Financial advisors spend a lot of time thinking about how much money their clients will need when they’re no longer working – particularly those getting closer to retirement. That figure depends on various factors such as when clients will retire, how much they plan to spend in their non-working years and how much they’ve invested.
Some advisors project clients’ retirement spending based on the well-known “four-per-cent rule,” which suggests withdrawing four-per-cent of a portfolio every year during retirement, adjusting withdrawals for inflation in order to avoid running out of money.
William Bengen, a retired advisor from the United States, developed the rule in 1994 based on a retirement of 30 years and using historical returns for stocks and bonds from 1926 to 1976. The rule was also made popular by a study that three professors of finance at Trinity University in San Antonio published in 1998 of what might be a safe withdrawal rate from portfolios during retirement.
To make the four-per-cent rule work, investors have to stick to it, use a balanced portfolio of stocks and bonds and avoid high-risk investments or splurging on big-ticket items that might throw the numbers off.
The rule isn’t for everyone, but advisors believe it can be a good place to start the conversation about how much money investors need to retire – and what investment strategies should be used to reach their needs and goals.
“The four-per-cent rule continues to be used often and has gained a lot of popularity over the years ... due to the fact that it’s simple and easy to understand,” says Tuula Jalasjaa, a wealth-management executive who recently launched Smart Money for Her, a digital online portfolio manager geared to women.
However, the rule should be used as a “rough guide versus a hard and fast rule,” Ms. Jalasjaa says. “For example, some [advisors] use four per cent with inflation adjustment; some deviate depending on the retirees’ needs or on the volatility of the markets and can go down to three per cent or up to five per cent.”
The advantage of the rule is that it can help both advisors and investors determine the right mix of stocks and bonds required to try to establish a predictable income in retirement. The disadvantage is the rule may not leave enough room for emergency spending in retirement, such as the costs of health care in the event of a serious illness.
“[The] rule is best for those clients who have certainty over the fixed amount of money they need, but are also able to be flexible,” Ms. Jalasjaa says. “[The] rule also works well when the investor also has other retirement income sources – their withdrawal strategies should factor in all available income sources.”
Dan Bortolotti, portfolio manager at PWL Capital Inc. in Toronto, agrees there’s some merit to the four-per-cent rule – similar to another rule of thumb that individuals should hold a percentage of stocks equal to 100 minus their age. “It’s a reasonable starting point for an average investor.”
However, he says investors need to be aware of the many factors that can impact the effectiveness of the four-per-cent rule, such as higher taxes paid on registered assets withdrawn from a portfolio and the impact of investment fees on returns.
Also, Mr. Bortolotti notes the research is based on historical data, which include interest rates that are higher compared with the current historically low interest rates. Furthermore, the research backing up the strategy is also based on past data for U.S. stock markets – and Mr. Bortolotti notes that they have been one of the best-performing markets of the past century.
“Had you done the study in another country, you would have come up with significantly different results,” he says. “Naturally, we have to be a bit more conservative.”
Mr. Bortolotti urges advisors to go much deeper to assess each client’s individual retirement needs and goals.
For example, his firm uses specialized software to run a so-called “Monte Carlo simulation,” for clients to help them determine outcomes based on various investment scenarios, such as withdrawals and market returns. Mr. Bortolotti describes it as a portfolio stress test and recommends it be revisited every year alongside regular portfolio maintenance
Kathryn Del Greco, vice president and investment advisor with Del Greco Wealth Management at TD Wealth Private Investment Advice in Toronto, says the four-per-cent rule can provides investors with rough guidance around their retirement income needs. She says advisors could use it as an opportunity to provide a much more customized service to clients by showing how the rule may or may not work in their situations.
“Like anything, there are guidelines and discussion points for [retirement] planning purposes, but planning is always customized and very personal – and should be viewed that way,” she says. “Most advisors build their relationship [with clients] on value-added advice and take it to a much deeper discussion and a much more customized solution. It can be a conversation piece, but it comes down to what the client needs.”