If your answer is "no" to any of the following, you should keep reading:
For half of my career, I've been surrounded with leading Academics in economics and finance that catered to a mostly institutional audience. During this time, a lot of my energy was heavily focused on how to better understand the science of investing, which included extensive quantitative data and/or leading academic research. The more difficult task was often how to share these academic findings and solutions to individual investors around the country. As a result, I spent several years educating and "translating" how these best ideas could help individual investors have a successful investment experience.
Today, I continue these efforts for my own Firm as it helps my clients implement more holistic wealth management solutions. However, in recent years I've also worked closely with numerous academic thought leaders on how to help investors transition from accumulation mode (working years) into an appropriate retirement income solution.
If you recall, in Part 1, we shared a lot of common questions, considerations, and concerns as it related to how to best position one's assets for the future. In Part 2, we proposed ideas about what the proper household asset allocation could be as well as how it can benefit investors in retirement.
In Part 3, we direct our attention to the investor who is considering retirement (or perhaps already in early retirement). We know from experience that many at this stage of their lives want to know whether their current strategy will provide them with a sustainable lifetime income.
Is Bengen’s Four Percent Rule Still Relevant?
How much should retirees safely withdraw each year? Key Takeaways:
The calculus of retirement planning has changed as people live longer in an era of extended low interest yields, inadequate nest egg accumulation, market volatility and high medical costs.
SAFEMAX refers to the highest sustainable withdrawal rate for the worst-case retirement scenario in a retiree’s lifespan.
Sequence of return risk refers to the danger of receiving lower (or negative) returns, which substantially deplete assets, in the early stages of one’s retirement.
Some of you may remember William Bengen, the trailblazing advisor who in 1994 first proposed the concept of a “levelized” withdrawal (SAFEMAX) from an investment account. His research was predicated on the 1992 Ibbotson Associates’ Stocks, Bonds, Bills and Inflation Yearbook. This data was used to determine whether a portfolio invested in stocks and bonds could sustain a four percent withdrawal rate over an extended life expectancy. His conclusion was that retirees could withdraw 4.2 percent of their nest egg every year with confidence that their money would last for 30 years. Is this still valid today?
Financial advisors are helping clients cope with the reality of retirement. This reality includes living longer, extended low interest yields, inadequate retirement accumulation and market volatility, not to mention the impact of inflation and high medical costs. The question of “Where should I invest my money?” is being asked more and more frequently.
So is Bengen’s recommended withdrawal rate still valid today? Since his inaugural quest, many academics have attempted to modify his four percent analysis to include “Monte Carlo” simulation, more sophisticated asset class allocations and strategies to protect capital from sequence risk. The conclusions are varied, with estimates the SAFEMAX rate could be as high as 5 percent or as low as 2.5 percent.
Sequence of Return Risk
The issue for many clients and their advisors is sequence of return risk. Over the past 90 years, the stock market has returned, on average, 10 percent (with dividends reinvested). But again, that’s the average. It is the down years—which we potentially face in any given year--that can impact the risk of running out of money. So it is important for retirees to protect themselves against a protracted down market. Based on the data, the market has never been down for five consecutive years, even during the Great Depression.
A possible solution would be for clients to split their money into two funds. One is their income fund and the other is their growth fund. Set aside five years of income in the income fund and then invest the rest in the growth fund. By doing this, they can drain the income fund without negatively impacting their growth fund. In those years when their growth fund increases, they can refill their income fund. By using this strategy, it prevents you from having to liquidate in a down market. Of course, there are no guarantees.
Rising Equity Glide Path
For some investors, using a Rising Equity Glide Path may be a better alternative. The basic idea is that your stock exposure should increase, rather than decrease, as you age in retirement. While this may be counter intuitive, the reality is that the time to be most conservative is at the beginning of retirement, not in retirement. Why: Because your portfolio is most vulnerable to risk right after you retire. Should the market experience a significant drop during the first few years of your retirement, then it’s difficult to rebuild your nest egg without going back to work. Therefore, it can be wise to maintain low stock exposure in the beginning of retirement when you may be most vulnerable. But since stocks have historically risen over the long-term, gradually increasing your exposure over time increases your odds that your portfolio will last into your later years.
Other options include annuities or a laddered bond approach using inflation adjusted bonds. A pension income secures a guaranteed benefit for life. But it all depends on the amount of capital someone has accumulated. Don’t forget how powerful Social Security can be for many retirees. If retirees can push back their normal retirement date until age 70, their benefit will grow eight percent every year until they start taking their income. Also, since Social Security has an inflation boost each year, it is a way for retirees to keep pace with purchasing power pressure.
The question remains: What is the SAFEMAX rate? Despite all of the studies that have been done, no one knows for sure. Markets are unpredictable. But one thing is for certain; the coming influx of retirees (including those who have already retired) is going to have to navigate these troubled waters. So, advisors who can help clients find a safe harbor for a reasonable time frame and then invest the rest will provide a meaningful benefit to those clients.
We are here to help.