How the Financial Services Industry is Dangerous to your Wealth – The First Deadly Dogma.

April 23, 2013

Retirement Planning

The  Four Percent Withdrawal Rule: The First Deadly Dogma. 


Retirement distribution subject matter in financial planning has been rising in importance and justifiably so.

Over the next decade more than 80 million Americans are going to retire; those who seek out trusted advisers and planners are going to require an ongoing retirement distribution strategy and discussion which incorporates a full examination, integration, of various financial resources retirees will need to tap to create sustainable retirement income streams. Some options may first appear unorthodox.

As a forward-thinking, well-educated planner assisting those entering the distribution phase , one will need to help clients examine tax drag implications of withdrawals, the ongoing impact of distributions on the longevity of assets earmarked for retirement, and a complete assessment of resources available to clients that may not have been included in the distribution formula in the past.

For example, planners and advisers must open the door to discussion about the integration of  home equity into the retirement income equation; the possible continued earning power of an individual must be considered, too. Many retirees, pre-retirees have already decided to re-examine their ability to earn as those 55 and older are remaining in the workforce or re-entering.


The chart above, credit to reflects how age co-horts 45-49, 50-54, are increasing participants in the labor force. Notice the change since 2010.

Large  players in the financial services industry have lightly breached the topic of smarter retirement distributions – perhaps they’ll eventually get around to fine-tuning strategies for clients. From my observation, it appears they’ve decided to default to a rule created close to 20 years ago; they have allowed their sales force to preach something called the 4 percent rule, providing in some cases, false comfort to prospective retirees who will, based on that advice, be in danger of outliving their money due to future higher inflation rates (which will cause retirees to withdraw more to sustain their lifestyles) and an important issue called “sequence of returns.”

Generally, it’s not in the financial services industry’s best interest to admit to prolonged sideways trending or bear markets. It’s much more attractive for business purposes, to preach never-ending long-term bull cycles. And that’s just not the real world.

So what is this “sequence of returns” risk?

Per Jim C. Otar, author of the seminal book “Unveiling the Retirement Myth,” and creator of the Otar Retirement Calculator:

“The most important thing in a distribution portfolio is the sequence of returns. In this context, luck refers to the timing of the start your retirement relative to a secular (long-term) trend. If you are lucky, the start of your retirement coincides with the start of a secular bull market and you experience a favorable sequence of returns during the initial years of retirement.”

I fear those who retire in 2013 will face formidable challenges preserving the longevity of their assets earmarked to generate ongoing retirement income. Here’s why:

  •  You are not retiring into a new, long-term bull market no matter what you hear in the media. The Shiller P/E, a longer-term price/earnings analysis which shakes out fluctuations in business cycles over ten-year rolling periods. As of April 8, 2013, the Shiller P/E was 23.37.  Going back as far as 1890, secular bull markets have never been born from these levels, so why would it be any different this time? Long-term bull cycles begin at much lower stock market valuations.  Retirees in the year 2000, now in their tenth year, or those fully retiring today, face great risk or the possibility of running out of money before they run out of life. 
  • Future returns of fixed income (bonds) are going to face formidable headwinds. Bonds, the anchor of retiree portfolios will most likely face principal risk and/or lower future yields, which will pressure retire portfolio withdrawal rates.
  • Don’t count out inflation. Inflation per the Federal Reserve has been relatively benign, this is true. Inflation has averaged roughly 2 percent over the last few years.  However, inflation risk varies and is personal for each household. For example, when it comes to retirees on fixed incomes, even small increases in food and gas prices create a major impact to restricted budgets. Let’s also not forget medical care inflation which has increased dramatically since the year 2000. As planners we also need to consider how Congress may consider limiting COLA (cost-of-living adjustments) utilizing a concept called “chained CPI” which means retirees will feel more inflation pressure in the future as Social Security cost-of-living adjustments are at risk of being formidably curtailed.

Read the following about the impact of  “chained CPI” from friend and knowledgeable writer, Tara Siegel Bernard of The New York Times:

Yes – A segment of retired folks can certainly extract 4 percent or more from investment accounts whether it’s due to a long, strong saving discipline,  or greater earning power combined with effective planning, however for the masses  it’s not true any longer. The 4% rule hasn’t been wise to follow since the year 2000.  This prehistoric beast may swallow your wealth if it’s blindly utilized going forward.

