In the early 1990s, investors could count on two things: stocks would outperform bonds over the long run; and they could withdraw 4% a year from their retirement portfolios for 30 years.
Those assumptions may no longer hold. For one thing, bonds returned more than stocks over the past 30 years. And that’s renewed calls to make bonds the foundation of retirement portfolios, even in the accumulation phase — a position championed by Boston University finance professor Zvi Bodie in a series of exchanges with Wharton School finance professor Jeremy Siegel, who originally proposed the stocks-for-the-run thesis.
But bonds will falter as interest rates rise. And, despite two stock market crashes, there is little evidence suggesting the equity market is undervalued.
All this uncertainty challenges the 4% withdrawal rule. It might seem better to let an insurance company bear the risk, through annuities providing a certain income for retirees.
But with interest rates at rock bottom, insurers are unable to provide usable products — certainly not without hiking their fees to compensate for bearing the investment risk. And even with guaranteed income, retirement expenses may not behave as expected.
For those already retired, that’s not a big deal, says Cathie Hurlburt, a financial planner with Assante Financial Management in Vancouver. They grew up in the Great Depression and most keep enough slack in their portfolios to compensate for contingencies.
For the next generation, it could be crunch time. Many have debts or spending patterns their parents would have considered imprudent. But they do have wealth. Unfortunately, argues Hurlburt, they confuse capital with income and so dive into tomorrow’s nest egg to fund today’s new car or kitchen.
Retirement isn’t just a number
The 4% rule, originally suggested by American financial planner William Bengen in the Journal of Financial Planning in 1994, seems to have bested the passage of time. He based it on the historical performance of a portfolio split equally between U.S. large caps and Treasuries. But can retirement really boil down to a number?
Unlikely. Rates of return are not the only variables. To maintain a constant real spending rate, inflation has to be added to an initial 4% withdrawal rate. So the worst-affected retirees aren’t those who lived through the Depression.
Instead, it’s those who lived through post-war prosperity and retired close to a stock market peak in 1969. Their retirements coincided with sharp inflationary ramp-ups that forced them to move the 4% withdrawal rate to 12% to maintain their lifestyle (that’s 4% plus 8% inflation).
Read: Rearranging retirement
In inflationary times, then, retirees have been forced to spend more. That required liquidating capital, since stock market returns were flat from 1966 to 1982, and real-return bonds did not yet exist. Or, they could have adopted simpler lifestyles, and substituted lower-priced goods for higher-priced ones.
There were three occasions in the 1960s and 1970s when the 4% rule failed, noted John Ameriks, who leads Vanguard’s Investment Counselling and Research group, in a 2010 blog post. To be sure, the great bull market may have helped replenish their portfolios, but the damage was already done.
And what about those who retired in 2000? Equity markets have since collapsed twice, but inflation is low. Bengen, in a recent article, says these retirees have a good chance to make it to 2030.
For people retiring now, there’s a chance the rule won’t hold. Much depends on the year of retirement, as well as changing patterns of spending. That’s why some planners shy away from standard planning software to make projections. A 30-year horizon has worked so far. But much depends on how markets perform.
And then there’s just the unpredictable rhythms of life. Before financial planners can make a decision about the reliability of future income projections, they have to take into account the unexpected. It can come on either side of the balance sheet. For example, there may be a sudden medical emergency.
Moshe Milevsky, a finance professor at York University’s Schulich School of Business, says, “Most of this by definition is unmodellable. All we can really do is have contingencies in place. But if a huge disaster hits, their reserves aren’t going to be enough.”
In other words, there is no absolute margin of safety, barring insurance. Here, Milevsky argues, people may have to draw on their social capital and turn to friends and family to make up shortfalls.
On the other side of the balance sheet, Hurlburt is reluctant to count home equity — people promise to downsize, but don’t, and if they do, their new abode, although smaller in size, costs as much as their former one did.