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Recent research that Dr. Wade Pfau and I have conducted finds that investors retiring as of January 1, 2015, who pursue a traditional 4% withdrawal rate from their savings to fund retirement have a more than 50% chance of outliving their savings. Last month in Financial Advisor, we detailed our research on safe withdrawal rates for retirees and the findings that could disrupt the current idea about what savings can safely be generated during a person’s retirement. Taking into account the person’s investment decisions, the real safe withdrawal rate is much closer to 2% and could be lower.

But we also believe that understanding investor behavior is key to understanding the withdrawal figure.

How many of your clients fear outliving their money, and how many of them fear dying? In a recent national survey of more than 1,100 retirees and pre-retirees between the ages of 50 and 65, the fear is resounding: More than 70% of these respondents fear outliving their assets, while only 30% fear dying. Simply stated—investors had tremendous anxiety about the prospect of outliving their funds.

It’s important to show your clients that the fears of dying and outliving assets are essentially in conflict, and you must address these concerns as you frame the situation for them and show them how their spending and investing patterns will allay their fears and affect outcomes.

Another critical psychological consideration is where your clients are today, after two major market corrections in the past 15 years, the largest housing market collapse in over 75 years and the deepest recession since the Great Depression. In this type of environment, are they seeking more risk or less risk?

We found—again, overwhelmingly—that investors in this age group are considerably more conservative about investment risk than they were 10 years ago.

Our firm, WealthVest, became fascinated with the literature on sustainable withdrawal rates in late 2014. The U.S. 10-year Treasury bond yield slipped below 2%. Before the current turmoil, U.S. interest rates had dropped below 2% only one time in the past 145 years, in 1941. Since 2013, worldwide interest rates have been at nearly unprecedented lows. The German bund yield for a 10-year maturity fell below 0.5%.

Conversely, the U.S. equity market in late 2014 was at record highs (expressed in terms of the Shiller CAPE PE 10 ratio)—levels seen only in 1929, from 1998 to 2000 and from 2007 to 2008.

Of course, someone retiring when valuations are this high would be cursed with a high likelihood of negative returns, plus 10-year average annual returns far below long-term market averages. Likewise, someone would be fortunate—and, therefore, able to justify very high safe withdrawal rates—when bonds had high yields and stock PE ratios were low (suggesting there would be long-term above-average appreciation).

This is the basis of our WealthVest/Pfau/Shiller dynamic withdrawal rule (named in part for Dr. Pfau, a professor of retirement income at the American College, and Robert Shiller, Nobel laureate and professor of economics at Yale University). The rule’s most dramatic finding is that there is no universal safe withdrawal rule for retirees.

Such a rule would depend on when a person retires. And today is a particularly unfortunate time to become a new retiree. The sustainable withdrawal rates that we forecast is 1.70% for a 60/40 stock-bond portfolio for 30 years and 1.26% for a 60/40 stock-bond portfolio for 40 years. But those results are time-dependent. Next year, a different Shiller PE 10 level and a different U.S.

10-year Treasury bond yield will result in different rates.

Our research uses the U.S. 10-year bond yield as of January 1, 2015, and the Shiller PE 10 recorded on the same day. Once we incorporate the appropriate management fees and average advisor fees, the 10-year trailing after-fee returns for stocks and bonds during these periods are not only far below historic averages, but the equity returns are negative. This has a doubly negative impact on today’s retirees—they are losing money on their investment portfolios and they are reducing the principal amounts for their retirement needs. That means their portfolios would be much reduced if and when the market recovers.


We have never seen a time like today, when a standard 60/40 stock-bond asset allocation could see returns below historic averages on both sides of the investment pie and when they even threaten negative total returns.

Bill Bengen deserves much of the credit for starting the debate on what constitutes a safe withdrawal rate from a retirement investment portfolio—and for coming up with the 4% figure. Since he was dealing with the broad marketplace, he did not include mutual fund management fees or investment advisor fees, which must be added by a financial advisor doing serious planning today. Furthermore, he was working from a more generalized set of market return forecasts.