Some background: Back in 1994, two astute individuals-Larry Bierwith and later William Bengen, understood how actual asset returns and inflation rates were historically volatile and cash-flow modeling at the time was too unrealistic to allow for portfolio longevity. Both were in search of a way for retirees to sustain spending for a retirement period of thirty years with reasonable assurance the money would last. A lofty endeavor back then.

They collected scenarios of past asset returns, inflation rates and simulated a number of plans under the scenarios. When they tested a four percent first-year withdrawal followed by inflation-adjusted withdrawals in subsequent years, it was discovered that a four percent withdrawal was safe when using a portfolio mix between fifty and seventy-five percent stocks.

Bengen’s analysis remains groundbreaking and extremely popular. He continued his work in a series of future papers too. Astute advisers who began adjusting withdrawals downward since then have benefited clients following the rule. Today however, it’s extremely difficult for retirees to maintain such a hefty portfolio weighting to stocks (50-75 percent). The volatility of markets and changing needs of retirees requires much greater flexibility when dealing with investment account withdrawals.

No doubt this work was important at the time however, it’s time to re-consider portfolio withdrawal rates – create a new “SAFEMAX” withdrawal benchmark personalized for each client, otherwise the financial services industry is going to need to answer to retiree clients a decade from now.  How embarrassing  it will be when we discover that our clients are in great risk of outliving their retirement assets and it’s partially our fault as we resisted change and continued to follow an old rule which no longer effectively applies.

Additional proof that withdrawal rates must change:  Wade Pfau, Associate Professor at the National Graduate Institute for Policy Studies in his paper “Will 2000-Era Retirees Experience the Worst Retirement Outcomes in U.S. History?” provides evidence that retirees in 2000 are on course to potentially experience the worst retirement outcomes of any retiree since 1926, if the 4 percent withdrawal rule continues to be followed.

The years 1926, 1966 and 2000 were examined in the paper. If you retired in the beginning of any of these three years, well, you picked a bad time to collect the gold watch (does anyone receive a corporate parting gift anymore?) Retiring at times when stock market valuations are unattractive and/or inflation is a formidable obstacle creates headwinds that ten years into retirement, pose great longevity risk.

So what to do? Some ideas:

1). Gently remind your financial consultant or broker (and yourself) that the 4 percent withdrawal rule is a relic. The four percent rule has good intentions. It’s a rule of thumb (although I’m not a fan of these thumb-rule things), which provides a retiree a method to implement a disciplined, long-term account withdrawal pattern. It’s beautifully simple. Perhaps that’s the main reason it has some staying power. The goal of the original study was, and still is an honorable effort.

Leave it to the financial services industry: When it grabs a hold of a marketable concept, it becomes a permanent fixture on the menu even when conditions  warrant re-examination and change. An enlightening revisit to the rule was outlined in 2008 by Jason S. Scott, Nobel-prize winner William F. Sharpe and John G. Watson in a paper titled “The 4% Rule-At What Price?”

For example, if your portfolio lost 20-40 percent during the financial crisis would you have felt comfortable sticking with the rule? Would you have adjusted future withdrawals to compensate? Would you have been ringing up my cheese at the supermarket to prevent further erosion to your nest egg? I think so.

As the authors commented: “We have argued that the major flaw of the 4% rule is its attempt to support non-volatile spending with volatile investing.”

The rule is ineffective: In good years, the portfolio holds a surplus you don’t enjoy. In bad years, the portfolio overpays you as proven in the study. What’s required is a flexible, customized approach.

2). Consider a reverse mortgage line of credit. And yes, you read correctly: A reverse mortgage line of credit.

Barry H. Sacks, J.D., Ph.D., and Stephen R. Sacks, Ph.D., in the February 2012 “Journal of Financial Planning,”in a paper titled “Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income,” examine “cash flow survival,” in retirement by testing several strategies using a reverse mortgage credit line to supplement income for a 30-year period (yes you can live 30 years in retirement).

