Can Your Retirement Survive
a Low Return Environment?
I originally wrote this post in May 2015, and I’m leaving it largely intact, with a few amendments.
How much retirement income can you expect if the stock market doesn’t produce the types of investment returns that you’re anticipating during your retirement years? It’s no longer a secret that retirees are facing multiple challenges as they transition into their retirement years. Longevity, for one, is becoming a real risk for the Baby Boomer generation since it amplifies the impact of several other risks retirees may face: inflation, adverse health events, cost of healthcare, legislative and market risk. Now, it seems that some baby boomers may be building their retirement income plan using flawed market return assumptions as well.
Are you relying on the “The Number"?
One of the most commonly used rules for distribution portfolios is what’s known as the 4% rule. This rule originated from research done by William Bengen, who determined that an individual could safely withdraw 4% of the assets accumulated at retirement, adjust their spending for inflation, and have their portfolio survive a 30-year retirement period.
(Bengen used portfolios that adjusted between 50% to 75% stocks, with the remaining percentage in bonds).
As you might expect, this rule has helped frame the conversation around how much one needs to retire for years. The 4% rule and its many derivatives are highly favored by firms that primarily focus on asset management for clients. Here’s how it could work in theory: If you’d like to have around $40,000/year in income from your investment portfolio, the rule of thumb is that you’d need a cool 1 million of investable assets. (4% X 1 million = $40,000)
It has been over 20 years since the original findings came from that study, and since then, there has been additional research findings:
- Bengen’s original work did not account for taxes, advisory fees, or healthcare costs
- Diversification can actually help increase safe withdrawal rates
- Market valuations at the beginning of retirement have a disproportionate impact on portfolio success
- Like many academic studies, it assumes perfect investor behavior during periods of market volatility
Since the original research was formed, there have been many variations of the rule proposed. For the sake of this conversation, we’re going to keep it simple and focus on the philosophy behind the 4% rule and how it may impact retirees today, especially if retiree portfolios do not perform as expected.
History versus Today
There’s an old saying that is often quoted in the financial services industry, “Nothing beats the market over time.” The key word in that entire sentence is time. If you look at a long enough time horizon, equity returns are usually quite compelling. One of the most serial offenders for abusing this principle is Dave Ramsey. (In the spirit of fairness, I will concede that I like Dave, and I think he is a great motivator in teaching people about the dangers of consumer debt. However, Dave is not a financial planner—something he openly admits.) For years, Ramsey has promoted that people can invest in certain mutual funds and earn average returns of 12%, backing up his assertion with historical returns from 1926 until the end of 2012. That is a 90-year time horizon for growth that I’m sure assumes perfect investor behavior; however, I would argue that, for retirees, what matters to them is their time horizon.
How Do You Feel about Portfolio Failure?
One view that became popular more recently came from the study done by Blanchett, Finke, & Pfau. In their study from 2013, “The 4% Rule is Not Safe in a Low-Yield World,” they found that-
“if we calibrate bond returns to the January 2013 real yields offered on 5-year TIPS, while maintaining the historical equity premium, the failure rate jumps to a whopping 57%,” which led to the conclusion that “the 4% rule cannot be treated as a safe initial withdrawal rate in today’s low-interest-rate environment.”
Naturally, some would argue that rates are due to rise, and they continued their study as if rates did indeed increase in 5 years and/or 10 years. In the 5-year scenario, the failure rate was still at 18%; and for rate increases that occurred in 10 years, the failure rate was 32%—roughly 1 out of 3 portfolios would fail.
The emphasis for me came with the statement,
“The bottom line is that the current low-yield environment is a retirement income game changer. And hoping that things will get better eventually is a risky strategy...By relying on 20th century market returns which we may never see again we’re giving people a false sense of security.”
Finke then explains to advisors:
“I think an advisor has to think more carefully about constructing a retirement income portfolio that includes safeguards to prevent disaster if a client runs out of money.”
*Quotes from Finke were pulled from an interview he did with ThinkAdvisor and the actual white paper itself.
2020 Update: We are in the middle of a pandemic that has once again seen the Federal Reserve return to zero percent interest rate policy. The yield on the US 10-year bond is .64%
As you can see, retirement income solutions are becoming more frequently debated and discussed; and increased awareness will be necessary due to the massive number of Baby Boomers retiring every day. I am concerned, however, that there are many individuals who are retiring on the idea that having a set “number” will be a panacea for their retirement income needs.
For this reason, we have chosen at our firm to focus intently on the cash flow side of retirement. Retirement is a season of life that requires certain outcomes, and we seek to protect income sources first and foremost for our clients. No matter how hard we try, we cannot force the equity markets to cooperate with our goals. Even the best laid plans can succumb to unexpected events like black swans.
What we MUST focus on is the things we can control—and build our plan to be flexible and resilient. If we have a retirement income plan intact, we are then able to construct portfolios that can give us the best chance for realizing our long-term investment goals.
As more and more Boomers retire and age into their retirement years, effective retirement income strategies will be paramount to their success. This is why social security claiming strategies are becoming an integral part of retirement income planning, and it’s also a reason that annuity income is beginning to see more and more praise in the academic world. Hopefully, this increased demand for cash flow and income security by the retiring Boomers will continue to be a driver of public awareness for the importance of having a comprehensive retirement income strategy and rewire future generations to consider cash flow generation over a specific account balance.
Investment advisory and financial planning services offered through Planners Alliance, LLC, a SEC Registered Investment Advisor. Subadvisory services are provided by Advisory Alpha, LLC, a SEC Registered Investment Advisor. Insurance, Consulting and Education services offered through Vertex Capital Advisors. Vertex Capital Advisors is a separate and unaffiliated entity from Planners Alliance, LLC and Advisory Alpha, LLC.
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