The Fallacy of the 4% Rule Michael Tove Ph.D, CEP, RFC January 2015 For decades, investors have sought to use return on investment as a means of generating income, including retirement income. Historically this worked, in large part because before the mid1990’s, market returns experienced relatively minor short-term fluctuations in value and were fairly predictable over time horizons as short as a few years. In 1994, William Bengen suggested that an average investor could safely withdraw up to 4% of a portfolio without risk of outliving the money. Subsequently, Cooley, Hubbard and Waltz (1998 – the “Trinity Study”) affirmed Bengen’s conclusions that a 4% withdrawal rate was reliable for income generation. In 2006, Bengen revised his recommendations to suggest that if the money was received tax-free, the safe withdrawal rate was as high as 4.5% and if taxable, 4.1%. Bengen’s (1994, 2006) conclusions assumed an investment portfolio which consisted of a mix of 50% stocks and 50% bonds. But, safe withdrawal rates would drop for portfolios with more stock exposure. However, Bengen’s conclusions were derived from market conditions prevalent in the latter half of the 20th Century. But starting January 1995 through the first decade of the 21st Century was characterized by unprecedented market volatility in which the oscillations in market value increased by hundreds if not thousands of times more than ever previously recorded. So great were these changes, that it prompted Nobel Laureate William Sharpe and colleagues (Scott, Sharpe & Watson 2008) to re-examine Bengen’s hypothesis. Their conclusion was that the 4% Rule had a 53% chance of failure. These findings have been sustained by other researchers (e.g., see Pfau 2013, Voegtlin and Pfau 2014). There are several errors with the Bengen (1994, 2006) and Cooley et al. (1998) recommendations: 1. Unprecedented market volatility. From January 3, 1995 through March 24, 2000, the S&P 500 Index® roared upward at an enviable average rate of 21.21% per year. Then, over the next 2½ years, it plummeted 45.47%, reaching a new low on October 4, 2002. Then, for the next five years, it roared upward again at 14.29% per year, reaching an all-time high by October 12, 2007. Sixteen months later, on March 9, 2009, it crashed, bottoming out with a total loss of 56.72%. Then it again climbed 22.95% per year through December 31, 2014. The net result of those huge swings which included two of the three largest bull markets in US history was that from January 1, 2000 through December 31, 2014, the total average return was just 2.15%, BEFORE deducting investment fees and taxes. 2. Historically low bond rates. Normally bond rates improve when stock markets are weak but that didn’t happen with the financial crisis of 2008. Yields on the 10-year Treasury Note (bonds) fell from a high of 5.19% on July 6, 2007 to 2.17% by December 31, 2014. 1 3. Increasing Human Life Expectancies. Increased longevity raises the demand on return to sustain income. As Voegtlin and Pfau (2014) point out, in 1950, the average life expectancy of a 65 year-old male was 12.8 years and half would die before age 78. As of 2014, demographic analysis of increasing life expectancy projects that by 2050 one in four men age 65 will live past age 85. 4. Sequence of Returns Risk. For those people who are “lucky” and start their retirement (based on 4% withdrawal) at the beginning of the “bull markets,” the probability of success is far greater than those who start their retirement when the markets are at (or past) their peaks. Kelly Greene (2013) and Voegtlin and Pfau (2014), citing analysis from T. Rowe Price, point out that a retiree, starting 4% rule income on January 1, 2000, by 2010, would have lost a third of the total portfolio. 5. Inflation Risk. From 1995 through 2014, according to the U.S. Bureau of Labor Statistics, the average rate of inflation was 2.2% per year. Many people popularly doubt inflation was actually that low, but even taking the BLS statistic at face value, it’s easy to see how an inflation load equal to if not greater than the net average annual return defeats any ability to preserve principal while withdrawing income. But the impact of inflation is far greater than may initially be realized. Even assuming no inflation, as the underlying account value falls (e.g., Greene 2013, Voegtlin and Pfau 2014), the actual amount of income (in dollars) generated by 4% of the total, goes down. Of course, income must be in fixed dollars, not fixed percentage. Therefore, as account value drops, to generate the same dollars of income requires the percentage taken to increase. Now throw in inflation. What happens is that as the account value falls, the withdrawal load on the account increases rapidly. The account is depleted to nothing and the rate of loss accelerates rapidly throughout the process. All these reasons (and more) are the reason a growing number of financial professionals admonish DO NOT base your long-term or permanent income on investment portfolios because At the point of retirement, one bad year can ruin the rest of your life (see also Milevsky and Robinson 2005). RELIABLE INCOME GENERATION. Historically, for