In this post, we will discuss a recent Kitces.com post defending the 4% Rule, and we will compare this widely-used rule of thumb with the Actuarial Financial Planner (AFP) approach for a hypothetical single retiree. We believe the example illustrates that many retirees can better meet their spending goals and better manage their investment risk by using the AFP approach rather than the 4% Rule.
Kitces.com Post Defending the 4% Rule
Kitces.com is one of the top financial advisor blogs in the U.S. In his January 26, 2022 Kitces.com post, Why High Equity Valuations and Low Bond Yields Won’t (Necessarily) Break the 4% Rule, Ben-Henry Moreland takes on the Morningstar report conclusion that the 4% Rule should be lowered to something like 3.3%. We discussed this Morningstar report in our post of January 6, 2022. In his post, Mr. Moreland vigorously defends continued use of the 4% Rule in today’s low-interest rate, high-stock valuation market. He is so confident that the assumptions used by Morningstar to develop its alternative 3.3% safe withdrawal rate are wrong that he says:
“Because the 4% rule was created to survive the worst possible return environments for retirees, the vast majority of actual 30-year time periods in the historical data have supported a higher initial withdrawal rate than 4% (and often significantly higher). In other words, 4% can be considered a floor for retirement spending, not a ceiling, because anything less than a 4% initial withdrawal rate would virtually guarantee there would be excess money left ‘on the table’ after 30 years. [bolding added]”
Note that the “virtual guarantee” described by Mr. Moreland would pay 30-years (or more) of inflation-indexed annual payments. Is Mr. Moreland offering a product with such a guarantee to customers in the open insurance market? Unfortunately for retirees and near retirees, he is not. In order to obtain this virtually guaranteed “safe product”, customers actually have to self-insure their own retirement and, according to Mr. Moreland, they have to invest approximately 60% of their portfolio assets in risky currently high-valued stocks and the rest in currently low-yielding bonds and hope to achieve historical returns before they run out of money.
Despite Mr. Moreland’s assurances, there are no virtual or real guarantees in the 4% Rule that investment returns will equal or exceed expectations and no virtual or real guarantees that households won’t outlive their savings. It is important to note that the guarantee implied by Mr. Moreland depends totally on reoccurrence of historical returns. And yet we all have been frequently warned, and in fact, Mr. Moreland warns us again in his post that, “past performance is no guarantee of future results.”
While Mr. Moreland agrees with Morningstar researchers that returns on 60% equity/40% fixed income portfolios may languish over the next 15-20 years, he is not convinced that these relatively poor returns will continue for the next thirty years as assumed in the Morningstar report. So, even for a new retiree, for example, historical patterns of mean reversion would be expected to follow relatively poor market returns that may be experienced and bring total returns over the next 30 years close to average, though, according to Mr. Moreland, “they might take little comfort in that fact if they were forced to withdraw too much of their portfolio in the poorer-performing first half of retirement to benefit from the above-average returns in the second half!”. Again, Mr. Moreland relies on historical cyclical patterns of bull and bear markets and reversions to the mean to argue that the 4% rule is a safe (if perhaps not guaranteed) spending floor.
We say that maybe future returns will revert to the mean and the 4% Rule will work for many successive 30-year periods and, then again, maybe it won’t. Nothing is guaranteed. Investment in equities is a risky business, and not every retiree is comfortable investing 60% of their investible assets in equities.
In the next section we look at an example of how a retiree’s spending goals may be addressed without taking on quite so much investment risk as anticipated under the 4% Rule.
Example
To make the example less complicated, we will assume that our retiree (Betty)
- Is single
- Is age 66
- Has $1,000,000 in accumulated savings
- Has an immediately payable Social Security benefit of $24,000 per annum
- Owns a home free of mortgage that she intends to use to cover her future long term care costs or other emergencies, and
- Has no other significant sources of income
In addition to not running out of money in retirement, not worrying too much about her finances and not becoming a burden on her children, her spending goals in retirement include:
- Non-Health essential recurring expenses of about $35,000 per annum (including taxes)
- Health-related essential recurring expenses of about $11,000 per annum
- Travel expenses of about $10,000 per annum (but only until she reaches age 80),
- Other annual recurring discretionary expenses starting at about $17,000 (but could be reduced in the future),
- Other relatively minor unexpected expenses and funeral expenses (no bequest motive)
Betty knows that to achieve her financial goals in retirement, she must find the appropriate balance between growing, protecting and prudently spending her assets. Like many retirees, she is much more concerned about protecting her standard of living than she is about investing to significantly increase it.
Under the 4% Rule, Betty quickly calculates that she can spend a total of $64,000 per annum ($24,000 from Social Security plus a $40,000 withdrawal from her accumulated savings) based on the Kitces.com “virtual guarantee.” If Betty is more conservative, she can only spend $57,000 per annum ($24,000 from Social Security plus a $33,000 withdrawal) based on the Morningstar-calculated safe withdrawal rate. She is also uncomfortable with the 4% Rule requirement to invest something like 60% of her accumulated savings ($600,000) in equities at this time. And she doesn’t even want to start thinking about the possibility that her Social Security benefit might be reduced at some time in the future because of system funding deficiencies.
Betty then enters her desired annual spending amounts and expected future increases in her expenses (including future decreases in certain discretionary spending) in the Actuarial Financial Planner (AFP) and uses the default assumptions to calculate the assets and liabilities in her Actuarial Balance Sheet and annual spending budget. The screen shot below shows Betty’s calculations.
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Betty considers whether it makes sense to invest some of her indicated non-risky asset allocation in life annuities rather than bonds.
For comparison purposes, the table below summarizes Betty’s first year spending and anticipated investment in equities under the 4% Rule, the 3.33% Morningstar modification and the AFP.
4% Rule | 3.33% Morningstar Modification | Actuarial Financial Planner | |
First Year Total Spending Budget | $64,000 | $57,000 | $73,000 |
Anticipated Investment Allocation to Equities | $600,000 (60%) | $600,000 (60%) | $360,000 (36%) |
Betty sees that by using the Liability Driven Investment (LDI) strategy built-in to the AFP, she can better achieve her spending goals and better manage her investment risk in retirement. She understands that there are no guarantees and she may have to reduce her future spending if future experience is not as favorable as assumed, but that such reductions will generally affect her discretionary spending and will be unlikely to affect her essential spending.
Conclusion
One of the biggest questions in retirement is how much of your assets should be invested in non-risky investments vs. how much should be invested in risky investments. The answer depends on willing you are to risk your current standard of living for a higher standard of living and requires a comparison of your desired essential expense spending with your non-risky asset investments. The 4% Rule does not address this issue and simply says if one invests at least 50% of one’s portfolio in equities, one can “safely” spend 4% of the portfolio at retirement, together with inflation increases, for 30 years. We aren’t big fans of this rule (or the Morningstar modification) and are not particularly pleased that the Kitces.com post will encourage many financial advisors and retirees to continue its use by implying that its success is virtually guaranteed.
