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Concern about outliving one’s wealth is a major fear in the minds of Americans over 50 years old. Most retirees cannot re-enter the labor force under the same terms that they exited it, so their assets must constitute their lifetime income stream. And if they suffer poor returns early in their retirement, it means that their sustainable withdrawal rate will likely be sharply lower. Their standard of living will be more vulnerable to market volatility, and extra caution is warranted.

New research shows that Americans retiring in 2015 need to be far more conservative in their withdrawal rates during retirement. The historic 4% annual withdrawal rate is over two times the level that Americans can safely withdraw without expecting to outlive their assets. The real safe withdrawal rate, accounting for fees and today’s stock and bond market levels, is under 2% per year.

Because retirement income planning is still a relatively new field, views differ on sustainable withdrawal rates in retirement. William Bengen initiated the formal study in this area of “safe withdrawal rates” with an article he published in the Journal of Financial Planning in 1994. His research was a response to previous simplistic approaches that plugged fixed return assumptions into a spreadsheet—before, if a retiree assumed there would be a fixed return of 7% a year on retirement assets, then he or she could take 7% out safely without tapping into principal.

Bengen recognized it was naïve to use fixed returns such as those for calculations, as they masked significant underlying financial market volatility.
In the process, he uncovered the concept of “sequence of returns risk.” The average market return over a 30-year period might be quite generous, but if negative returns occur early—when the retirees have just started unwinding their assets for spending—then their safe lifetime income would be severely threatened.

At the time, Bengen considered 30 years to be a reasonably conservative planning horizon for a 65-year-old couple. He then looked at all the different rolling 30-year periods of financial market returns in the U.S. historical record since 1926 (for example, 1926-1955, 1927-1956 and so on, up to 1985-2014, the most recent period available).

For a hypothetical retiree beginning retirement at the start of each year, he tested what was the highest sustainable spending rate as a percentage of retirement date assets, adjusted for inflation and meant to last precisely 30 years. Using a 50% to 75% allocation to the S&P 500, and putting the remainder into intermediate-term government bonds, he found that the hypothetical retiree in 1966 could withdraw just over 4% of his or her retirement date assets and sustain this spending level over 30 years. That was the worst-case scenario from the U.S. historical record.

This was simplified, but the idea of the 4% rule took hold in the popular consciousness for advisors and consumers alike. It was a great way for advisors to frame the initial conversation.

Oversimplified
But the 4% rule was really meant to be a simplification for research purposes. It includes a number of assumptions that do not reflect reality.

One is that international market data suggests the worst-case scenario would be worse than that seen in U.S. history and we overestimate future U.S.
returns. Another is that the combined unprecedented low interest rate and high stock market valuation levels facing today’s retirees are extremely rare in the U.S. historical record. This leads to much lower returns over the following 10 years, when millions of baby boomers will leave the work force.

Nor does the 4% rule take into account other factors, such as investment fees, which need to be accounted for in any analysis. And as people live longer, 30 years is no longer a conservative planning horizon for 65-year-old couples.

Our Research
In this article, we try to correct some of those assumptions. We have used Monte Carlo simulations to estimate sustainable spending rates for retirements beginning in January 2015, and we draw elements from previously published research articles.

We take into account fees for both financial advice and fund management while also incorporating the heightened sequence of returns risk facing retirees in the current low-yield world and the reality that 30 years is increasingly not a conservative planning horizon.

As a preview of the findings, we estimated that a 40% stock allocation and a 30-year planning horizon would support a 2.1% sustainable initial spending rate, provided one is willing to accept a 10% chance of failure (with a volatile investment portfolio, there is no such thing as a guaranteed spending rate). There are also very few investors who would accept a 10% chance of outliving their money.

If we extend the horizon to 40 years, with the same asset allocation and acceptable failure probability, the sustainable spending rate drops even further, to 1.49%.

So it’s clear to us that after incorporating fees and today’s sequence-of-return risk, the 4% rule of thumb has a very low chance of success. Even a 2% withdrawal has a 10% chance of failure.

