Financial advisors relying on the classic "4% rule" for their clients' retirement income have a better than even chance of failure, according to newly published research.
Titled "The 4 Percent Rule is Not Safe in a Low-Yield World," the study by Michael Finke, Wade Pfau and David Blanchett argues that advisors make a grave mistake in basing their clients' retirement plans on historical returns that may be an anomaly.
Investment companies often include in their disclosures that "past returns do not guarantee future results," but to the study's co-author, Michael Finke, that's not just rhetoric.
In an interview with AdvisorOne, Finke, who is agnostic on what future returns will be, cites research by Rob Arnott to the effect that demographics have a determining effect on asset demand.
"It's really a demographic storm," says Finke, an AdvisorOne contributor who heads the Personal Financial Planning program at Texas Tech University. "You have the largest cohort of people who are in early retirement, and you also have the emergence of countries that have higher savings rates and are becoming wealthier and wealthier."
The result, he says, is a capital glut that is having a depressing impact on yields in the U.S.
"We're trying to acknowledge what present reality looks like and apply that reality to the retirement income plan," Finke (left) continues. "There's no reason to believe that the market for assets in the 21st century is going to look like the market for assets in the 20th century."
Yet that's exactly what advisors who follow the 4% rule are doing, since that withdrawal rate is only "safe" based on returns seen in the 20th century.
"Most planners take some comfort in knowing that a 4% inflation-adjusted withdrawal rate wouldn't cause a retiree to run out of money in a 30-year retirement," Finke says. "Previous studies that supported the 4% rate used historical yield data that don't look anything like what new retirees are facing today."
Indeed, according to his study, Monte Carlo simulations based on historic returns for a 30-year retirement give a 4% withdrawal rate a failure rate of just 6%, which many advisors consider reasonably safe.
"What many don't realize is that portfolio returns during the first years of retirement have a disproportionate impact on failure rates," Finke continues. "We estimated what would happen if bond yields, and equity returns corrected for a low-yield risk-free rate of return, persisted in the future."
The researchers' study notes William Bengen, the planner who originated the 4% rule, based his calculations on average real bond returns of 2.6% and average real stock returns of 8.6%. But bond yields as of January 2013 are 4% less than their historical average.
The Tipping Point
Based on current low yields, the study's authors find that "if we calibrate bond returns to the January 2013 real yields offered on 5-year TIPS, while maintaining the historical equity premium, the failure rate jumps to a whopping 57%," concluding that "the 4% rule cannot be treated as a safe initial withdrawal rate in today's low-interest-rate environment."
In other words, advisors must take into account that the real return on risk-free (i.e., TIPS) investments is negative today. Finke thus reiterates the key finding of the study: "Using current TIPS rates, which are the most accurate current inflation-adjusted bond yield, we find that failure rates rise beyond 50% using the 4% rule." To advisors who would challenge this argument on the assumption that today's low rates will eventually climb higher, Finke and his co-authors looked at portfolio failure rates under scenarios in which bond yields returned to their historical average.
"Even if rates go back up in 5 years, retirees are still facing an 18% failure rate," or three times the rate Bengen thought acceptable. "If they go back up after 10 years, the failure rate rises to 32%. The bottom line is that the current low-yield environment is a retirement income game changer. And hoping that things will get better eventually is a risky strategy.
"By relying on 20th century market returns which we may never see again," Finke continues, "we're giving people a false sense of security."
