The 4 Percent Rule is Not Safe in a Low-Yield World

[jacob]

http://papers.ssrn.com/sol3/papers.cfm? ... id=2201323

Abstract:
The safety of a 4% initial withdrawal strategy depends on asset return assumptions. Using historical averages to guide simulations for failure rates for retirees spending an inflation-adjusted 4% of retirement date assets over 30 years results in an estimated failure rate of about 6%. This modest projected failure rate rises sharply if real returns decline. As of January 2013, intermediate-term real interest rates are about 4% less than their historical average. Calibrating bond returns to the January 2013 real yields offered on 5-year TIPS, while maintaining the historical equity premium, causes the projected failure rate for retirement account withdrawals to jump to 57%. The 4% rule cannot be treated as a safe initial withdrawal rate in today’s low interest rate environment. Some planners may wish to assume that today’s low interest rates are an aberration and that higher real interest rates will return in the medium-term horizon. Although there is little evidence to support this assumption, we estimate how a reversion to historical real yields will impact failure rates. Because of sequence of returns risk, portfolio withdrawals can cause the events in early retirement to have a disproportionate effect on the sustainability of an income strategy. We simulate failure rates if today's bond rates return to their historical average after either 5 or 10 years and find that failure rates are much higher (18% and 32%, respectively for a 50% stock allocation) than many retirees may be willing to accept. The success of the 4% rule in the U.S. may be an historical anomaly, and clients may wish to consider their retirement income strategies more broadly than relying solely on systematic withdrawals from a volatile portfolio.

[Felix]

Makes sense -unfortunately. So... what's the SWR then?

[Ego]

Failure rates, volatile portfolios, low-interest environments, disproportional effects on sustainability of an income strategy.... What is it they are trying to accomplish with this? Why are they trying to terrify me?

Safety is overrated.

[Felix]

Well, if you think you're safe and you are actually not, it is good to know. A major part of ERE is about becoming less fragile (to use the Taleb term) to circumstances.

[jacob]

@Felix - Ain't no such thing as safe and withdrawing should probably not happen or at least not happen in any sense that could be assigned to a "rate".

@Ego - Based on comments like this http://www.amazon.com/review/R2UIUT6E5N ... deID=&tag= and the disturbingly large amount of emails I've received, there are many people who
1) Think that a 4% SWR(*) is a guarantee because it's a "historical fact" which "they read on a blog/book/forum".
2) Wants to know exactly what kind of investment strategy they should follow so that they may happily stop thinking about their money for the rest of their lives...
3) Wants to rely strictly on investments for multiple decades.

(*) Somehow the Trinity result morphed from a 30 year backtest to a 30 year horizon to an infinite horizon along the way.

It's meant to scare those people. Or at least wake them up.

[George the original one]

Wade Pfau would say that the best way to increase safety is by using an annuity. If you are one of the increasingly few who have a defined benefit pension, then you will already have an annuity.

[Ego]

It's meant to scare those people. Or at least wake them up.

Yeah, but rather than saying the concept of SWR is suspect, they say it is only suspect at 4%.

Edit: Scratch that..... I reread the conclusion.

[slowth]

William Bernstein says 2% is a SWR in the expected low-yield environment. This, however, is far from certain. It's a general guideline, not a law of finance. The idea that save x dollars to allow for a x SWR and you are DONE is a problem. You are never done.

[workathome]

I've ready a couple beginners investing books now that introduce the topic by saying "stocks always go up"

[Felix]

@jacob: Yes, I worried you'd say something like that.

That's why I'd like to get into growing my food and owning my home.

@workathome: yes, also real estate always goes up. They don't make more land is the "bullet-proof reasoning" behind it.

[jacob]

That's interesting on the Bernstein quote. The problem is that low-yield is the Feds' preferred strategy (for the time being)(*). However, they're fighting the problem of a demographic bubble of having paper claims (owned by the older generations) on a decreasing work force (the younger generation). The Fed solution seems to be to inflate the size of the paper claims (increased nominal value inflates the stock market despite the lack of productivity to match) so as to make it possible for retirees to command a relatively larger fraction of the economy. In return, yield, which is a marker for real growth goes down. First ones out the door---realizing that boomers want yield, not growth---benefits^Hed. Last ones pay---expected nominal ROI at these valuations for the next decade is now <3% according the Hussman's econometrics. TANSTAAFL.

(*) Mainly helped along by the market's complete and utter faith in the Bernanke put.---That is derived from the Philips curve (an economic conjecture that inflation decreases unemployment) which apparently does not hold in reality (zero correlation).

