Somewhere along the line, the shortfall methodology that underlies the 4% rule was anointed the gold standard for judging withdrawal rate strategies. What began as a good-faith exercise to point out the risks from withdrawing too much each year from a retirement portfolio has gained a mythic and potentially unhelpful place among advisors. It's time to dust off the 4% rule and see whether it deserves its place on the shelf of best practices.
First a mea culpa. My co-authors David Blanchett, Wade Pfau and I recently pointed out that low bond yields may nuke the 4% rule. We used the same shortfall methodology, but we ran a Monte Carlo analysis since we don't have historical bond rates as low as the current real bond rates. So I've used the shortfall methodology in my own research. We can possibly be forgiven since we did it to point out one flaw of the shortfall methodology—that it only uses healthy 20th-century U.S.bond and equity returns that may not be relevant in the 21st century.
We wanted to make the point that today's forward-looking bond rates imply no positive real yields for more than 10 years (according to TIPS rates). Since we've never experienced a sustained period of negative real bond yields, we might get a false sense of security from using historical bond returns in our safe withdrawal rate analyses. And current bond yields have historically predicted future 10-year bond returns with a 90% coefficient of variation (R-squared).
Add to that the importance of the first decade in retirement on portfolio failure rate, known as sequence of return risk, and relying on the safety of a 4% rule starts to look like a sucker's bet. We estimate a failure rate beyond 50% if real yields don't revert to their historical mean, and a 20% failure rate if yields mean revert after just five years. Unfortunately, there's no evidence that bond rates have mean-reverted predictably in the past.
The most sobering conclusion is that retirees who believed a 4% withdrawal rate was safe in the past should instead rely on a much lower rate—perhaps as low as 2.8%—to achieve the same degree of shortfall security. Such a low rate suggests that workers need to save a lot more and retirees should cut back sharply on their lifestyle to avoid the risk of running out of money. But it doesn't have to be that way. That's because there's something else wrong with shortfall studies.
Longevity Risk
Running out of money is usually at the top of the list of concerns when building a retirement income plan. It should be. The traditional shortfall methodology assumes you spend down your assets without a safety net. What happens when the trapeze artist performs without a safety net? Obviously, they're going to be more cautious and a lot less fun to watch. You can think the same way about a retirement income plan without a longevity hedge. If you bear that risk, you're going to be a lot more careful. And careful does not a fun retirement make.
Bearing longevity risk without a hedge is stupid. Many advisors would recoil at the idea of investing a retirement portfolio in the stocks and bonds of one company. The reason? Excessive unsystematic risk means that you get no expected reward for the amount of risk taken. These same advisors, however, don't think twice about building a retirement portfolio without a longevity risk hedge even though the client gets no reward for the amount of longevity risk they assume.
In order to avoid this risk, advisors employ an extremely conservative retirement income strategy. Or at least it was conservative before asset yields sank to unprecedented lows. The flip side of the conservative strategy is that the retiree leaves money on the table by not enjoying retirement.
Ideally, retirees would decide how much they wanted to leave to charity and heirs, divide the remaining assets by their expected longevity, and live it up. But since their actual longevity is in the hands of the normal distribution, they spend a lot less so they have a 95% or more chance of dying with money in the bank. That money in the bank over and above their desired legacy is the money left on the table in the game of retirement living.
I asked David Blanchett, head of retirement research for Morningstar Investment Management, to estimate a traditional retirement income shortfall analysis using historical returns. We then plotted the distribution of residual wealth left over after the demise of the hypothetical client who begins with a million dollars in retirement saving and invests 50% of a portfolio in stocks, 40% in bonds, and 10% in cash. We added a 1% asset management fee. (See graph.)
