It amazes me that there are so many adherents to the 4% rule for retirement withdrawal rates. It is a bad rule for many reasons, including one that is obvious.
It bases inflation adjusted withdrawals throughout retirement on the level of assets at the beginning of retirement. This could only work well if all the assets are liability matched with real bonds. However, nearly everyone has volatile risky assets included in their retirement portfolio. It is almost a certainty that such a rule will either result in unspent assets, if stocks perform well, or result in overspending, if stocks perform poorly. In other words, any sound withdrawal strategy for a portfolio that includes volatile assets (such as stocks) must calculate the withdrawal rate for each year based on the portfolio asset level in that year – not the initial asset level at the beginning of retirement, and then adjusted for inflation over time.
There are many articles criticizing the 4% rule that are readily available, but I am going to focus on three. The first is by Nobel laureate William Sharpe et al. and focuses on the weaknesses of the 4% rule. A key quote.
This rule and its variants finance a constant, non-volatile spending plan using a risky, volatile investment strategy. As a result, retirees accumulate unspent surpluses when markets outperform and face spending shortfalls when markets underperform.
Link to The 4% Rule – At What Price?
The other two papers are by Wei Sun and Anthony Webb and published by the Center for Retirement Research at Boston College.
Should Households Base Asset Decumulation Strategies on Required Minimum Distribution Tables?
Link - https://crr.bc.edu/wp-content/uploads/ ... 10-508.pdf
Can Retirees Base Wealth Withdrawals on the IRS’ Required Minimum Distributions?
Link - https://crr.bc.edu/wp-content/uploads/2 ... 19-508.pdf
The first of the above two papers compares the efficacy of four rule of thumb withdrawal rates to a theoretically optimal withdrawal rate.
The four rule of thumb withdrawal rate strategies are –
1.) Spend only interest and dividends
2.) Life expectancy withdrawal rate (uses the annuity factor)
3.) fixed percentage of initial wealth each period in real terms (the 4% rule and its variants)
4.) RMD rule
The above life expectancy rule is Withdrawal Amount = r/[1-(1+r)^-n] x (portfolio value in current year)
Where n is life expectancy for your current age and for r, I would use the rate for TIPS at .5n, the duration of a real fixed term immediate annuity of fixed term n. This, of course, doesn't mean that you should purchase a real fixed term immediate annuity. It is simply a method to calculate your portfolio withdrawal rate.
Here are their main conclusions.
When deciding how rapidly to decumulate their wealth, households will likely fall back on rules of thumb. We show that two of the rules of thumb that households might plausibly adopt -- spending the interest and dividends while preserving the capital, and consuming a fixed 4 percent of initial wealth – can be highly sub-optimal. A strategy of using the RMD tables often performs better, but still represents a substantial departure from optimality.
… The RMD strategy is sometimes outperformed by a strategy of spending down over the household’s life expectancy. But, as mentioned previously, the effectiveness of this strategy is highly sensitive to the coefficient of risk aversion and proportion of pre-annuitized wealth.
The second paper by Sun and Webb considers a fifth rule of thumb strategy.
5.) Use RMD withdrawal rate plus dividends and interest.
A criticism of the RMD rule is that it somewhat restricts spending in the early years of retirement when the elderly are typically more active. The RMD rule can be adjusted by adding dividends and interest to the portfolio withdrawal amount. Such a strategy would likely result in bigger withdrawals in early retirement relative to late retirement, but that is a spending plan many retirees prefer. Since most people retire before age 70, the authors have included a table in the appendix with calculated RMD rates starting at age 65.
Sun and Webb conclude the second paper with the following.
Rather than attempt the complex calculations necessary to arrive at an optimal strategy for drawing down and spending their retirement savings, retirees rely on easy-to-follow rules of thumb such as the 4-percent rule advocated by some financial planners. This brief suggests that the IRS’ Required Minimum Distribution rules may be a viable alternative. For financial and practical reasons, the effectiveness of the alternative RMD strategy compares favorably to traditional rules of thumb. And a modified RMD strategy does even better.
Two more observations about the 4% rule compared to the RMD and life expectancy rules.
1.) A complaint sometimes made of rules based on each year’s level of assets, is that the withdrawals will vary from year to year as volatile assets move up and down. That’s true. But don’t blame the messenger! If you don’t want withdrawal amounts fluctuating over the years, lower the allocation to volatile assets.
2.) Adherents to the 4% rule claim that you need to be flexible when applying the rule. But flexibility turns out to be guessing how to adjust the rule when assets are either significantly higher or lower than was previously expected for a given year. Flexible guessing isn’t much of a strategy. Better to rely on a dynamic rule that adjusts automatically, such as one of the RMD rules or the life expectancy rule.
While the life expectancy rule and the RMD rules are more robust than the 4% rule, all withdrawal rate rules of thumb have deficiencies. A close to optimal portfolio withdrawal rate is affected by many things including the amount of Social Security and db pension benefits, the distribution of portfolio assets between regular and tax advantaged accounts, how risk averse the members of the household are, and the composition of the household, e.g., a couple or the survivor.
Milevsky and Huang consider some of the most important of these issues in their paper,
Spending Retirement on Planet Vulcan
. Here is a key take-away.
The main point of our study can be summarized in one sentence: The optimal portfolio withdrawal rate (PWR) depends on longevity risk aversion and the level of pre-existing pension income. The larger the amount of the pre-existing pension income, the greater the optimal consumption rate and the greater the PWR.
The pension acts primarily as a buffer and allows the retiree to consume more from discretionary wealth. Even at high levels of longevity risk aversion, the risk of living a long life does not “worry” retirees too much because they have pension income to fall back on should that chance (i.e., a long life) materialize. We believe that this insight is absent from most of the popular media discussion (and practitioner implementation) of optimal spending rates. If a potential client has substantial income from a DB pension or Social Security, she can afford to withdraw more—percentagewise—than her neighbor, who is relying entirely on his investment portfolio to finance his retirement income needs.
Link to paper –
https://www.soa.org/globalassets/assets ... levsky.pdf
In summary, the best withdrawal rate strategy is to use a sound financial planning software such as MaxiFi to calculate your portfolio withdrawal rate. Such a tool needs to take account of SS & db pension benefits, the distribution of portfolio assets between regular accounts and tax advantaged accounts, the composition of the household, and be able to at least take some account of the household’s risk aversion. I realize most people won’t do that. So, if you are going to use a rule of thumb, don’t use the 4% rule or one of its variants, or the spend only dividends and interest rule. Instead use the life expectancy rule or one of the RMD rules. And informally take account whether you have a relatively large amount of SS & pension income relative to your portfolio, or a small amount and make an adjustment to the pwr up or down. Also take account how longevity risk averse you are. If you are using the life expectancy rule - raise your life expectancy if you are are worried about outliving your money. If you are using RMD and are worried about outliving your money stick closer to the RMD, rather than the RMD plus dividends and interest.
In finance risk is defined as uncertainty that is consequential (nontrivial). |
The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.