Should Retirees Expect Less Moving Forward? Can We Save The 4% Rule?

by: Dale Roberts

Summary

A retirement funding standard is the 4% rule, that we might be able to spend 4% of portfolio values, adjusted for inflation.

In the present environment, are we constrained due to low interest rates, low bond yields, and lower earnings yields for stocks?

Should retirees aim for that 4% spending rate, or adjust for the times?

Is there a way to save the 4% rule?

What worked in the past does not necessarily work in the future. Yes, that is stating the obvious. As we often repeat, in the land of investments, "past performance does not guarantee future returns". While a traditional Balanced Portfolio has treated retirees to generous returns over the last few decades, the past may not repeat due to the current state of low bond yields. In this article How Retirees Made It Through The Last Two Recessions, charts demonstrated how the simple allocation to large-cap stocks and bonds provided a wonderful 1-2 punch courtesy of Vanguard's managed (VWELX) and (VWINX) funds. What we should take into consideration is bonds 'used to pay' a little something back in the days of the last two recessions. These days? Not so much.

A 7-10 year Treasury fund will pay you in the area of 2.6% these days. And, of course, over a shorter time period, that yield could get wiped out due to some increases in rates or bond demand that can move the Treasury markets. As you know, when yields increase, bond prices decrease; there's an inverse relationship. The reason for that inverse relationship is that with higher yielding bonds now being available, the bonds with lesser yield need to be discounted in price to compensate. Bonds might now deliver that negative 1-2 punch - low income payments and price risks.

Now, keep in mind if you hold a bond your payment will continue as long as you hold that bond, default risk accepted. Your bond fund might keep a level of consistency with respect to income. So, at the core, you are likely still receiving that fixed income in the area of 2.5-3% depending on the duration and level of bond risk you are able to accept. For the sake of argument or demonstration, and based on the current yield for higher quality government and corporate bonds, we'll use a 3% current yield. As you may have noticed, that 3% is below 4%, so the stock component will have to pick up the slack to bring the spending rate up to 4%, and the stocks will have to cover for the inflation adjustment. In a 60-40 Balanced Portfolio with 60% stocks and 40% bonds, that 3% bond income would cover 1.2% of the 4% spending needs, meaning 2.8% has to come from that 60% stock component. The stocks would have to deliver a 4.7% average rate of return that also increases over time.

4.7 x .60 = 2.82

Now that may not sound like a great task for stock markets, but consider that the current earnings yield for the S&P 500 is 4.13%, according to multpl.com.

We are not covered by the current earnings of S&P 500 companies as an index, so we are relying on the growth of those companies to cover the additional spending needs and to compensate for inflation. Currently, multpl.com shows a recent trend of generous earnings growth.

Of course, that growth can quickly turn to earnings declines as we look down that chart to the recession years of 2007 and 2008. It appears that a retiree that invests in higher quality bonds and the broad large-cap stock market is relying on earnings growth to fund retirement at that 4% spending rate, if that retiree is attempting to create durable income and maintain that spending for decades. With low bond yields and higher stock valuations, there is certainly not a lot of room for error.

Now, certainly, a retiree may choose to increase the bond income by moving to lower quality/higher risk bonds or bond funds. The current yield on the iBoxx USD Liquid High Yield index is the range of 5.5%. That retiree might also attempt to cover spending needs with bigger dividends. Those bigger dividends might also bring increased risks as big dividend payers can be closer to being maxed out with respect to the amount of free cash flow that they pay out as dividends. That said, the yield on the FTSE High Dividend Yield Index is just above 3%. The yield on the S&P High Yield Dividend Aristocrats Index is just 2.78%. Certainly, retirees could also move into higher yielding REIT funds and other income-based assets such as BDCs and MLPs, but once again, we might be taking on additional risks. As the saying goes...

More money has been lost reaching for yield than at the point of a gun.

Retirees might simply curb their enthusiasm or expectations. The current environment might present its challenges in the future, but it's all likely not worth the worry. We might make hay while the sun shines, but be prepared for those cloudy days. The recent US stock market performance has presented a wonderful opportunity for many to enjoy a very fruitful retirement over the last several years. Maybe the stock market run continues for many more years? We simply don't know what the future holds. But we should be prepared for severe market downturns and recessions. Managing portfolio risks might be a key.

Adjusting spending needs might also be a consideration. There's no golden rule that states we have to spend at that 4-4.5% rate (at least until mandatory withdrawal rates kick in). When the option is available, retirees might simply adjust that spending rate of portfolio assets should we enter a recession or major market correction sans recession. Also, retirees might simply be comfortable with drawing down their portfolio assets (value) to a predetermined level. We might determine what is our Personal Value of Money. That is to say that money has more value when we are in the early stages of retirement when we have good health, compared to later years when we might not have the ability to truly enjoy those monies. Early in retirement, we also might want to share our wealth with family while we can watch them enjoy the fruits of our labour. The value of money and when we spend it is very personal. A retiree might create a very conservative portfolio, knowing that it is likely to decrease over time. Of course, we should understand our own longevity risks. What if we do live to the age of 90, 95 or 100?

Given the times and the stage of the stock market bull run, retirees might want to read these two articles that I penned on extensive de-risking at retirement start date. The retiree moves to a very conservative asset allocation and then conducts an equity glide path, moving monies back into the stocks by the way of dollar cost averaging. Here's What If A Retiree Went All To Cash and Bonds followed up with More on Retirees Going All to Cash and Bonds. From the second article, you'll see that the sweet spot includes maintaining some equity exposure at the retirement start date.

Thanks for reading. Hit that Like button if you like. Please share your thoughts on retirement for the times.

Please always know and invest within your risk tolerance level. Always know and understand all tax implications and consequences.

Happy Investing. Happy Retiring.

Dale

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.

Additional disclosure: Dale Roberts is an Investment Funds Advisor at Tangerine Investment Funds Limited a subsidiary of Tangerine Bank, wholly owned by Scotia Bank; he is not licensed to provide professional advice on stocks. The opinions expressed herein are Dale Roberts' personal opinions relating to his experience as an investor and are not those of Tangerine Bank or its subsidiaries and/or affiliates. This article is for information purposes only and does not constitute investment advice or an offer or the solicitation of an offer to buy or sell any securities. Past performance is not a guarantee and may not be repeated. Investment strategies are not suitable for everyone and you should always conduct your own research or speak to a financial advisor.