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.
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.