Friday, June 3, 2016

Adjust the 4% Rule Enough and You Might End Up with Something as Good as The Actuarial Approach—Part 2

This post is a follow-up to my post of May 9, where I described all the adjustments to the 4% Rule recommended by Charles Schwab to make it work.  And Schwab is not alone in this pursuit.  There is no shortage of experts out there proposing adjustments to the 4% Rule to come up with what they believe is a better safe withdrawal rate approach.   As indicated in my previous post, the Motley Fool suggested that perhaps instead of using the 4% Rule, you might want to use 3% or perhaps you may want to withdraw “more” than the spending called for under the 4% Rule after a good investment year and “less” after a poor investment year.  In my June 24, 2015 post, I looked at Michael Kitces’ proposal to “ratchet up” spending under the 4% Rule by 10% whenever the retiree’s account balance exceeds more than 150% of the initial account balance.  He further proposed that if the account balance continues to remain high thereafter, the retiree can continue to apply further increases every three years.  He indicated that these spending increases can be “ratcheted” up without much concern about subsequent declines.

As readers of this blog know, I’m not a big fan of safe withdrawal rate (SWR) approaches.  My most recent list of the disadvantages of SWR approaches is contained in my post of April 25, 2016.  There are, however, two significant potential advantages of using a SWR when compared with a more dynamic approach such as the Actuarial Approach:  simplicity and stability of withdrawals.  Of course, if you implement all these recommended adjustments, these potential advantages quickly fade away.

Thanks once again to Martin from Maine for providing me with more grist for my blog mill.  This time, he alerted me to yet another individual who believes that the 4% Rule needs to be adjusted to work properly.   Rob Bennett has developed a “new school” of safe withdrawal rate analysis that adjusts the safe withdrawal rate to reflect market valuations at time of retirement.  His website,, includes a safe withdrawal rate calculator that requires four input items:  “(1) the [Shiller] P/E10 (valuation) level that applies at the start of the retirement; (2) the real return being paid on Treasury Inflation-Protected Securities (the non-stock investment class examined by the calculator); (3) the stock-allocation percentage; and (4) the percentage balance that the retiree desires at the end of 30 years.”  For 80% stock allocation percentages, the safe withdrawal rates developed by Mr. Bennett’s calculator vary dramatically depending on the inputted P/E10 level.  Using the default assumptions, for example, the safe withdrawal rate (95% probability of not-running out of assets over 30 years and no desired legacy assets) varies from 9.13% for an initial P/E10 ratio of 8 to 2.02% for an initial P/E10 ratio of 44.

Mr. Bennett’s “new school” differs from the “old school” in that current market expectations are expected to affect future investment experience rather than old school techniques that project future experience based on historical results without regard for current market conditions.  Mr. Bennett’s default results for Scenario 3 (P/E10 of 26, which is approximately the current level) are not much different from results obtained by Blanchett, Finke and Pfau in their article, Retiring in a Low-Return Environment, which used similar concepts to account for current market conditions (Mr. Bennett’s calculator produces somewhat higher safe withdrawal rates). 

If I had to use a SWR approach, I might consider the results of Mr. Bennett’s calculator as another data point to use in my selection process.  Fortunately, I am not required to use a SWR approach, and I will stick with the Actuarial Approach, which I believe to be a much sounder approach.  And, as I have indicated many times in prior posts, the Actuarial Approach produces a spending budget for the year; it does not tell you how much you must spend.  If you are bothered by the potential volatility associated with the Actuarial Approach, you can always smooth the results from year to year (or smooth your actual spending or reduce the expected volatility of your investments).  If you insist on using a SWR approach, you can still use the Actuarial Approach to see how far off track you may have strayed.  But, of course if you do this, you are adding yet another layer of complication to all those adjustments the experts want you to make to the “simple” 4% Rule.