most Americans, the primary source of retirement income was their employer’s pension (more accurately known as a Defined Benefit Plan), plus Social Security. Even as recently as the end of the 20th Century, these income sources were the primary, if not sole source of retirement income. Fundamentally, a typical pension promises to pay a stated amount of income for as long as the retired employee lives and in many cases, extends that promise to the employee’s spouse. Similarly Social Security pays a given amount of income starting at the point of retirement, for life, with some annual adjustments for inflation. While specifics of how 2 pension and Social Security incomes are determined, what they both have in common is the promise of income that cannot be out-lived. Regardless of any other circumstances, those income sources are reliable and permanent. In short, they are annuities. According to Webster’s, the word “Annuity” means “a fixed amount of money that is paid to someone each year.” In other words, anyone who receives permanent retirement income has an annuity. Of course, annuities are also offered for purchase by insurance companies. Just like traditional pensions and Social Security, they guarantee income for life. However, some of them – particularly some of the newer ones, offer additional benefits such as death benefit in addition to income, enhanced payments for certain medical needs such as Long Term Care and in some cases, continued growth of the underlying account after income has begun. More significantly, a few offer increasing or inflation-adjusted income payments. This is a feature specifically mentioned by Nobel Laureate Robert Merton (2014) when he specifically recommended ALL retirement plans MUST include income that is “inflation-protected and guaranteed for life…” which ONLY an annuity can do. ANNUITY RETURN FOR INCOME. Another advantage of using annuities is that many offer payouts greater than 4%, commonly 5% or higher. For example, a $300,000 investment portfolio paying 4% will generate $1000/month. Conversely, an annuity that pays 5% will generate $1250 per month; 25% more income on the same money. Moreover, where the former has no guarantee of permanence, the latter is guaranteed to last for life. SUMMARY. Retirement is a time when permanent income must be reliable and predictable. Bills (and bill collectors) are a monthly reality that tend to be unforgiving of “unfortunate circumstances.” The only theoretical advantage in using market investments to generate income is growth potential in excess of the income. Unfortunately, the days when that strategy was reasonably reliable are long gone. Instead, it has been replaced with the very real risk of a person outliving his/her money. Further, with combined effects of inflation and increasing longevity, the probability that an investor will outlive his/her money is increasing. Annuities are specifically designed to guarantee a permanent source of income that cannot be out-lived. It’s what they “do for a living” and retirees would be well-advised to consider using them as a central portion of their retirement plan. Having said that, there are literally hundreds of different annuity products in the marketplace and they’re not all created equally. Determining the right one for an individual requires consultation with a licensed professional, ideally someone who is independent with access to a wide array of products from many different carriers and no pre-determined bias as to which company or product should be recommended. Rather than shop for the “best” product or investment portfolio, better shop for the “best” professional and avail yourself of his/her advice. 3 REFERENCES: Bengen, William P. 1994. Determining Withdrawal Rates Using Historical Data. Journal of Financial Planning. October, pp. 171-180. http://www.retailinvestor.org/pdf/Bengen1.pdf Bengen, William P. 2006. Conserving Client Portfolios During Retirement. FPA Press, Denver, CO. Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz. 1998. Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable. AAII Journal 10 (3):16–21. http://209.31.88.154/journal/article/retirement-savings-choosing-a-withdrawal-rate-that-issustainable Greene, Kelly. March 1, 2013. Say Goodbye to the 4% Rule. The Wall Street Journal.com. http://www.wsj.com/articles/SB10001424127887324162304578304491492559684 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 Pfau, Wade D., March 5, 2013. Breaking Free from the Safe Withdrawal Rate Paradigm: Extending the Efficient Frontier for Retirement Income. AdvisorPerspectives.com. https://www.immediateannuities.com/pdfs/articles/breaking_free_from_the_safe_withdrawal_rat e_paradigm.pdf Scott, Jason S., William F. Sharpe and John G. Watson. 2008. The 4% Rule – At What Price. Stanford.edu., April 3. http://web.stanford.edu/~wfsharpe/retecon/4percent.pdf Voegtlin, Rex and Wade D. Pfau. 2014. Mitigating the Four Major Risks of Sustainable Inflation-Adjusted Retirement Income. A White Paper by the Annexus Research Institute. https://www.immediateannuities.com/pdfs/articles/mitigating-the-four-major-risks-ofsustainable-inflation-adjusted-retirement-income.pdf 4