The 4% rule is dead. What should an advisor do?
Another potential problem with the 4% rule literature is that analyzes often do not include asset management fees and investment expenses. Even after the longest bull run in U.S. stock history, by Blanchett’s calculations, someone who retired with $ 1 million on Jan. 1, 2000, would only have $ 462,282 left today. if he had followed the 4% rule while paying 1% of assets under management. fees and a low 0.25% on invested assets.
In other words, a Y2K retiree would have to fund $ 61,707 plus inflation per year (up to $ 65,000 in 2022) for the next nine years with $ 462,282 in savings. Invest in TIPS and you will fail (in less than seven years). If the bull market doesn’t continue, you fail.
In fact, Americans who retired in the worst 99 months between 1926 and 1991 would have been cash-strapped for 30 years if they had followed the 4% rule with 1.25% commissions on the job. total assets with 60% big stocks / 40% treasury. wallet. At 1% assets under management and 75bp average fund fees, retirees in the Worst 160 Months would have failed before 30 years.
All this pessimism about the 4% rule isn’t just a buzzkill for those who believe in the power of US stocks to overcome historically low real bond yields. He should remind advisors that risk is real and the downside of risk is that clients should be prepared to spend less if they invest in risky assets and are unlucky.
As an example, a person who retired on February 17, 2020, with an initial portfolio of $ 1 million, had a 94% chance of being able to spend $ 30,000 plus inflation each year until the age 95 using the capital market return forecast. Three weeks later, that probability had dropped to 65%.
The market has recovered, but a retiree cannot bet their lifestyle on the certainty of an immediate recovery in future bear markets. The implication is that when asset returns fall short of expectations, a retiree must be prepared to spend less each year.
And not all retirees can dramatically cut spending to maintain a comfortable probability of success. It is more important to begin the retirement income planning process with a conversation about the lifestyle a client hopes to lead and the spending flexibility they are willing to accept than to match their lifestyle with faith in the ability of the market to offer a consistent return on risk. when they need it most.
Match investments with spending flexibility
“How much do you need to live?” Or “How much of your monthly spending is essential?” Should be the first step in a goal-oriented retirement planning process. For most affluent retirees, that number represents a relatively high percentage of their pre-retirement lifestyle – around 70%, according to my own unpublished research based on the Survey of Consumer Spending (CEX).
Consider the following example, also based on CEX search. A worker earns $ 120,000 before retirement. A close look at their spending reveals that consumption accounts for about 60% of their gross salary, or about $ 72,000. Fifty thousand dollars of that amount is inflexible. They have $ 30,000 in Social Security, which leaves a gap of $ 20,000 in basic spending needs and a gap of $ 22,000 in more flexible spending needs.
Stocks are not appropriate to fund the first $ 20,000. This is where things get interesting. Are Bonds Really the Best Way to Fund the $ 20,000 Spread?
Researchers like Blanchett and I agree to fund the $ 20,000 in nominal dollars since $ 25,000 of basic spending is funded using inflation-adjusted Social Security payments (we don’t think neither will social security benefits be cut) and some core spending is fixed (like property taxes for retirees in many states, a mortgage, etc.) or declines in real terms with age.
Creating regular income from bonds can be achieved with bond funds, or with greater precision using a liability-driven investment approach that matches the duration of the cash flow with the duration of the bond investment. This approach will require much more capital to implement than an approach that mixes bonds and annuity.
For example, a healthy 65 year old man could buy a 25 year PIMCO ZROZ zero coupon bond today for about $ 13,000. But he has a 41% chance of being alive by age 90. By pooling the risk of mortality with other retirees through, say, a deferred income annuity, he might instead pay 0.41 * $ 13,000 = $ 5,330 for a company to insurance promises a payment of $ 20,000 at age 90 if he is still alive. This gives him more money early in his retirement to spend on fun things.
The remaining $ 22,000 of expenses can be funded using a traditional portfolio of stocks and bonds. The asset allocation of this portfolio, again, should correspond to a retiree’s willingness to trade off the probability of spending more by accepting investment risk with the possibility of spending less if the markets do not cooperate.
Do you still think that the 4% rule is not risky?
Advisors who still prefer a portfolio-based approach to a goal-based approach to creating retirement income should think about the level of risk they are asking their clients to accept.
An interesting thinking exercise may be to ask a financial advisor or their parent company, “Would you be willing to accept the risk of paying inflation-adjusted income to any client who outlives their savings?” “
This could motivate those advisers and companies to rethink their confidence in the security of a 4% withdrawal rule. If the advisor assures the client that the rule is perfectly safe, they must be prepared to put their own fortune on the line as a safety net.
This is a reflection exercise because, as we know, no investment firm would be willing to provide this guarantee. To do this, they should set aside a portion of the profits each year and invest that money in a combination of assets that can be used in the future to protect against the risk that many clients outlive their savings (e.g. , buying bonds and interest rate or longevity swaps and puts).
It is expensive to cover a portfolio for the long term and longevity risk, which is why insurance companies charge a fee to provide the protection of a guaranteed minimum income for life on a risky portfolio. If asset managers were to provide that same lifetime income protection, they would also charge a fee.
A final benefit of following a goal-based retirement income approach is clarity. Retirees want to know how much they can safely spend each month. They don’t want to worry about cutting back the most important part of their lifestyle if the stock market is having a bad month, bad year, or bad decade.