Retirement Watch

Planning for the post-4% generation

Bengen's iconic retirement spending rate must be flexible, and only the beginning of the discussion

Jul 26, 2015 @ 12:01 am

By Jonathan Rugg

The 4% rule was created by a financial planner named Bill Bengen more than 20 years ago. His goal was to come up with a sustainable rate of spending that a retiree could safely withdraw from their portfolio on an annual basis. His research found that if a portfolio was invested 50% in large-cap stocks and 50% in intermediate-term bonds over a 30-year period, a retiree should be able to withdraw 4% (adjusted for inflation) per year without outliving his or her assets.

Later studies by Wade Pfau, a professor of retirement income at The American College, found that the estimated failure rate of this approach was around 6%, meaning that 94% of the projected outcomes resulted in a safe retirement. However, the largest drivers of projected outcomes are the return assumptions, as well as the sequence of returns.

In today's low-rate and expected-low-return environment, this rule may become more relevant than ever.

RETURN ASSUMPTIONS

A recent paper by Mr. Pfau and fellow retirement researchers Michael Finke of Texas Tech University and David Blanchett of Morningstar Investment Management expands on this concept. If we assume that the current market prices of bonds are the best estimate of future bond yields and that long-run stock returns either have a constant risk premium over bonds or follow the formula of GDP plus inflation, plus productivity gains, plus dividends, then projected failure rates go up dramatically. The paper used bond rates from January 2013 with a constant equity risk premium, and projected failure rates increased from 6% to 57%. Even if rates were to increase and mean-revert over a five- or 10-year period, they projected failure rates to be in the realm of 18% to 32%.

In a prior paper, Mr. Pfau estimated that cumulative portfolio returns and inflation in the first 10 years of retirement account for approximately 80% of final retirement outcomes. A major market correction or even a low-return environment during this period can have significant consequences on a client's ability to compound returns over the next 20 years. Therefore, the asset allocation also plays an integral role. Generating decent relative returns is still important, but equally as important, in our opinion, is risk management. This can be done by structuring a portfolio to minimize drawdowns, since a large drawdown in the early years can have lasting effects on long-run success or failure.

CAUTIOUS APPROACH

Most retirees are walking a tightrope, which doesn't necessarily mean they are going to fall off. It just points to the fact that looking at risk is becoming more and more important, and adopting a cautious approach with continuous monitoring should become the norm. Bond yields are incredibly low and most forecasters' 10-year outlooks for stock returns are not anywhere near long-term historical averages. For someone approaching retirement today, that means those first 10 crucial years of retirement are facing head winds in the form of lower projected returns and a suboptimal return sequence. When analyzed on current return assumptions, Mr. Pfau finds that a spending rate closer to 2.5% is more realistic.

PLAN ADAPTATIONS

Many planners view a financial plan as a living, breathing document that adapts to changes in a client's personal circumstances or risk preferences. Why should the 4% rule be any different? Four percent seems like a limiting figure and can create a sense of paranoia when retirees are trying to enjoy the time of life they've worked so hard to enjoy. Instead of constantly worrying, retirees should have a more fluid and realistic understanding of their ability to spend during retirement without trying to stick to an arbitrary hard and fast rule.

While we believe the 4% rule is a good starting point for a discussion about the planning process, it may no longer be adequate and requires educating clients about today's expected realities. Each client's situation is different. Perhaps some clients have other assets or sources of income — such as Social Security or a pension — to offset a lower drawdown rate. But in the end, it comes back to time-tested principles such as spending less, saving more and planning for the worst. If markets turn around and significant money remains after 30 years, it could go toward inheritance or charitable donations.

We advocate being flexible and having an evolving strategy with clients, but most importantly, having these conversations with clients from the outset. Managing expectations in this environment is critical.

Jonathan Rugg is vice president at investment advisory firm Charlesworth and Rugg Inc.

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