This research will be revised annually to incorporate changes in stocks’ and bonds’ current valuations. Though the withdrawal rates are low today, they wouldn’t have been at other times. They would have been much higher, for example, for an investor starting retirement on January 1, 1982.



Our Limited Historical Experience
It is a fallacy to conclude that just because the 4% rule worked in the U.S. historical data, it can be expected to continue to work just as well for today’s retirees. During the past 145 years, America grew at an unprecedented rate and became the world’s economic superpower. Other developed markets experienced lower growth. The 4% rule has not worked nearly as well in most other developed market countries, for which we have sufficient financial market data to create such a test. While it seems reasonable to focus on U.S. historical data, a century of slower growth will mean lower returns for future retirees.

Figure 1 summarizes the international experience on the topic of “safe withdrawal rates.” The table provides historical success rates for the 4% rule using financial market data for 20 countries since 1900.

Results can vary when we use different data sets and asset allocations. In this case, with a fixed allocation of 60% stocks and 40% bonds, the 4% rule worked in 95% of the rolling historical periods in the U.S. Success rates were also over 90% for the local stock and bond data in Canada, Denmark, New Zealand and South Africa. In the other 15 countries, results varied dramatically. The historical success rates for the 4% rule were as low as 28% for Italy, 41% for France and 46% for Belgium and Germany. If the U.S. has lower GDP growth in the coming century than it did in the last century, our success rate would also be much lower.

Today’s Market Environment
Future stock returns depend on dividend income, the growth of the underlying earnings, and changes in the valuation multiples placed on those earnings. If the current dividend yield is below its historical average, then future stock returns will also tend to be lower. When price-earnings multiples are high, markets tend to exhibit mean reversion and relatively lower future returns are to be expected.

Returns on bonds, meanwhile, depend on the initial bond yield and on subsequent yield changes. Low bond yields will tend to translate into lower returns because there is less income and there could be capital losses if interest rates rise.

Sustainable withdrawal rates are intricately related to the returns provided by the underlying investment portfolio. And with sequence-of-return risk, the returns experienced in early retirement will weigh disproportionately on the final outcome. The current market conditions are much more relevant to this approach, yet many financial planning software programs unfortunately still default their Monte Carlo simulations to higher historical average returns.

That’s another reason we must question the relevance of conclusions based on what worked in the past. The U.S. historical record is too short to determine how much can be safely withdrawn from a rather aggressive investment portfolio. The combination of low bond yields and high stock market valuations today suggests that the situation is different now. Today we are dealing with a situation in which Shiller’s cyclically adjusted price-to-earnings ratio (PE10) is well above historical averages, while bond yields are at historic lows.

Figure 2 demonstrates how today’s high-valuation/low-yield situation has been quite rare in U.S. history, indicating that we are in uncharted territory when trying to determine whether the 4% rule will remain a safe strategy. Historical simulations don’t analyze this possibility, but with Monte Carlo simulations we can adjust our capital-market expectations to better account for the types of returns that are more likely to be experienced in the future.

In January 2015, the 10-Year Treasury rate was 1.88%. This is about 2.8 percentage points less than the historical average of 4.7%. Today’s retirees will be more strained to spend principal to achieve a 4% sustainable withdrawal rate. Even if we assume the historical risk premium for stocks and other asset characteristics remain the same, but adjust the average return on stocks and bonds downward to reflect today’s lower bond yields, we will obtain higher failure rates for the 4% rule. But we must also consider that Shiller’s PE10 registered a value of 26.67 in January 2015. This is quite high, and a statistical regression of the subsequent 10-year average for the equity premium over bonds suggest that the equity premium will average 1.55% for the next 10 years when starting from this PE10 value.

Given that we require 30 years of data to calculate past sustainable withdrawal rates, 1941 is the only starting year with such low interest rates, and 1929 is the only year with such lofty stock market valuations for which we can know the subsequent outcomes.

There have been no past years with both of these rare events happening simultaneously. Again, this is uncharted territory.

