What's so funny about peace, love and the 4% withdrawal rule?

It's easy to knock beloved institutions and ideals in tumultuous times. As protestors across the country rage about Wall Street excesses from the streets, academics are also questioning financial orthodoxy behind red brick walls covered with ivy. Since the economic maelstrom of 2008, such sacred cows as the efficient market hypothesis and the reliability of mean reversion for returns have come under attack.

Some academics have even started to question the 4% rule-which hits financial advisors where they live. This thumbnail withdrawal strategy allows retirees to take 4% of their pretax money out in the first year of retirement and then continue to take that out plus inflation (adjusting up by 3%, or some other inflation rate, each year). The 4% rule stresses capital preservation so people can keep their money at play in the market for long-term growth but still unwind enough to live comfortably. If a client is older, the withdrawal can rise to 5% or 6%.

But like a lot of dearly held beliefs in the recession, it's being re-evaluated. Given that 2009 saw a decade of lost returns, clients likely think that taking out 4% every year will leave them broke before they die. Indeed, according to a recent study by the Employee Benefit Research Institute, 70% of workers say they are not on track for retirement.

William Sharpe, the Nobel prize laureate in economics, chimed in when he co-wrote a paper in 2008 called "The 4% Rule-At What Price?" Sharpe and co-authors Jason Scott and John Watson, suggested that the 4% rule tries to tackle fixed spending but doesn't know what to do with volatility. They wrote, "This rule and its variants finance a constant, non-volatile spending plan using a risky, volatile investment strategy. As a result, retirees accumulate unspent surpluses when markets outperform and face spending shortfalls when markets underperform."

In effect, Sharpe says that a retiree who uses the 4% rule is paying too much for the surplus he won't use in good times. (Imagine a dart-throwing game at Coney Island. You've won a prize ham after throwing $50 worth of darts, but you've overpaid anyway by buying $100 worth of darts.) And yet you can still come up short when the market plunges into the toilet.

In 2010, Sharpe told members of the National Association of Personal Financial Advisors at their annual conference in San Diego that clients are now facing new risks never before addressed by steady withdrawal rates. People are living longer, facing higher health-care costs and the possible shrinking of government programs such as Social Security and Medicare. There is also, of course, the specter of inflation. To those, Sharpe added another fear to make the blood turn cold: counterparty risk. What if more companies you've trusted your life savings with go the way of Lehman Brothers?

The changes in thinking have led many advisors to come up with new solutions and innovate new ways to juice yields for their retiree clients.

New Tricks
With short-term interest rates near zero, few people are extolling the virtues of bonds, which are facing a prolonged bear market if interest rates rise. But some fight that orthodoxy, saying that bonds are still the best way to preserve wealth when it's needed, and that bond ladders are still great ways to generate income.

Joseph Alfonso, a solo practitioner RIA based in Lake Oswego, Ore., and Santa Clara, Calif., has devised a strategy of building a 15-year ladder of U.S. Treasury "strip" bonds to match his clients' cash flow needs and beyond that budgets an annual 10% savings rate in retirement. He says that this strategy makes a priori withdrawal rate calculations unnecessary.