Is The 4% Rule Becoming The 2% Rule?

by: David Van Knapp

Summary

A new paper from a noted retirement expert suggests that safe withdrawal rates in retirement are down around 2% in the first year of retirement.

The reasons include low interest rates, an overvalued stock market, and advisory fees.

Does the 2% rule make sense?

In 2013, I published "Is the 4% Rule Becoming the 3% Rule?" The article was based on a study published by Morningstar, authored by David Blanchett, Michael Finke, and Wade D. Pfau. Mr. Pfau has won numerous awards in the retirement planning field. He is a Professor of Retirement Income at The American College for Financial Services in Bryn Mawr, PA, and he also serves as the Director of Retirement Research for McLean Asset Management and inStream Solutions.

The 2013 study's conclusions were startling. After constructing a model MPT-type portfolio and running Monte Carlo tests of return scenarios that utilized factors deemed to be more realistic than those used in prior studies, the authors found:

  • A significant reduction in "safe" initial withdrawal rates across the board.
  • A 4% initial real withdrawal rate had only a 50% probability of success over a 30-year period. ("Success" means that you don't run out of money.)
  • A retiree who wants a 90% probability of success over a 30-year time horizon from a 40/60 stock/bond portfolio would be able to use only an initial withdrawal rate of 2.8%.

The 4% Rule, of course, is the common rule of thumb in the retirement-advice industry that a 4% withdrawal rate is safe for a 60/40 mix of stocks and bonds. The initial withdrawal amount is incremented each year for inflation, and a 30-year time period is considered to be a standard length of retirement.

Mr. Pfau has studied the same subject again. He recently co-authored a paper, available through Financial Advisor magazine, which concludes that the safe withdrawal rate may have dropped under 2%. His co-author this time is Wade Dokken, Co-Founder and Co-President of WealthVest Marketing.

The main reasons that the authors reached the 2% conclusion are:

  • They accounted for fees for both financial advice and fund management.
  • They incorporated the heightened sequence of returns risk facing retirees in the current low-yield and high-valuation world.
  • They ran the simulations out to 40 years in the belief that 30 years is increasingly no longer a conservative planning horizon for 65-year-olds.
  • Their simulations reflect the market environment as of the start of 2015. Because they find this to be an unusual period of low interest rates + high stock valuations, their models provided mechanisms for market returns to gravitate toward historical averages over the retirement horizon.

The authors illustrate that the low interest rate and high stock valuations facing today's retirees are historically unprecedented in combination. Using their models, the authors concluded that, starting in 2015, these are the "safe" spending rates for various stock/bond mixes using an annual 3% increment in withdrawal amount to account for inflation:

As you can see, they concluded that the safe spending rate for a 60/40 portfolio and a 30-year time frame is 1.7%. If the time frame is stretched to 40 years, it becomes 1.3%. In both cases, the safe rate is defined as one that has a failure rate of 5%.

If one widens the definition of "safe" to allow for a 10% chance of failure, the 30-year safe withdrawal rate rises to just about 2%, and the 40-year rate becomes 1.5%.

The authors point out that with a volatile investment portfolio, there is no such thing as a guaranteed spending rate.

A more realistic assessment of sustainable spending from a volatile investment portfolio does suggest that the 4% rule-of-thumb for retirement spending is considerably more risky than many realize. These numbers may seem low, and it is true that there is still upside potential for these strategies to end up doing better with the investments in the volatile portfolio, but this is the reality for clients self-managing market and longevity risks, paying fees, and entering retirement in the current market environment.

To further help understand and critique the new paper, I have constructed a Q-and-A sequence.

Q: What is sequence-of-returns risk?

A: It is the heightened vulnerability that a retiree has to bad early returns once he or she is spending from their portfolio. Poor returns early in retirement mean that the sustainable withdrawal rate may be well below what would be computed by using average portfolio returns over the whole retirement period.

For example, if one assumes a steady return of 5% a year, then 5% is a safe withdrawal rate; it won't even deplete principal over the years. If you allow depletion, the safe rate can go even higher.

Poor returns in the first few years of retirement may create a deficit that cannot be undone by higher returns later.

Q: Why is prior research into safe withdrawal rates considered flawed?

A: Pfau and Dokken state that "it is a fallacy to conclude that just because the 4% rule worked in the U.S. historical data, it can be expected to continue to work just as well for today's retirees."

They feel that the problem with using only back-tested outcomes with historical data is that future outcomes will likely be less, given current conditions as a starting point.

Take stocks, for example:

Future stock returns depend on dividend income, growth of the underlying earnings, and changes in the valuation multiples placed on those earnings. If the current dividend yield is below its historical average, then future stock returns will also tend to be lower. When price-earnings multiples are high, markets tend to exhibit mean reversion and relatively lower future returns should be expected.

Similarly as to bonds:

Returns on bonds, meanwhile, depend on the initial bond yield and on subsequent yield changes. Low bond yields will tend to translate into lower returns due to less income and the heightened interest rate risk associated with capital losses if interest rates rise.

The authors hold that current market conditions are much more relevant than historical averages. They maintain that today's current combination of low bond yields and high stock market valuations suggest that the situation today is "uncharted territory," given that Shiller's cyclically adjusted price-to-earnings ratio (PE10) is well above historical averages and bond yields are at historic lows.

