Rethink 4% retirement withdrawal rate

If you use the standard 4% withdrawal rate for your retired client’s portfolio, it’s time to reconsider your approach.

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“The 4% withdrawal rate has long been presumed the industry standard for investors entering retirement, but this rate is no longer optimal,” says Vjosana Klosi, director of portfolio construction at CIBC and co-author of a May 2017 research paper on sustainable withdrawal rates.

Why? As Klosi explains, “The [4%] rate was determined by financial planning practitioners as early as 1994.” Further, “It was based on models [that] relied on historical returns to determine the performance of a balanced portfolio with 60% exposure to equities and 40% exposure to debt.”

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And those historical returns are relatively high: 9% to 10%, on average, for Canadian equities, and 6% to 7% for Canadian bonds. On a 10-year basis, however, returns are considerably lower, at 5% to 6% for Canadian equities, and 2% to 3% for Canadian bonds, says Klosi.

Given this discrepancy, her firm has revised its long-term return expectations for balanced portfolios. “The main reason why […] is that, during the past nine years, the downward sloping trend for rates has resulted in increased valuations for fixed income,” she says, adding that the forecasted return for long-term Canadian bond yields is now 2.5%.

So, Klosi adds, “Even though [withdrawal rates] are expected to increase in the long run, the forecasted expected rates should not be higher than 2.8% to 3%, which is still lower than the historical [withdrawal] target of 4%.”

For equities, “lower growth rates and demographics in developed markets have resulted in lower expected returns for equities in general and, therefore, lower expected returns for balanced portfolios,” she says.

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Risky business

Along with expected returns, a client’s risk profile affects his withdrawal rate.

For a client with a medium-risk profile, who is willing to accept a 10% probability of their portfolio having no residual value, the recommended withdrawal rate is between 3.5% and 3.75%, finds Klosi.

In the research paper, Klosi cites a 2015 survey from Financial Advisor magazine that finds 55% of respondents (ages 50 to 65) want a 0% risk of outliving their retirement savings. For a client with a medium-risk profile to achieve that outcome, “the withdrawal rate is substantially lower,” says Klosi — between 2.25% and 2.75%.

Overall, depending on a client’s risk appetite, Klosi says recommended withdrawal rates vary between 2.5% and 4%.

“Investors who are willing to take on additional risk can increase their target withdrawal rates,” she says. Of course, those investors would also have to accept a greater failure probability, of above 10%. Such clients could also be few and far between, considering retirees’ primary fear is outliving their money, as revealed by the survey.

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