When it comes to managing retirees' nest eggs, many financial advisors follow the 4% rule. Namely, apply a roughly 4% yearly withdrawal rate from portfolios to meet spending needs while preserving enough capital so clients don't outlive their resources.
But Nobel Laureate William Sharpe, the man behind the Sharpe Ratio that measures risk-adjusted investment performance, posits that the 4% rule might be harmful to a portfolio's health.
In an article published this month by the Stanford Graduate School of Business, Sharpe states that 4% withdrawal rates don't take into account the downside of investment risk. He says the big problem with the 4% rule is its insistence on fixed spending coupled with investing in a portfolio with variable returns. Maintaining the same withdrawal rate in down markets will cause the retiree to run out of money.
Moreover, insisting on a withdrawal rate of about 4% can be deleterious in bullish markets. The reason: it might generate surpluses and cause money to be left over at the end--which is waste on the back end, as well as on the front end because the individual paid for investment surpluses he didn't need.
"If a retiree adopts a 4% rule, he will waste money by purchasing surpluses, will overpay for his spending distribution, and may be saddled with an inferior spending plan," wrote Sharpe and colleagues Jason Scott, managing director of the Retiree Research Center at Financial Engines, and John Watson, a fellow at Financial Engines.
Sharpe, a finance professor emeritus at the Stanford Graduate School of Business, in 1996 co-founded Financial Engines Inc., a Palo Alto, Calif.-based company that provides technology-enabled portfolio management services. The company's initial public offering in March was a smash hit, but its stock recently traded below its first-day closing price.
Of course, advisors often modify a client's withdrawal rates to account for varying market conditions. But according to Sharpe and his colleagues, that only perpetuates the underlying problem. "All these variations have a common theme-they attempt to finance a constant, nonvolatile spending plan using a risky, volatile investment strategy," they wrote.
To take a different tack, they created a scenario of a client with a portfolio of $1 million. Instead of employing the 4% plan with risky securities, the investor could instead invest in treasury inflation protected securities (TIPS). The yield will be lower than that of equities in bull markets, but they say TIPS deliver the most purchasing power without risk. So an investor might be guaranteed approximately 3%, which would allow him to withdraw $30,000 a year.
If that's not enough, the client might choose to accept some level of risk as a tradeoff for higher earnings.
And to ascertain the appropriate risk level, Sharpe and other colleagues proposed in a 2008 research paper that advisors need to find better ways to gauge client risk tolerance rather than the standard questionnaire they have them fill out. The researchers doubt the usefulness of such quizzes.
Sharpe and other researchers are working on ways to identify true risk tolerances, according to the Stanford article.