Most retirees like things to be simple, and financial advisers have accommodated them. So for more than two decades, they have passed along the basic rule of thumb that suggested that retirees withdrew 4 percent of their investment portfolio annually, and adjust the amount for inflation. If they did so, they were told, the odds were heavily stacked in their favor of not running out of money for 30 years.
But times are changing. A growing consensus of financial planning pros say this strategy no longer works. Instead, they say it make much more sense to withdraw only about 3 percent a year if, like most people, you stick with traditional stock and bond investments.
The biggest culprit behind the change is the belief that financial markets are poised to behave differently than they have in the past, and in fact have already begun doing so. Ultra-low interest rates for years is one example, and the widespread prediction that future stock market gains will be muted is another.
When the “four percent rule” was created in October1994 by former financial adviser William Bengen, average annual stock market returns were 8.6 percent and bond returns 2.6 percent. After a prolonged descent, bond rates are once again near that level but very few financial pros see the stock market continuing to produce average annual gains of roughly 10 percent, as it did for decades. Stocks are too pricey as it is, they say, and the global economy and profits stubbornly weak.
Goldman Sachs, for example, recently forecast mid-single-digit annual returns for the next five to seven years (most from dividends) and bond returns of no more than two percent. Under this scenario, four percent annual withdrawal rates would exhaust retirement savings far too quickly.
Donald Trump’s Policies
The U.S. economy is faring better than most and may strengthen this year under new policies that President-elect Donald Trump intends to implement, but few economists expect economic growth to return to the pace we commonly saw before the advent of the Great Recession in 2008. “The U.S. economy is like a tortoise,” says Scott Sadar, an executive at Somerset Wealth Strategies, a Portland, Ore., wealth management firm. “It’s going somewhere, but certainly not quickly.”
Skepticism about the viability of the four percent rule has been mounting for years.
Research published in 2013 by Michael Finke of Texas Tech University, Wade Pfau of The American College and Morningstar Inc. examined historical interest rate averages and found that a retiree drawing down savings for a 30-year retirement using the four percent rule had only a six percent change of running out. of money. But using interest rate levels from January 2013, when the research was published, the authors found that retirees’ savings would grow so slowly that the chance of failure soared to 57 percent. (The benchmark U.S. 10-year Treasury note at the time was about 1.9 percent, lower than today but roughly the same level it has been in recent years.)
Making the most of your retirement nest egg is no small matter. More than 46 million Americans are 65 or older, representing nearly 15 percent of the U.S. population, according to Aging Statistics. And the Social Security Administration says that roughly 11,000 Americans, on average, will turn 65 every day for the next 15 years.
The Four Percent Rule Was Never Perfect
To be sure, the four percent rule was always far from perfect. Some financial advisers used it as a guidepost for clients solely to get them started in their first year of taking withdrawals. In addition, it has always been true that most retirees don’t withdraw and spend their money in a linear fashion. Some people may want to spend more early in retirement and others may be willing to take special steps to leave more money to their children. Also true is that some people have never followed the core principal upon which the four percent rule rests – that it’s foolish to sell retirement assets in a bear market.
But at least the rule served as a guidepost – some advice was better than no advice – and now many financial planners say it needs to be changed. Lower investment returns, always disappointing, may lead to the biggest problem of all – the disappearance of a person’s entire investment portfolio.in the waning years of retirement. That’s a particularly valid concern today because retirees are living longer. According to the Society of Actuaries, a 65-year-old man is expected live another 21 to 22 years on average and a 65-year-old woman another 23 to 24 years. And many 65-year-olds will live much longer than this, and in an era in which relatively few people have pensions anymore.
Life expectancy in recent years has increased about three years. This may not seem dramatic, but it can have a big impact on someone’s retirement security. Say, for example, that somebody has $50,000 in annual expenses. For someone who lives 18 years, that totals $900,000. If he instead lives 21 years, this figure rises to $1.05 million. These figures are even higher, of course, when you factor in inflation.
One seemingly simple solution might be to plan on a portfolio supporting you for only 20 years. That might, in fact, even allow you to increase, not decrease, your annual withdrawal rate, say to five percent or even six percent. The problem with this approach is that unless you’re positive you will die within the next 20 years – say, for example, you have a life-shortening disease – it is too risky.
Annuities Are One Solution
A more realistic solution might be to invest in one or more annuities to pay a hefty portion of your monthly bills in retirement. Many offer lifetime income payouts paying as much as 5 percent annually, starting at age 65, and immediate and deferred income annuities usually pay more. Retirees might also consider putting much of the rest of their retirement funds in non-market correlated investments such as commodities, managed futures contracts, federal government-sanctioned Business Development Corporations and Real Estate Investment Trusts, all purchased through qualified financial advisers.
“Pre-retirees and retirees can buy these contracts and receive steady income as long as they live, without worrying about liquidating their retirement assets monthly,” Sadar says. “This has always made sense, but it makes even more sense today because prospects for conventional investments have deteriorated.”
At absolute minimum, pre-retirees and retirees should be mindful of so-called sequence of return risk – the notion that how well your investments ultimately fare depends heavily depends on the trajectory of the markets in the early years of retirement. If the stock market nosedives in the initial years, while you’re also regularly withdrawing retirement funds, you might eventually exhaust your nest egg because you no longer have the principal required to recoup losses. The way to avoid this is to withdraw materially less money that once planned in the first five years of retirement.
On an upbeat note, interestingly, many retirees have historically accumulated much more money than expected toward the end of life by following the four percent rule — courtesy of relatively good stock market performance. In their case, this meant that adherence to a rule undermined their retirement lifestyle. In hindsight, they could have spent more and lived larger.
While an unfortunate outcome, it certainly beats the opposite – and all too-real — outcome of exhausting your nest egg while still alive. The upshot is that pre-retirees and retirees should seriously weigh the suggestions of discarding the four percent rule. And they should also take steps to minimize sequence of return risk.
For those retirees who think they may now have to trim their withdrawal rate, a discussion with a financial advisor makes a lot of sense. Speak to an advisor at Annuity FYI by calling 888-451-3438 or sending us an email here.
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