losses, which your clients may experience with a sudden rise in interest rates; nor did the simulations include fees and other portfolio costs.
Using inappropriate assumptions can doom retiree clients to outlive their savings or forgo a lifestyle they could otherwise afford, argues actuary Joe Tomlinson in another recent paper, entitled Predicting Asset Class Returns: Recommendations for Financial Planners.
However, as no one knows what the future will bring, it pays to be cautious and flexible, Tomlinson’s paper says. To do that, you will have to stretch your thinking beyond the application of mechanical rules.
A plan based on historical average returns might look just fine; but with only slightly modified assumptions, the more appropriate recommendation could just as easily be to keep working and/or dramatically cut expenses.
Tomlinson’s message to advisors: give careful thought to the variables that go into your assumptions and appreciate the importance of putting a lot of thought into this aspect of the planning process.IE
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