Page 32 - Investment Advisor January/February 2022

Cover Story

These are the ones who most need a retirement income plan
where investment risk matches their spending flexibility.
Risk in Retirement
The 4% rule’s fixed-spending concept is consistent with con-
sumption smoothing, or the idea that humans are generally
happiest if we maintain about the same lifestyle over time.
Maintaining the same lifestyle means adjusting spending each
year by the rate of inflation.
Investors can build a completely safe stream of infla-
tion-protected income using Treasury Inflation-Protected
Securities (or TIPS), but at today’s TIPS yields they’ll run
out of money by age 86, which represents an 80% failure rate
for a healthy couple. If you measure success rates of the 4%
rule using the traditional 30-year sustainability yardstick, safe
investments have a zero percent chance of success.
So a retiree has two choices. They can spend less or they can
take investment risk. The good thing about taking risk is that
investors have historically been rewarded with a big return
bonus (the equity risk premium) for investing in stocks.
A point made in the original 4% rule article is that histori-
cally the stock market has reliably provided enough of a bonus
to allow retirees to maintain this safe withdrawal rate even if
they begin retirement in a low interest rate environment.
In 2010, my American College colleague Wade Pfau made Money Drain
an important point about the singularity of U.S. 20th century Another potential problem with literature on the 4% rule
stock returns in an article published in the Journal of Financial is that the analyses often do not include asset management
Planning. The 4% rule may have worked for a limited number fees and investment expenses. Even after the longest bull run
of years in the United States, but it didn’t work in 13 of 17 coun- in U.S. stock history, according to calculations by Blanchett,
tries during the prior 109 years. someone who retired with $1 million on Jan. 1, 2000, would
Stock returns in the United States during the 20th century have just $462,282 left today if they’d followed the 4% rule
were so high compared to bonds that they represent a puzzle while paying 1% AUM fees and a low 0.25% on invested assets.
to financial economists. But the bonus for taking investment In other words, a year 2000 retiree would need to fund
risk wasn’t as high in other countries. $61,707 plus inflation per year (up to $65,000 in 2022) for the
If we use historical U.S. returns, a 4% withdrawal rate seems next nine years with $462,282 in savings. Invest in TIPS and
pretty safe. By playing around with a Monte Carlo simulator, you fail (in less than seven years). If the bull market doesn’t
it’s easy to see how sensitive a fixed withdrawal rate is to both continue, you fail.
stock and bond return expectations. In fact, Americans who retired in the worst 99 months between
In 2013, Pfau, David Blanchett (head of retirement research 1926 and 1991 would have run out of money before 30 years if
at PGIM) and I wrote a series of papers describing the impact they’d followed the 4% rule with 1.25% in total asset fees with
of lower bond yield and higher equity valuations on safe with- a 60% large stocks/40% Treasury portfolio. At 1% assets under
drawal rates. management and 75 basis points as average fund fees, retirees in
Historical periods in the U.S. when stocks were as expensive the worst 160 months would have failed before 30 years.
as they are right now and yields on bonds were as low as they All this pessimism about the 4% rule isn’t merely a buzzkill
are today simply don’t exist in the historical data. That makes to those who believe in the power of U.S. equities to overcome
it hard to predict whether risky assets can bail out the negative historically low real bond yields. It should remind advisors
after-inflation yields on bonds. that risk is real and that the downside of risk is that clients
Blanchett notes that “too many advisors and financial plan- must be prepared to spend less if they invest in risky assets
ning tools/calculators still use historical long-term averages. and get unlucky.
While it’s hard to say how long today’s low bond yield envi- As an example, someone who retired on Feb. 17, 2020, with
ronment will last, it’s incredibly important for projections for an initial $1 million portfolio faced a 94% probability that they
current and near-retirees to take today’s challenging return could spend $30,000 plus inflation each year to the age of 95
environment into account.” using projected capital market return expectations. Three

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