Q: How unusual are today's market conditions?

A: The authors present the following graphic to illustrate that today's conditions are historically unusual.

As can be seen in the graphic, no time period other than the present has had both the 10-year Treasury rate under 2% and the Shiller PE10 above 26 at the same time.

The historical average of the 10-year Treasury is about 4.7%. It stands today as I write this at 2.07%; when the paper's research was done in January 2015, it was 1.88%. It has been meandering around 2% since 2012.

The historical average of the Shiller PE10 is 16.6. Today, it stands at 24.5. That suggests lower future stock returns as the multiple regresses toward average values.

Source: Doug Short

Per the authors, "even if we assume that the historical risk premium for stocks and other asset characteristics remain the same, but we adjust the average return on stocks and bonds downward to reflect today's lower bond yields, we will obtain higher failure rates for the 4% rule."

Q: What is a conservative retirement time span to model?

A: The Society of Actuaries publishes estimates about life expectancies. According to the new paper, in 2000, they estimated a 31% probability that at least one member of a 65-year old couple would live beyond their 95th birthday. By 2012, this probability rose to 43%.

Thus, the authors state, "A 30-year horizon is becoming the life expectancy, and it is no longer a conservative number."

Q: What changed since 2013?

A: Mr. Pfau modeled safe withdrawal rates that have come down from around 3% in 2013 to around 2% today. In the 2013 paper, Pfau and his colleagues took most of the current paper's factors into account: low interest rates, sequence risk, allowing bond yields to drift upward over time toward historical averages, and modeling both 30- and 40-year time frames.

However, some inputs changed. First, in the 2013 paper, the model's starting input for bond yield was 2.5%. In the 2015 paper, it was 1.88% This is a significant difference.

Second, the new paper added fees and expenses for mutual funds. In 2013, the authors used 1.0% as a proxy for advisory fees that were likely to be paid by an investor. The input for combined advisory and fund fees into the current model were jacked up to 1.67% for stocks and 1.6% for bonds.

Finally, it is likely that the input for expected stock returns beginning in 2015 was lower than the input used in 2013. I do not have exact numbers on that factor.

Discussion and Critique

I personally do not find much to criticize in the new paper except the use of Shiller's PE10 and the presumption of fees in the 1.6%-1.7% range. The methodology itself seems sound.

But inputs matter. My feeling is that PE10 distorts market valuations, and in particular right now it overstates market valuation by quite a bit.

The current value of PE10 is 24.5 compared to its long-term average of 16.6. That suggests that the stock market (for which the proxy is the S&P 500) is nearly 50% overvalued. Using Doug Short's two regressions from the chart above, it could also be argued that the market is 77% or 29% overvalued.

The reason I think this is a distortion is that the PE10's 10-year look-back period still includes the high valuations in 2007-2009. The PE10 has never been higher than that period, except in 1929 and 2000. When those valuations fall off the calculation starting in 2017, the PE10 will fall back toward historically normal levels, just because of the elimination of unusual values from the calculation.

For a comparison, Morningstar's current fair value estimate for the stock market, based on its individual fair values for the stocks in its coverage universe, suggests that the market is 7% undervalued right now.

My problem with the 1.6% input for advisory fees and fund expenses is that they can be avoided by many self-directed individual investors. Many SA readers do not employ advisors at a charge of 1% per year and fund expense ratios of 0.6% are very high in my experience. If you add fees of 1.6% back into a withdrawal rate of 2.5%, you are back above the 4% Rule.

A couple of weeks ago, Roger Nusbaum published an article, "Say Goodbye To The 4% Rule?" discussing Pfau and Dokken's new paper. Mr. Nusbaum was skeptical of the new low 2% safe withdrawal rate:

1.49%? Get a grip, it is not that dire for a whole bunch of reasons. For a little context of my own, a 4% withdrawal rate invested in cash at zero percent will last 25 years. That is not a recommendation obviously as 4% of $X in 2040 would be worth a lot less than today (could easily be a 50% inflation haircut) but that point has helped conversationally to make the point.

A 4% withdrawal rate can still work, but it has always been the case that 3.5% would be better and 3.0% would be better still. It is also not a good assumption to think you'll never spend principal. If you have taxable accounts, a Roth IRA and a traditional IRA it likely will make sense to deplete an account for maximum tax efficiency and then move on to the next one which as I have said before will be uncomfortable at first.

A much bigger threat to financial plan success in my opinion are human factors related to poor decision making (panic selling after a large decline) and spending habits that are clearly unsustainable. Some folks will do all the right things but have some sort of bad luck (grown children who get into trouble or some sort of health event that requires going deep into savings) but like market results, bad luck is beyond any reasonable control.

Also missing was the idea that people adapt to whatever their financial reality becomes, many people do anyway. I've written hundreds of posts about people I've encountered who have adapted one way or another as well as sharing articles from others that also address different ways to adapt.

My own way to get a grip, of course, is to arrange things so that more of your retirement income comes from equity dividends. If you have a portfolio of dividend growth stocks that yields 4% and whose income rises every year due to dividend increases, you pretty much have the 4% rule covered right there.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.