Wednesday, June 24, 2015

Will “Ratcheting” the 4% Rule Make it Less Insane?

Long-time readers of this blog know that I have no love for the 4% Rule.   It has a number of deficiencies when compared with the Actuarial Method advocated in this website, including:
  • It doesn’t coordinate well with other fixed-dollar sources of retirement income such as pension income, immediate income annuities or deferred income annuities. 
  • It doesn’t anticipate a specific bequest motive.
  • There is no spending flexibility from year to year.
  • There is no adjustment process for actual experience, spending deviations or changes in assumptions about the future.
  • After the initial year, it is not based on how much assets you have or on how long you expect to live.
  • It is a “set and forget” strategy that requires the retiree to have faith that it will work in the future based on analysis of historical returns that may have absolutely nothing to do with future returns. 
  • It doesn’t accommodate a retiree’s desire to have different spending pattern objectives for different components of the retiree’s overall spending budget.
  • It requires the retiree to invest at least 50% of accumulated assets in equities, irrespective of the retiree’s risk preferences.
Notwithstanding recent research from David Blanchett, Michael Finke and Wade Pfau showing that a safe withdrawal rate for a 30-year retirement based on a forward looking model (rather than historical returns) that reflects current low interest rates and relatively high price/earnings ratios in equities is closer to about 2.4%-2.8% for a portfolio with 60% equities, Michael Kitces is back with his variation of the 4% Rule based on historical returns.  In his new article entitled, “Ratcheting the 4% Rule for saner retirement spending”, Mr. Kitces notes that based on his analysis of historical periods, the 4% Rule would have generally resulted in significant underspending that in most cases would leave “a huge amount of wealth left over.”  As a result, he proposes that a retiree increase spending by 10% of the spending called for under the 4% Rule whenever the retiree’s account balance exceeds more than 150% of the initial account balance.  He further proposes that if the account balance continues to remain high thereafter, the retiree can continue to apply further increases every three years.  He indicates that these spending increases can be “ratcheted” up without much concern about subsequent declines. 

Thus, rather than looking at the current economic environment, Mr. Kitces looks into his rear-view mirror and encourages a new retiree to invest at least 60% of her portfolio in equities and withdraw 4% of her assets in her initial year of retirement with inflation increases each year thereafter.  She can blissfully ignore actual investment experience.  If her assets become too high in the future, she can increase her spending, apparently without much concern for having to reduce spending later on. 

I have no problem with dynamic spending strategies (ones that can go up or down).  I advocate a dynamic strategy.   If you are not going to insure a significant portion of your wealth through lifetime annuity products, and you invest in risky assets, I believe you are going to have to live with a certain amount of variability in spending.  But I don’t think in today’s current economic environment, you can withdraw something like 4% of your initial accumulated savings (with subsequent inflation increases) over a 30-year period and realistically expect to never have to decrease your spending.   Retirees should be very cautious about using the 4% Rule with Mr. Kitces’ ratcheting modification.  The research by Blanchett, Finke and Pfau noted above showed a less than 60% success rate (i.e., a greater than 40% failure rate) over a 30-year period for the 4% Rule based on their forward looking model and 60% investment in equities, and that is before application of any “ratcheting” increases advocated by Mr. Kitces.