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.
Why 4% Could Fail
September 1, 2015
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Comments
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Interesting perspective. I'm wondering if the authors can provide a little more detail on methods used to compute joint life expectant from the Society of Actuaries data. I haven't been able to locate the exact data set used in this study, but I have found and used the 2000 data set from the Society of Actuaries via the Vanguard Life Expectancy Calculator (https://personal.vanguard.com/us/insights/retirement/plan-for-a-long-retirement-tool). Joint life expectancy until age 95 for a 65 year old couple is 18% under this calculator...I can't find the data set used to support a 31% probability cited in the study. The SOA has a calculator using the Social Security mortality rates via 2010 which pegs the probability of the couple living until 95 at 14% (https://www.soa.org/research/software-tools/research-simple-life-calculator.aspx). I'm just seeking to understand the difference in joint life expediencies to better improve the conversations I have with clients.
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Thank you for the comments, both Mr. Wilson and demendels. Our research does not actually make a negative inference in our projections from the past performance in other countries. We only present this as a possibility, but not an element of our calculations. In short, if the long-term equity performance of the equity market were to look like the more developed countries of the 20th century, then our projections would be more negative. Dr. Pfau has not hidden agenda, and my company, WealthVest, does sell annuities to major broker-dealers. However, the key facts remain the same---after including mutual fund management fees, advisor fees and today's stock and bond market valuations--today's investor is likely to achieve low returns in the near term and this will negatively impact their sustainable withdrawal rate. The inclusion of all of these data points (plus a more up-to-date view of longevity) seems essential for near-retirees and retirees as they attempt to plan the safe withdrawal rate over their lifetime for their savings.
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While the long-term experience of US markets may be limited, I am not sure that simply combining it the experience of other countries help-s a great deal. I found it interesting that the four countries with the lowest success rates were the same countries that probably endured the worst damage from both WWI and WWII. Italy, Germany and France all went through multiple government collapses and Germany suffered hyper-inflation during the Weimar regime the likes of which has never been seen in either the US or any number of other countries. Germany was also saddled with enormous reparation payments post-WWI as well as strict limitations on industry. A number of the countries were dependent upon colonial empires to support their economies and saw those wither away after the two world wars. Of the countries with success rates less than 75%, all suffered war on their sovereign territory and/or were occupied by invading forces for years. Interestingly, of the 9 countries with success rates greater than 75%, 6 were not occupied during either world war, two were not fully independent states until after 1900 (RSA 1931, AUS consolidated multiple indpendent territories in 1901). While one can make many arguments as to why 4% may or may not be sustainable but it seems to me that comparing countries with such widely different diverse political, military and economic experiences is a misuse of history.
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Let's start with the end, few would argue against the notion that a 2% withdrawal rate is "safer" than a 4% withdrawal rate. For that matter a 1% withdrawal rate is "safer" than a 2% withdrawal rate, and a 0% withdrawal rate is unquestionably safer still. However, as anyone who has sat down with a client facing retirement knows, these even "safer" withdrawal rates have significant drawbacks of their own. No one can predict the future, certainly not I, and to his credit, neither to my knowledge did Bill Bengen. What he did try to do, though, is to learn from the past. It was based on those lessons, that the "4% rule" was born. If anyone ever presented the "4% Rule" as a guarantee of success they either never read any of the studies on which it was based, or grossly misrepresented them. That argument is simply what philosophers call a "straw man", a weak argument that misrepresents another's point of view presented solely because it is so easy to knock down. The authors refer to data from other countries dating back to 1900. That sounds impressive, but fundamental to the "4% rule" is the notion of annual adjustments to account for changes in the cost of living. Yet in none of those countries, or anywhere else for that matter, was anyone even tracking changes in the cost of living. While I have not studied it extensively, my understanding is that did not start in even its crudest form until the 1920s when it started here, so it far from clear how relevant that analysis is. The importance of a having a sound basis for calculating changes in the cost of living is underlined by looking at just where the failures started to occur in Bengen's analysis when he tried to plug in higher withdrawal rates. The failures did not occur, as the authors would have you infer, due to the poor sequence of returns that confronted those retiring just before the great stock market crash of 1929, but with those who retired just before the onset of the great inflation of the 1970s. Upon reflection, the greater impact of early onset inflation over early market downturns actually makes sense. If we think about it, the impact of low or adverse returns in the early years is limited to the withdrawals made during those early years. The remaining funds are able to recover later when the returns are better. The impact of early inflation, though, is cumulative and, baring an equal or greater period of subsequent deflation, it is irreversible and compounds over time. It is of course, true that we have no reason to expect history to repeat itself. The disclaimer that "past performance..." need not be repeated for this audience. However, the use of Monte Carlo analysis has its limitations as well. It is highly dependent on the assumptions built into the model being used. Is there any reason to believe that those assumptions will be any more predictive of the future? The authors refer to historical precedent to justify their assumptions which is curious since they then argue for using their model that relies on those assumptions to argue against relying on historical precedent which seems rather selective on their part. Finally, the authors' hidden agenda here, that annuities are a better alternative is problematic as well. Keep in mind that insurance companies are not magical investors. They would be investing right along side the rest of us in that dismal environment. Does anyone seriously believe that insurance companies are that much better at investing than the rest of us? They certainly have far less flexibility. And if they can't make the returns required to support the promised payouts, they don't have the flexibility to make adjustments. They are committed to making the promised payouts until they can no longer at which time they will fail. When they fail, they can only fail catastrophically which would leave those dependent on them far worse off than those who might have had to cut back a bit in their latter years. The "4%" rule is not now, nor was it ever any kind of a guarantee of what the future has in store for us. That is, always was, and probably will be for the forseable future, unpredictable. It is a rule of thumb, but a rule of thumb based on an effort to learn from the lessons of the past. There is no question that anyone who suggest that it be blindly followed is committing gross malpractice. But if I have to chose between suggesting to my clients that they base themselves on that rule of thumb or suggesting that they halve their lifestyle based on some algorithms cooked up by the authors, I think I'll stick with the "4% rule", thank you very much.