Don’t Believe in the “Safe Withdrawal Rate”
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You’ve been a good saver. Now, as you get ready for retirement, you begin to consider how you will use your retirement savings to generate monthly retirement income. Will you need the advice of a financial advisor? Sensibly, you conclude that you do. You have questions:
- How much can I safely spend each month?
- How much risk should I take?
- How can I protect my financial security if my investments don’t perform well?
To answer these questions, you contact several local financial advisors. You find that when it comes to generating retirement income from your investment portfolio, each of their advice is the same: use the 4% rule. After conversations with these advisors, you’ve come to believe that the 4% rule is the best or the only approach to implement.
What is the 4% rule? It’s a popular methodology for producing income that states you will be able to “safely” draw down annual income beginning at 4% of your portfolio’s value, and then in each subsequent year, you’ll withdraw an amount adjusted for inflation based upon the Consumer Price Index (CPI). The rule assumes that your portfolio is composed of stocks and bonds.
The 4% rule is like dollar-cost-averaging, in reverse. This is but one of its numerous flaws. When you are accumulating money, dollar-cost-averaging is an exceptionally good and well-proven strategy for investing in stocks.
But reversing the process can be fatal to your retirement income.
This is because selling stocks when prices are depressed removes your ability to enjoy gains once stock prices recover. In a prolonged downturn, it’s all too easy to ignite a downward spiral in your investment portfolio’s values that ultimately leads to having no income at all.
Why do so many financial advisors recommend the 4% rule? In part, the past 11 years of unprecedented appreciation in stock prices has caused some to underweight risk. This recency bias makes for a dangerous mindset.
It’s important to understand other weaknesses of the 4% rule. It was developed using “back-testing,” a process that creates projections of future financial results based upon historical investment performance. The justification for the 4% rule was based upon historical investment performance during the period between 1925 to 1995. But what is the value of relying upon historical investment results when today’s economy looks so different than in the past? For example, in 1994, the 5-year Treasury paid an interest rate of 6.69%. Today’s 5-year Treasury pays a little more than 1%.
In recent years, especially since 2008, we’ve seen major structural changes to the U.S. economy. Today, it’s credit growth that drives economic growth. In the pandemic year of 2020, for example, to generate economic growth and to keep pushing stock prices skyward, The Federal Reserve, through the process of quantitative easing, pumped $3 trillion into the U.S. money supply. The Fed’s balance sheet assets now stand at an unbelievable $8.6 trillion. That’s a 1,000% increase since 2008! Is it a coincidence that asset prices have climbed consistently during this period? We are living in a very, very different world, one with radically transformed drivers of growth. Ask yourself: How long do you believe the Fed can continue to print money to keep stock prices high?
In terms of advice for retirees, some in the financial services industry are beginning to focus on these changes. Morningstar recently completed an analysis that recommended lowering the allegedly “safe withdrawal rate” from 4% to 3.3%. I credit Morningstar because it shows that people are rethinking the wisdom of relying upon outdated investment assumptions as justification for assumed levels of income that retirees can “safely” withdraw from their investment portfolios.
But I would go much, much further. There is no “safe withdrawal rate.”
Why do I assert this? A fatal shortcoming lies beneath all the academic papers which have been written over the years and that have relied upon “back-testing” to promote the 4% rule: They assume that the investor never sells any of his or her investments. Consider your own investing experience. During a scary period of market losses or volatility, has fear ever driven you to sell some of your investments? Selling negates the entire premise of the 4% rule.
Fortunately, there are alternative approaches to the 4% rule. Depending upon your investing profile, other strategies may offer you big advantages. You can read about them here.
Wealth2k® founder David Macchia is an entrepreneur, author, IP inventor and public speaker whose work involves improving the processes used in retirement income planning. David is the developer of the widely used The Income for Life Model®, and the recently introduced Women And Income®. David has authored many articles on the subjects of retirement income planning and financial communications. He is the author of two books, Constrained Investor®, and Lucky Retiree: How to Create and Keep Your Retirement Income with The Income for Life Model®.