Our model is focused on the very specific probabilities of safe withdrawal rates at today’s stock and bond market levels. And our analysis strongly suggests that excluding fees and not solving for the specific sequence-of-return risk—the effect of very poor returns or losses early in the life of the portfolio—places retirees at an unreasonably high risk of running out of money, especially given the shape of today’s asset prices. That is why, using the January 1, 2015, numbers, we find there’s a 50% chance that the retiree will run out of money before he or she dies if the 4% rule is employed.

Bengen is not alone in attempting to find a direct and simple way to inform advisors and retirees. Wade Pfau has written extensively on these issues. So have Gordon Pye, Michael Kitces, William Sharpe, Jason Scott, Laurence Kotlikoff and others, often focusing on a consumption-smoothing approach whereby the retiree adjusts spending as assets either appreciate or depreciate.

Such approaches are very problematic. For one thing, many middle-income retirees are already balancing very low savings against their retirement needs, so they need something more concrete.

Adjusting expenditures to market ups and downs has limited real-life possibilities. If a couple spends too freely in the early years and markets plummet, they may be destitute or, at a minimum, desperate—whereas a more cautious plan would leave them more secure.



Perhaps more to the point, it seems unlikely that most financial advisors would remain that involved in the day-to-day lifestyle decisions of a retiree whose portfolio is unwinding. The strategy is not realistic.

We rarely know our own longevity, so we are balancing decision-making against two foundational unknowns: our individual life expectancy and the future returns of the stock and bond markets. By adjusting expenditures according to asset returns, we are attempting to “self-insure” our individual longevity risk—insuring against both the vagaries of the market and the possibility of becoming centenarians. Marginally, this is possible, but talk to enough children of retirees and you’ll soon hear stories of anguish and dashed hopes.

Consumers buy life insurance (even though there’s only a slim chance they’ll unexpectedly die) because there is a large downside for the remaining family members if the person dying is also an income earner. We pool our risks with an insurance company, and this allows us to pay low premiums and receive large death benefits for our families. Our alternative is to have savings in advance early in life for our children’s education, home mortgage payouts and spousal retirements.

The WealthVest/Pfau/Shiller rule and all of the other competing strategies are attempts to manage longevity for individuals. This is why the resulting payouts are so low. Each individual or couple is self-insuring for a very broad set of potential outcomes, including long life and negative markets.

The WealthVest/Pfau/Shiller dynamic safe withdrawal rates are much lower (“safe” defined as a probability of failing less than 5% of the time, taking into account fees and all current market risk and the January 1 market pricing). These rates are 1.70%, for those who assume they will have a 30-year life expectancy (their retirement beginning at 63 and continuing to age 93), and 1.26% for those with a life expectancy of up to 40 years.

It is important to remember that these sustainable rates anticipate rising cash flows to match future inflation.

This is why Pfau and others incorporate annuities into their analysis of sustainable withdrawal rates. Annuities (single-premium immediate annuities, fixed index annuities and fixed annuities) lack stock and bond market risk while they pool longevity risk. Fixed index annuities (with rising income provisions designed to help retirees’ future income increase with inflation) generally offer payout rates of 3.5% to 4% for 65-year-olds. So they create approximately twice the retirement income cash flow of our 60/40 stock/bond portfolio.

The key is the same risk-pooling dynamic that insurers use in life insurance pricing, only it’s applied to longevity. Annuity payouts are able to provide retirees far greater lifetime income benefits because the insurance company is pooling the longevity risk and balancing long life spans against shorter life spans.
There is no simple answer to this complex question. Retirees seek certainty and simplicity. Generally, systems with great variability cannot provide those things. And factors like individual longevity and market return are inevitably complex.

However, if investors in 2015 are attempting to self-insure their longevity risk without annuities, they need to be prepared to receive far less income than has historically been recommended. 

 

Wade Dokken is the founder of WealthVest Marketing. To see the white paper on which this article was based, Rethinking Retirement - Timing Risk click here