What’s a safe withdrawal rate in retirement? For years, the rule-of-thumb answer has been 4 percent, adjusted annually for inflation. But a growing number of financial planning experts are re-thinking that number.
“Advisors are getting the question a lot these days from clients,” says Maria Bruno, a senior investment analyst in Vanguard’s Investment Counseling and Research group. “Until a decade ago, a balanced portfolio could provide four percent purely from returns, and some retirees were still accumulating funds. Now, with interest rates so low, the question is whether retirees can still spend that amount, and how they can build a portfolio to sustain it.”
This is an area where clients will need hand-holding and education. In a 2011 Fidelity Investments survey, most pre-retirees (over age 55) couldn’t identify any “rule of thumb” for an appropriate annual percentage to draw down in retirement. Asked to pick a number, respondents were all over the map; their mean number was 8.4 percent, and answers ranged from 1 percent to 25 percent.
The Four Percent Rule stems from landmark financial planning research in the 1990s -- William Bengen’s 1994 article in the Journal of Financial Planning on sustainable rates, and a subsequent influential study by three researchers at Trinity University. The aim was to identify a sustainable withdrawal rate that allows retirees to meet their spending goals while not running out of assets during their lifetimes.
Wade Pfau is in the forefront of retirement researchers who argues that it’s time to reconsider the Four Percent Rule. Writing in the February issue of the Journal of FInancial Planning, Pfau argues that the 4 percent framework fails to take into account the full balance sheet of retirees income-generating assets, such as Social Security, defined benefit pensions or annuities. And, it also ignores the possible enjoyment of spending more early in retirement and may overestimate the severity of the problem of “failure” in the later years of retirement in light of guaranteed income sources.
Pfau, who is joining the American College this spring as a professor of retirement income in the school’s new Ph.D. program on financial services and retirement planning, makes a case in the article for a portfolio of stocks and bonds, inflation-adjusted and fixed single-premium annuities and variable annuities with guaranteed living benefit riders.
“It’s important to decide what percentage of spending goals you can meet, and how much you can keep as reserves,” Pfau told me in an interview. “Then, you look at all the possible combinations of stocks, bonds, SPIAs and variable annuities, to see which do the best job of meeting those goals.”
“Just using a systematic withdrawal approach is risky in a market where bond yields and dividends are so low, and markets overvalued,” he says.
Income annuities will be a hard sell for many planners. The oft-heard objections are the loss of liquidity associated with the big upfront purchase commitment, and ultra-low interest rates, which make annuities very expensive right now. “An income annuity can be helpful for some retirees when you’re looking for additional levels of guarantee beyond Social Security,” says Bruno. “But the tradeoff is liquidity. We worry about locking up assets that you might need later in life to meet an unexpected expense.”
New research by Morningstar concludes that an initial 4 percent withdrawal rate -- in today’s low interest rate environment -- leads to a 50 percent probability of success over a 30-year period. For a portfolio containing 40 percent equities, boosting the odds of success to 90 percent requires either reducing the initial withdrawal rate to 2.8 percent, or 43 percent higher savings.
Vanguard thinks 4 percent remains a useful starting point for retirees who maintain a balanced portfolio. But the sustainability of that withdrawal rate depends on how balanced portfolios will perform in the decades ahead. For most years from 1926 to 2011, yields from balanced 50/50 stock/bond portfolios exceeded 4 percent, Vanguard research found. But that figure has been dropping steadily, and was just 2.8 percent in 2011.
Vanguard still expects balanced portfolios to produce a real return of around 4 percent over the coming decade, perhaps with a slightly higher (60 percent) equity allocation. “You could argue that will sustain the Four Percent Rule,” Bruno says. “It’s a gauge, but those are median figures. So there’s a 50 percent chance of falling lower.”
Advisers also need to consider lifestyle and health considerations, Bruno says. “Planning for a 30- to 35-year period is a good starting point, but there are dangers on both ends, because longevity risk is a two-sided coin. We usually focus on the risk of outliving money, but the flip side is under-spending - someone who wanted to enjoy the early years of retirement and was too frugal.”
Mark Miller is a journalist and author who writes about trends in retirement and aging. He is a columnist for Reuters and also contributes to Morningstar and the AARP Magazine. Mark is the author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living(John Wiley & Sons, 2010). He edits RetirementRevised.com. Twitter: @retirerevised