Rethinking the 4% withdrawal rule

What makes the task so difficult is that many of the critical factors in the decision are largely unpredictable, says Matthew Ardrey, manager of financial planning with T.E. Financial Consultants Ltd. in Toronto.

Advisors really have little control, for instance, over portfolio returns, the rate of inflation or how long clients actually have to plan for, he says. “But you can certainly help them budget realistically,” he adds. “As they approach retirement and their ability to earn income becomes more limited, understanding how much they spend, and where they spend it, is crucial.”

One popular rule of thumb assumes that retirees with balanced portfolios simply can spend up to 4% of their savings annually, adjusted for inflation, without too much trouble. The problem with a strict application of this rule is it has little to do with the real world.

“Conceptually, [this strategy] makes sense. But only as a starting point – and then only for some people,” says financial planner Derek Moran, president of Smarter Financial Planning Ltd. in Kelowna, B.C. “For most clients, I think it’s too simple; too linear.”

The more money clients have, the higher the percentage they can use, he suggests. Affluent clients, because they have access to lower management fees and may not need all of their capital during their lives, can accept a higher degree of volatility in both returns and income, he adds.

A better starting point

The trouble with the 4% rule is that it was developed at a time when interest rates were much higher, says David Blanchett, head of retirement research, investment management, with Chicago-based Morningstar Inc.

“The original research had about a 10% chance of failure, which is pretty good,” he says. “But using yields today, that failure rate is closer to 50% – and that’s much too high.” As a result, he feels that a 3% withdrawal rate might be a better starting point for retirees today.

The 4% rule also doesn’t take into account market volatility and how important investment results are in the early years of retirement – something known as the “sequence of returns.”

Portfolio losses that occur early in retirement have a much greater impact than losses suffered later on. And the damage increases exponentially when clients are draining their portfolios by making regular withdrawals simultaneously.

As well, people are living longer, meaning their assets need to last longer, too. The 4% rule implies a standard retirement period of 25 years or so, Moran points out: “But as the period increases, because of the capital erosion, that number simply has to change.”

Using median life expectancy – the age at which half the cohort is expected to survive – you’re talking to only some of your clients, he adds. At the very least, tack on about five years to the longest life expectancy, Moran suggests.

To address these problems, some advisors opt for more of an “endowment” approach, in which the retirement “paycheque” is limited to 4% of the assets remaining at the beginning of each year – in other words, no annual raises, regardless of inflation.

Using a hybrid approach

The result, which is contingent upon market performance, is a more volatile year-to-year income stream – which can be a challenge, especially if the majority of a client’s retirement costs are fixed.

For higher net-worth clients who wish to leave a bequest, however, this strategy can be an attractive approach, as it essentially prevents the portfolio from ever being exhausted.

“That [strategy] seems a bit rigid,” Ardrey suggests. “If it’s to be successful, a spending strategy in retirement needs to be flexible. The key is helping clients adjust to changing lifestyles and a shifting asset base.”

Although telling clients that they may have to forgo some things if they want their funds to last can be painful, you need to embrace the responsibility, Ardrey believes: “That’s why [clients] come to us in the first place.”

Colleen Jaconetti, senior analyst with Malvern, Penn.-based the Vanguard Group Inc., suggests using a hybrid approach: calculate spending by taking a set percentage of the prior yearend balance, but build in limits – say, a 5% ceiling and a 2.5% floor.

If the newly calculated spending amount exceeds the ceiling, your client should throttle back to that threshold; if the calculated spending is below the floor, spending can be brought up to the floor amount. This hybrid strategy allows clients to benefit from good markets by increasing spending, while in less favourable periods, their spending is held back, thereby supporting the portfolio’s longevity, she says.

But whether the spending figure is 4% or some other number, depending upon a predetermined withdrawal formula is not the solution, maintains Ken Steiner, a pension actuary now retired from Virginia-based Watson Wyatt Worldwide Inc. For one, using a formula increases the risk of spending far less than would have been feasible.

“Rather than rely on a set [percentage] and forget strategy that’s supposed to be safe with respect to the risk of outliving one’s assets,” he says, “you need to crunch your numbers periodically based on your situation.”

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