[workathome]

Do the elites ever really retire, or are they basically managing their businesses/interests until death? Is retirement just a middle-class dream?

[Felix]

My bet is also that bond yield will go down further in a misguided attempt at solving unemployment with monetary policy. The Philips curve is too simplified to be useful (well, it's wrong You can't mix different causes of inflation in a single graph and get meaningful information out of it).

Inflating would be a way to reduce the share the elderly get of the real economy. If only they did this ...
I'm bearish.

[Felix]

@workathome: Well, you can buy government bonds and then hope that buying yourself politicians doesn't backfire. I also guess things get easier to manage when you have PR agencies including corresponding think-tanks at your disposal.

I also have read that they invest in different things. They put their money directly into startups and also hedge-funds and private equity funds, things that are only available with a certain amount of buy-in money.

[jacob]

@workathome - Retirement is a middle-class boomer dream. Before that generation, retirement was a short period before death. After the boomers, same. Retirement seems to have lived and died with the Defined Benefit era. The question really is ... do you have enough money and enough skill to manage that money to live off of your investments, or not?

Based on limited anecdotal evidence, it seems that elites(*) keep managing their wealth until the end, then hand it over to offspring who manages to hang onto it; then grandchildren who squander it. Apparently wealth-preservation is not genetically transferred.

(*) They have an entirely different perception of money than the middle class and the underclass. To add to what Felix said, rich wealth, with very few exceptions---isn't made in publicly traded companies (secondary markets). It's made in the primary market (IPOs). You gotta know people... Those of us who don't. Well, we're the suckers who invest in publicly traded stocks.

[steveo73]

My opinion is that the 4% rule provides a great goal because it is clear.

I think though that retirement is more the process of building assets that generate income and learning to live within the income level that your assets can generate within reason. Basically you can spend the income of your assets so long as your asset values retain their value. You can of course sell some of those assets over time however you had better be careful when you are doing this.

The less your expenses, the greater the value of your assets and the better your ability to manage your assets the greater your safety net.

I think that anyone who trusts any study that is completed on a massively incomplete data-set is being a little naive. If though you have taken the key points from that study and realise the holes within it you can probably utilise that knowledge to help create a better life for yourself.

[jennypenny]

I'm starting to think that for most people, annuitizing (is that a word?) the part of your portfolio that covers your 'nut' in retirement is a good idea. The rest can be invested.

The people I know with real money don't invest in stocks. They invest in real estate, VC or directly in businesses, art and other collectibles, and MLPs (mostly the southerners).

[Tyler9000]

I personally think the 4% rule is a very well-reasoned rule of thumb to get you on the right track for retirement planning. But it's based on a lot of mathematical assumptions that don't take into account the fluidity of human nature and the real world, and reading too much into equally rigid models of what the future might look like based on economic "projections" is just as academically myopic.

I wonder how many people in history have ever truly lived a 30-year retirement while holding to every assumption of the original 4% rule (always increasing spending exactly by inflation no matter what, rebalancing properly without panicking in down markets or getting greedy in up markets, avoiding all investment classes not stocks or bonds, never earning another dollar, etc). For all the academic talk about how dependable it is, I'd wager that if you looked for a living example of the perfect implementation you wouldn't be able to find one. So not only is it not foolproof looking forward, but it also isn't even demonstratively usable looking backward. Life doesn't act like a spreadsheet.

That said, I do find SWR discussions valuable. The idea that there is a portfolio threshold that can generally sustain a certain level of spending indefinitely is a core concept for early retirement finance. One just needs to realize that the mathematical theory must be further backed up by practical action in order to succeed in the real world. Just because the GPS didn't show that lake on the map doesn't mean it's safe to drive into it.

[Felix]

"I wonder how many people in history have ever truly lived a 30-year retirement while holding to every assumption of the original 4% rule"

Joe Dominguez did it pretty much:

http://www.nytimes.com/1997/01/27/us/jo ... style.html

... at 6%, it seems.

[RealPerson]

Even though 4% SWR is based on matematical assumptions, it really is a big deal when this is called into question. We have been living in an artifically low interest environment for years now. People who did retire on this assumption, may be feeling real pain by now.

A while back, I posted that I am more comfortable with a 1% SWR, as I am financially cautious. Many will find that too conservative, and it would mess up many nice graphs and charts on excel spreadsheets. However, I believe that the odds of a 1% SWR not being sufficient for retirement is virtually zero.

We should be Renaissance people. That is relatively easy at age 40, but may be a little more difficult at 70, after 30 or 40 years of retirement. Maybe now would be a good time to reassess the 4%.