The conventional wisdom is for a retiree is to consider a reverse mortgage exclusively as a strategy of last resort-when investment portfolios are completely exhausted. This is indeed antiquated thinking, especially when returns for aggressive assets like U.S. large company and international (outside of emerging markets like China) stocks, have been close to zero for a decade. Asset returns may be anemic for close to yet another decade. You probably haven’t made up for portfolio losses from 2008 yet or perhaps you haven’t yet recovered from the tech wreck of 2000.

You can’t depend on your house to increase in value like it did in the past (if it did). Might as well squeeze whatever liquidity currently exists between the walls and use it to extend the life of your retirement cash flows. The “last resort,” method feels desperate. I don’t like it. There’s a better way.

I prefer the “coordinated strategy,” tested by the writers. I call it the “synergy method,” as it permits flexibility to “re-creating the paycheck,” in retirement. Here’s how it works. Directly from the study:

“The coordinated strategy is based on the following algorithm: at the end of each year, the investment performance of the account during that year is determined; if the performance was positive, the next year’s income withdrawal is from the account, and if the performance was negative, the next year’s income withdrawal is from the reverse mortgage credit line. In this way, the account is spared any drain (resulting from withdrawal) when it is “down” because of its investment performance. This leaves the account more assets to “recover” in subsequent “up” years. This is done when most necessary—in the early years of retirement, so the account grows before the reverse mortgage credit line is exhausted.”

You’re not entitled to go hog wild with the check book that comes with a reverse mortgage credit line. Managing easily accessible credit requires tremendous restraint. The funds are to be released surgically and with great care. This isn’t a windfall – It’s a way to add longevity to your retirement cash flow.

Work closely with your financial coach. The strategy of withdrawals is an ongoing discussion. If your portfolio closed the year with a negative return and that includes taxes, fees, and commissions, then utilize the reverse mortgage line for the following year of living expenses.

Do not exceed 4 percent of the year-end balances in your investment accounts. For example, on the last business day of the year your $100,000 retirement account is $97,000. The distribution allowed from the line of credit amounts to $3,880.

Review your credit-line status with a financial advisor, spouse or whomever you discuss money matters with, every six months. The goal is to make sure someone you trust is looking over your shoulder and checking your resolve as credit lines can be seducing. You don’t really need that new red convertible, do you?

3). Here’s an idea: Your baseline annual withdrawal regardless of portfolio fluctuation should remain at 2 percent with always a year’s worth of withdrawals in a cash holding tank like a money market fund.

For every 1 percent the portfolio has increased in value for the previous year, withdraw an additional 1/2 percent for returns above the 2 percent baseline. For example, if your portfolio has increased 6 percent for the year, that’s 4 percent above the baseline. You deserve a raise. A half percent for each 1 percent above the baseline equals 2 percent. You’re allowed 4 percent the following year (2 percent baseline + 2% above due to appreciation. The “house” – you,  keeps the additional 2 percent, possibly for a time when the portfolio is under performing. Consider the additional 2 percent a reserve for future use.

If your portfolio has decreased 6 percent for the year (that’s 4 percent below the baseline.) then you’ll need to stick with the baseline rate of 2 percent for the following year. And if it’s really rough for you, tap into the 2 percent reserve you kept aside the previous year.

Every 3 years complete a checkup by totaling cumulative net gains minus withdrawals. If a  surplus exists after 3 years of distributions, which means you’ve experienced more gains than withdrawals, by all means go ahead and take some of the excess. Enjoy it. Do something fun, or buy that car. Whatever. This is a good time to assess the trend in inflation, fees you’re paying and taxes as well.

4). Remember, regardless of all the empirical studies that exist, withdrawals in retirement are a bit of an art. Financial people hate that. But it’s true. Tell your adviser to lighten up. You require a system that can change with your needs and  consider the long-term cycles in asset class returns. What if you experience two or three rough stock market years in a row? It could happen!

The retirement distribution phase is one of ongoing discovery – for the financial services industry, and within each client household. It will take greater discipline, monitoring and open-minded discussion. It’ll be frustrating at times for you and your financial partners.

Unfortunately, it’s the sign of the times.

Widely preached  financial rules-of-thumb must be re-examined regularly to stress test their validity.

Some should be refreshed, altered, or discarded.

Next: The Second Deadly Dogma – The Efficient Market Hypothesis. 

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