Fees And Fund Expenses
The 4% rule is also based on an assumption that investors precisely earn the underlying indexed market returns with annual rebalancing. Clients who pay investment fees or who otherwise underperform the indices because of either poor timing or asset selection decisions cannot rely on 4% working for them. And generally, a 1% fee lowers the sustainable spending rate by 0.5% to 0.6%. This must not be forgotten when estimating sustainable spending rates for clients.



Planning Horizon And Longevity Risk
The risk of people outliving their wealth can only be self-managed with a conservative income plan in which they spread assets over a longer period than their life expectancy. The 4% rule is based on a planning horizon of 30 years. In 1994, William Bengen felt that this was a reasonably conservative assumption for the longer living member of a 65-year old couple.

But it’s less true for more highly educated and higher-earning individuals who typically work with financial advisors. Using numbers from the year 2000, the Society of Actuaries estimated a 31% probability that at least one member of a 65-year-old couple would live beyond his or her 95th birthday. In a 2012 update, this probability rose to 43%. And with their projected mortality improvements, a 65-year-old couple in 2028 can expect a 50% chance that at least one of them will make it to 95 (to arrive at this last number, we used our own calculations using Society of Actuaries data).

In other words, a 30-year horizon is no longer a conservative number. So we provide sustainable spending estimates for 40-year horizons as well.

Sustainable Spending Rates In 2015
We now put all of this together to develop Monte Carlo simulations estimating sustainable spending rates for retirees using actual market conditions as of January 1, 2015. The initial spending rates in our simulations are specifically calibrated to include a 3% annual cost-of-living adjustment, rather than having spending adjust precisely with the realized inflation experienced over retirement. Figure 3 provides the results for these simulations.

We observe that sustainable spending rates are noticeably lower than 4% when we include fees and account for today’s low bond yields and high stock market valuations. Extending the retirement horizon from 30 to 40 years also makes a significant difference in the results. A 10% failure rate (or conversely, a 90% success rate) is usually considered a decent acceptable baseline for Monte Carlo analyses of sustainable spending rates, and over a 30-year horizon the highest sustainable spending rate is 2.12%. That is with a 20% stock allocation.

Over a 40-year horizon, the highest rate is sustained with 40% stocks, though this spending rate has fallen to 1.55%. However, in the real world few retirees will accept a 10% chance of outliving their money.

Generally, accepting a higher chance for failure, with its accompanying downside risks, allows for more opportunity to seek the equity premium through a higher stock allocation. Nonetheless, with the 50% failure rate we can observe the actual best guess about the sustainable spending rate without building in any conservatism for the estimate.

With 100% stocks, it is 3.38% over 30 years and 2.74% over 40 years. Of course, those worried about outliving their assets will want to spend less initially so that they do not have a 50% chance of running out of retirement funds. Even though the retirement horizon is long, stocks have less opportunity to demonstrate a long run equity premium because of the sequence risk that causes the early market returns to weigh disproportionately on the ultimate retirement outcomes. Low interest rates, high stock market valuations and financial advisory fees all contribute to lower sustainable spending rates than implied by the 4% rule.



Conclusion
The dual impacts of sequence and longevity risk create a very real possibility with investments that one cannot support their desired lifestyle over their full retirement. These risks can be pooled in vehicles such as annuities, resulting in higher lifetime withdrawal rates. The alternative—retirees spending conservatively early in retirement or cutting back dramatically after sequence of return failure—is an option few of them desire.

The U.S. historical record has been used to estimate that 4% is a reasonably conservative initial spending rate to self-manage these risks. However, the analysis included here has suggested this is not the case, and that the 4% rule is significantly more risky for today’s retirees who face fees, low bond yields, high stock market valuations and increasing longevity expectations. The “safe withdrawal rate” is considerably lower for new retirees in 2015.

Wade Pfau, Ph.D., CFA is a professor of retirement income at the American College. Wade Dokken is the founder of WealthVest Marketing.
To see the white paper on which this article is based, as well as included footnotes, visit the September 2015 issue at www.fa-mag.com/news/retirement-
rethinking-22785.html?section=40.