Wednesday, June 12, 2013

The 4% Safe Withdrawal Rate Misconception

There has been much discussion lately on the reliability of the suggested 4% withdrawal rate.  It has long been held that withdrawing 4% from your retirement assets per year was a “safe” withdrawal rate.  “Safe” means if the retiree starts taking 4% out of their portfolio when they retire and increase that amount by inflation each year then that income will last them the rest of their life.  4% became a rule-of-thumb even though it actually has strong academic backing.  Recently, however, online articles and general advisor talk have suggested that given the current low rate environment or due to big market collapses like 2008 and 2009 a 4% withdrawal rate is no longer feasible.

A recent WSJ article suggested we “Say Goodbye to the 4% Rule.”  They even gave an example suggesting had you retired on January 1, 2000 and used the 4% rule your portfolio value would have fallen a third by 2010.  (We call foul on this figure as our data shows a well diversified 60/40 portfolio would leave you with a third MORE in nominal value by 2010). The CFA Institute even conducted a poll of professional investors and found that 57% thought the 4% rule was no longer sustainable in the current low rate environment. (Click Here)

The debate may have merit, but the most troubling thing I see with this new trend in thinking is that advisors and “professional investors” actually have no idea where the 4% rule actually came from.  The 4% rule is already based on worst case scenarios, NOT average market returns.  So if your investment professional suggests that in this new low rate environment a 4% rule no longer applies then I would be very wary of their advice because they lack the very basic understanding of where the 4% rule came from.  Michael Kitces, a popular financial writer and head of research at Pinnacle Advisory Group, has written some very good articles on the subject and a video presentation of his research can be found here.  I will not regurgitate everything he already explained very clearly, so I highly encourage you to check the links out.  He found that in the last 140 years there were only four 30-year time periods where the safe withdrawal rate was between 4 and 4.5% (all other periods where higher with an average safe withdrawal rate of 6.5%).

Kitces also addresses the issue of actual spending needs changing in retirement.  This I believe should be the biggest take away from the 4% rule debate.  The real focus should be on working with your advisor to find a dollar value in real terms that will provide a comfortable retirement. Safe withdrawal rates should merely act as the guardrails to guide expectations.  The question should not be “How much can I safely withdraw?” but instead “How much do I need to live comfortably in retirement and is that amount sustainable given my portfolio value?”  Once this question is addressed the client and advisor can work through many variables together (one of them being a what a “safe” withdrawal rate is) to give the client the best chance of attaining his or her retirement goals.

Creating a plan based on desired retirement income and not a withdrawal rate also encourages clients to “take the pedal off the wheel” if they are several years out from retirement and they are substantially ahead of their plan.  Planning based on a safe withdrawal rate can often have the unintended consequence of a client reaching for return late in life to “lock in” the safe withdrawal rate of a larger portfolio.  This can potentially end very badly for them.

In Summary:

1) A 4% safe withdrawal rate is based on worst case scenarios NOT average returns.  The safe withdrawal rate was actually significantly higher in most 30 year time periods.

2) Safe withdrawal rates should really be the “guardrails” of your investment plan.  It is much more important to determine a real income value that will give you a comfortable retirement and then working within your personal circumstances to maximize the probability of reaching that goal.

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