Markets, Required Minimum Distributions, and the 4% Rule
Michael Tove Ph.D., CEP, RFC
February 2015
We spend our lives saving for retirement. Financial advisors are very skilled at telling their
clients how to invest for maximum return. Whether or not those returns are realized according to
expectations is another matter. But, when it comes to converting the retirement savings into an
actual retirement plan (meaning income) the details of that advice often become muddy.
Fundamentally, most advisors know a lot more about accumulation strategies (investing for
growth) than decumulation (converting money into income).
Robert C. Merton (2014), Nobel laureate and distinguished professor of finance at the MIT Sloan
School of Management and Professor Emeritus at Harvard University, strongly criticized
corporate America for a shift in their employee retirement plans. This shift was an abandonment
of traditional pension plans – formally known as Defined Benefit Plans in which a retiring
employee was guaranteed a monthly income for life to Defined Contribution Plans – A.K.A. the
401(k) which merely specified how much the employer and employee would each contribute. In
other words, corporate America shifted from a “we’ll take care of you for life” plan to a “good
luck in your retirement” plan. Merton’s central message is that when it comes to retirement
planning, people “need to think about monthly income, not net worth” (p. 3), and he is sharply
critical of corporate America for this error.
But the sins of corporate America are no worse than what personal investment advisors tell their
clients. Those advisors want you to believe – because they believe, that markets are sufficiently
predictable to be relied on for income generation or (worse) that the advisor’s advisory skills are
so advanced, they can insulate an investor from what will happen when markets correct.
For years, investment advisors touted the “Four Percent Rule” as a way of generating income.
The theory is to grow the account and withdraw 4% off the top each year as income and permit
growth within the underlying investment to replenish the amount just paid out. The plan even
goes further to suggest adding a 3% annual increase to keep pace with inflation.
In years past, when the average worker lived only a few years past retirement and markets were
less volatile than today, this strategy seemed to work. But in the 21st Century, neither is still the
case, and getting worse. Since the start of the new Millennium, the fastest growing demographic
in the United States are people 65 and older (Administration on Aging, 2013) and the population
aged 90 and up is expected to more than quadruple over the next four decades (US Census
Bureau, 2011).
Longer life expectancies and increasing market volatility have led a number of prominent
researchers to question the validity of the 4% Rule. Nobel Laureate William F. Sharpe and
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colleagues (Scott, Sharpe & Watson 2008) reported that adherence to the 4% Rule carried a 53%
chance of failure – meaning a 53% chance an investor would outlive his/her money. This finding
was echoed by Greene (2013), Pfau (2013), Voegtlin and Pfau (2014), and Finke (2013). Further,
Finke, Pfau and Blanchette (2013) reported that in light of the historically low bond rates that
typified the first 10-15 years of the 21st Century, the sustainable expectations from the 4% Rule
should be reduced to 2.8%. In other words, to sustain a long-term expectation of income, reduce
the amount of income one takes by 30%. Translated that means a hypothetical investor with
$300,000 who, under the 4% rule, would expect to generate income of $1000 per month, should
now take only $700. Moreover, because of low bond rates that dominated post the financial crisis
of 2008, Finke (2013) estimated the probability of failure somewhat higher, at 57%.
The sad conclusion to be drawn from these studies is that reliance on the 4% Rule for long-term
income is a very risky proposition and not advisable to anyone seeking a lifetime of income from
investments.
MANDATORY LIQUIDATION.
Within the United States, the largest single block of moneys is qualified retirement funds (IRA,
401(k), etc.). According to the Employee Benefit Research Institute (2015), by year-end 2012,
qualified retirement money totaled approximately $23.7 Trillion. Of that, more than $4.0 Trillion
(17%) was in Defined Contribution Plans (including 401(k) Plans) and nearly $5.7 Trillion
(24%) was in traditional Individual Retirement Accounts (IRAs).
