How sacred is the 4% rule of thumb?
In my previous article I discussed a couple of financial planning rules of thumb, including the 4% rule which states that if you withdraw 4% from your retirement portfolio annually (adjusted for inflation), your savings will last for 30 years. This assumes that you've invested strategically for risk and have a balanced portfolio (typically 50% equity and 50% interest-bearing investments).
The 4% rule can also assist in determining the amount of capital you need for retirement. For instance, if you need R30,000 per month in today's terms, the 4% rule of thumb will determine that you need a lump sum of R9 million when you retire. (All figures are pre-tax.)
As the world stares down an unprecedented financial and health crisis, the question on many people's lips is how sacred is this rule?
In the beginning
The Californian financial planner Willem Bengen first proposed the rule in the 1990s. The basis of the rule was to consider different withdrawal strategies through various investment cycles, including crashes, and to identify the withdrawal rate that would have succeeded in the one worst scenario in history.
The relevance of the 4% rule in current times
Even before the Covid-19 crisis, many people have spoken out against the 4% rule's one-size-fits-all approach. It's well nigh impossible, critics say, to come up with a rule that can account for varying time horizons, interest rates, market returns, inflation rates and fund management fees. A 2010 paper by Wade Pfau pointed out that the "US enjoyed a particularly favourable climate for asset returns in the twentieth century," and argued that "from an international perspective, a 4% real withdrawal rate is surprisingly risky."
The main problem with the 4% rule
What is known as 'sequence of returns risk' is the most significant risk to a retirement plan that's based purely on the 4% rule, without paying heed to what's going on the market. Put simply, suffering negative returns early on in your retirement is far more damaging than suffering these same returns later in your retirement. Early negative returns will have a lasting negative effect that reduces the total amount you can withdraw over your lifetime.
Ignore portfolio volatility at your peril
Recent research by Ninety One has shown that sequence of returns risk makes income-producing portfolios much more sensitive to portfolio volatility than other capital. Their modelling showed that even if investment returns and income drawdowns remained identical, increasing the portfolio volatility from 9% to 15% raised the risk of a living annuity failing almost threefold over 30 years. The research indicated that for every 1% reduction in the level of volatility of the investment portfolio's real returns, the investor could receive an additional 0.3% of sustainable income every year.
So does the 4% rule still work as a guideline?
I still believe that the 4% rule works well as a rule of thumb to help people understand the relationship between retirement capital and income. It's a useful yardstick when you're making decisions in a complex and dynamic environment.
But as Ninety One’s research shows, there's far more to prudent retirement planning than setting up a balanced portfolio and applying the 4% rule. You (and your financial planner) should regularly review the asset allocation of the retirement portfolio while also keeping the volatility and drawdown rate in check. It's probably a good idea for most retirees to temporarily decrease their income because of the impact the Covid-19 crisis is having on the markets. (Bear in mind that many earners are having to do the same thing at the moment.) And, it's never wise to increase your income by inflation annually regardless of the performance of the fund.
That said, despite the tumbling markets and the grim immediate outlook, it's essential to maintain a substantial equity component in a retirement portfolio. This is not the time to bail out of equity into cash and lock in a loss. The Ninety One’s research shows that for a 4% drawdown, a retirement portfolio needs at least 60 % invested in growth assets.
It's only fitting that the last word on the subject should go to the creator of the rule, Bengen himself. In an interview with the New York Times, his advice to those saving for retirement was to "go to a qualified adviser and sit down and pay for that. You are planning for a long time," he added. "If you make an error early in the process, you may not recover."
Can't argue with that.
Hardi Swart is director of Autus Private Clients and Financial Planner of the Year 2019.