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Rising inflation and the combination of falling stocks and bonds this year have many investors reconsidering the reliability of the “4-per-cent rule” as a guideline for how much to withdraw annually from their portfolios.
People are also living longer, and markets can behave differently in countries like Canada compared to the U.S., the market examined in the original 1994 study that introduced this concept.
A recent study states the 4-per-cent rule “proves woefully inadequate for current retirees.”
The report, from finance professors at the University of Arizona and the University of Missouri, says a retired couple faces a 17.4-per-cent probability of “financial ruin,” or outliving their money, using the 4-per-cent rule. It says a 65-year-old couple willing to bear a 5-per-cent chance of financial ruin over a 30-year retirement can withdraw just 2.26 per year. That number falls to 1.95 per cent when people born today retire at age 65.
The recent study is broader than the original, with a longer timeframe, from 1890 to 2019, and analyzes performance in 38 developed countries, including Canada.
“The 4-per-cent rule is a leading example of the divergence between finance theory and practice,” states the report, titled “The Safe Withdrawal Rate: Evidence from a Broad Sample of Developed Markets.”
It’s the latest of several studies scrutinizing the popular and often-debated 4-per-cent rule. Still, many advisors believe the guideline remains useful for retirees looking to ballpark how much money they may need to retire comfortably.
The original 1994 study, by U.S. financial planner William Bengen and based on historical returns of a 50-50 portfolio of stock and bonds from 1926 to 1976, says retirees with a 30-year time horizon could withdraw 4 per cent of their portfolios in the first year of their retirement, followed by inflation-adjusted withdrawals in subsequent years.
“Four per cent is still not a bad starting point,” says Steve Foerster, professor of finance at Western University’s Ivey Business School in London, Ont.
“It’s a guideline. What I don’t like about it is calling it a ‘rule’ because it implies rigidity,” he adds, citing a well-known principle that how much a person needs to withdraw in retirement depends on their individual lifestyle needs and wants.
Mr. Foerster also notes that Canadians have government programs, such as the Canada Pension Plan (CPP) and Old Age Security (OAS), to help backstop their retirement.
He says market conditions when someone begins their retirement are also a consideration. For example, someone retiring this year, amid the rout in stock and bond prices, may be worse off due to what’s known as the sequence risk. It’s the threat of having low or negative returns when withdrawing funds from a portfolio early in retirement, which can have a big impact on the overall value of a portfolio longer term.
Also, people pouring money into high-interest savings accounts and guaranteed investment certificates (GICs) may benefit from higher interest rates this year.
Mr. Foerster says advisors need to make their clients aware of these factors, which could impact any investing “rules.”
The other factors to consider
Jeet Dhillon, senior portfolio manager at TD Wealth Private Investment Counsel in Toronto, says she tries to steer clients away from some of the investing rules of thumb, like the 4-per-cent rule.
“Instead, we try to look at their personal situation because there’s a lot of factors that affect it,” she says.
Considerations include a person’s spending needs and life expectancy, which may depend on their health and the longevity of their parents and grandparents. The right withdrawal rate also depends on an investor’s risk tolerance, particularly the percentage of assets they want in equities versus fixed income. Advisors also need to factor in the broader mix of assets investors have today such as investments in real estate and private company assets or if they own their businesses.
The surging price of gas, groceries and other goods and services due to rapidly rising inflation this year is also affecting how much retirees will need to withdraw to cover expenses.
Ms. Dhillon also encourages retired clients to withdraw less from their equity portfolios when markets are down and either spend less or take out funds from an emergency saving account until the market recovers.
“Cash-flow management is critically important,” she says.
Ms. Dhillon says all of these considerations will inform a general guideline of a “reasonable and sustainable withdrawal rate” for retirees and people saving for retirement. Also, the answer may change from one year to the next.
“A plan isn’t something you do once and forget about,” she says. “Good advisors will look at this plan and see how a client is tracking” from year-to-year.
A good strategy ‘comes back to yield’
Ian Calvert, certified financial planner, vice president and principal, wealth planning at HighView Financial Group in Oakville, Ont., believes the 4-per-cent rule is “an appropriate number to work with” for investment planning.
He says a retiree with a well-designed portfolio should still be able to generate a cash flow of about 4 per cent annually, even in a market correction.
“Capital moves up and down … but accounts that have been structured correctly from the beginning have been able to maintain their withdrawal rates through this year,” he says. “It means having a portfolio where you’re not forced to sell equities in a negative market.”
Instead, he says retirees can still withdraw what they need as long as it’s not entirely dependent on capital appreciation.
“A good retirement planning strategy … comes back to yield. It could even be more than 4 per cent, depending on the asset allocation for the client,” he says.
The current market correction has also reminded investors that their plans may have been too risky. Mr. Calvert says it’s a chance for advisors to help clients revise their plans to something more appropriate.
“The problem that you see sometimes is, ‘Here’s a portfolio that I think will make money,’” he says, “when it should be, ‘Here’s a portfolio designed to support what you need to withdraw.’”
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