Current tax code mandates that a retiree who reaches the age of 70½ must begin a schedule of
Required Minimum Distributions (RMDs) from a Qualified Retirement Plan (such as IRA and
401(k) plans). The amount of that mandatory liquidation changes every year, starting at
approximately 3.65% for a 70 year-old and rising steadily from there, topping out at more than
52% for anyone fortunate enough to live to at least age 115. However, according to the IRS, the
average life expectancy of a 70 year-old (unisex) is 17 years. At that rate, the average RMD is
4.88% per year, with a range of 3.65% at age 70 to 7.09% at age 86. But, for someone who lives
to age 90, that average RMD jumps to 5.28%. Note that all of these required distribution
demands are well in excess of the 4% Rule, not to mention the revised estimate of 2.8%
necessary to sustain an account. In short, the schedule of Required Minimum Distributions – in
the face of volatile markets such as have typified the early portion of the 21st Century, spell a
formula for disaster for this, the largest single block of money in the United States.
INCOME NOT ACCUMULATION.
Merton (2014, p. 7) does not mince words when it comes to this simple reassessment of a
retirement goal. He states that a retiree (or employer of that person) approaching retirement, must
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“refine the goals. A good framework in which to do this is to divide income needs into three
categories:” which he lists as:
“Minimum Guaranteed Income”
“Conservatively Flexible Income”
“Desired Additional Income”
The danger of outliving one’s money falls squarely within the first category. In this instance,
Merton’s recommendations are specific and without waver. He states (p. 7) that Minimum
Guaranteed Income “must be inflation-protected and guaranteed for life...” In other words, “an
inflation-protected life annuity from a highly rated insurance company...”
For his categories two and three, Merton allows the moneys to be conservatively invested.
However, these recommendations do not seem to account for the faults associated with the 4%
Rule in light of Required Minimum Distributions. Even though one will not outlive his/her
money using investments for their “Conservatively Flexible Income,” the faults of the 4% Rule
and RMDs may mean there won’t be much left for beneficiaries. Specifically, once Required
Minimum Distributions begin, financial accounts that are exposed to the downsides of the stock
market will not survive past the first significant correction (see Milevsky and Robinson 2005). In
essence, when it comes to retirement money, one bad year can ruin the rest of your life.
The following graph illustrates the point. Assume an investor, with an IRA worth $100,000
invested in the market (S&P 500 Index® without fees) on January 1, 2000, the same day as his
70th birthday. Also assume he lives 15 years to December 31, 2014. Compare that to an
identically invested $100,000 which is not IRA money (with no RMD).
$160,000.00
$140,000.00
S&P 500 w/o RMDs
S&P 500 after RMDs
$120,000.00
$100,000.00
$80,000.00
$60,000.00
$40,000.00
$20,000.00
$0 $1 2001
2 2002
3 2003
4 2004
5 2005
6
7
8
9
10 2010
11 2011
12 2012
13 2013
14
15
16
2000
2006
2007
2008
2009
2014
2015
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On December 31, 2014, his non-IRA account is worth $137,999.80 while the IRA account is
worth only $65,962.19 and the sum of his RMDs for all 15 years is $49,370.68 for a total return
of $115,332.87. In other words, $22,666.93 less than the same market returned without the
RMDs. What makes this even worse is the realization that in the direct market, the actual annual
return was just 2.17% for the non-IRA money and -2.74% for the IRA (or 0.96% return after
adding back in the RMDs received). None of these are the sorts of returns which most investors
would call “attractive” and none of these includes the fees associated with investing.
Clearly, there are people don’t care about beneficiaries. They’ll look at the graph and say “The
RMDs didn’t reduce the account to zero. As long as I have money left, after I’m dead, I don’t
care.” Unfortunately, these investors forget how much less of their money they got.
A BETTER (SMARTER) OPTION.
Returning to Merton’s strong recommendation to rely on annuities as the cornerstone of
“Minimum Guaranteed Income,” there is yet the open question: Could annuities be suitable for
the other two income categories? From the perspective of finance, Merton is a traditionalist.
Conventional wisdom says “invest in the market for long-term growth.” But one wonders if, as
Merton himself says in the same article, even that’s wise. If income is the goal, then there is no
reason to be exposed to markets, especially if one can capture comparable returns without taking
the risk.
The Fixed Index Annuity (FIA) was invented in 1995 to serve as a bridge between traditional
fixed interest accounts that were safe and risk-based accounts that had much higher growth
potential. The late 1990’s was a time of great economic boom and investors were basking in the
glory of the biggest Bull Market in US History at the time. January 1, 2000 not only ushered in a
new century but also an era of unprecedented market volatility. That volatility is what gave the
dismal results seen in the graph above.
FIAs are designed to offer growth based on an indirect link to one or more market indexes when
markets are rising but credit no losses when markets fall. On the surface, this would seem ideal
but as everyone knows, or should know, there’s always a catch. With FIAs, that catch is simply
annuity owners do not get 100% of the gains on the upside as a trade-off for no risk of loss on
the downside. Many investors would use this simple observation as fodder to dismiss FIAs as a
poor alternative. However, the facts speak otherwise. Morningstar’s Director of Funds Research,
Russel Kinnel (2014) reported that from 2003-2013, where the average Mutual Fund returned
7.3%, the average Mutual Fund investor investor gained just 4.8%, fully 2.5% less than expected.
In large part this was attributed to imperfect timing by investors who sought to “beat” the
market. None-the-les, the risk returns were less than stellar.
To be sure, not all FIAs are created equal and some provide substantially better returns than
others. However, the average FIA over that same time frame did not return significantly less than
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actual markets and did so without suffering the catastrophic losses during the crashes of 20002002 and 2007-2009. In some cases, the best FIA products of today (which have no growth caps
on the upside) would have out-performed those same markets.
For example. A hypothetical non-risk account averaging 5% per year would have significantly
out-performed the markets over the time period indicated previously. Compared with the S&P
500, the schedule or RMDs would have not depleted the initial account. Rather, it would have
resulted in an end value of $102,338.14 plus RMDs which would have totaled $83,235.00.
$250,000.00
$200,000.00
5% fixed return w/o RMDs
5% fixed return after RMDs
S&P 500 after RMDs
$150,000.00
$100,000.00
$50,000.00
$0 $3 2003
4 2004
5 2005
6 2006
7 2007
8 2008
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10 11
20001 20012 2002
2009
2010 12
2011 13
2012 142013152014162015
To be fair, FIAs do not typically guarantee 5% per year. However, some average that without the
risk of losses during market corrections. A few are even better. All this begs the question “Why
take the risk when it’s not necessary?” The simple answer is nobody should. Risk does not buy
anything other than increasing the likelihood of failure. This is especially true when it comes to
income accounts such as 401(k) and IRAs in Required Minimum Distribution. Simply put, to
give an IRA the best possible chance to survive and grow once RMDs start, IRA money should
be held within an un-capped Fixed Index Annuity that is structured for high growth.
REFERENCES:
Administration on Aging 2013. Administration for Community Living. US Department of Health
and Human Services. Dec. 31.
Employee Benefit Research Institute 2015. FAQs About Benefits – Retirement Issues. ebri.org
online reports.
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Finke, Michael. 2013. Is the 4% Rule Folly? AdvisorOne. April 29.
http://www.thinkadvisor.com/2013/04/29/michael-finke-is-the-4-rule-folly
Finke. Michael S., Wade D. Pfau and David Blanchett. 2013. The 4 Percent Rule is Not Safe in a
Low-Yield World. Journal of Financial Planning, Online Report.
http://www.onefpa.org/journal/Pages/The%204%20Percent%20Rule%20Is%20Not%20Safe%20
in%20a%20Low-Yield%20World.aspx
Greene, Kelly. 2013. Say Goodbye to the 4% Rule. The Wall Street Journal online. Mar 3.
http://www.wsj.com/articles/SB10001424127887324162304578304491492559684
Kinnel, Russel. 2014. Mind the gap 2014. Morningstar Fund Investor, Online report, February
27. http://www.morningstar.com/advisor/t/88015528/mind-the-gap-2014.htm
Merton, Robert C. 2014. The Crisis in Retirement Planning. Harvard Business Review, JulyAugust: 3-10.
https://hbr.org/resources/pdfs/comm/fmglobal/the_crisis_in_retirement_planning.pdf
Milevsky, Moshe A. and Chris Robinson. 2005. A Sustainable Spending Rate without
Stimulation. Financial Analysis Journal 61(6): 89-100.
http://www.qwema.ca/pdf_research/2007SEPT_SustSpending.pdf
United States Census Bureau 2011. Census Bureau Releases Comprehensive Analysis of FastGrowing 90-and-Older Population. Nov 17.
Weinreich, Gill. 2013. Finke Study Warns: 4% Retirement Rule Is Dead, Long Live Annuities.
AdvisorOne. January 17. http://www.thinkadvisor.com/2013/01/17/finke-study-warns-4retirement-rule-is-dead-long-l
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