Refining the 4% Retirement Withdrawal Rate Rule: Pay Attention to Stock Market Valuation

How much can be withdrawn each year to spend on retirement expenses without depleting an investment portfolio can be a daunting decision considering the money has to last 25, 30 years or more. In 2009 we introduced the widely-recognized rule-of-thumb solution called the 4% rule, which entails taking out 4% of the capital in the first year of retirement and then continuing to take out the same amount year after year after increasing the amount for the previous year's inflation. (Note that the 4% rule is not withdrawing 4% of the remaining capital every year - obviously you will never run out no matter how small your balance gets.)

Actuary Fred Vettese wrote about the 4% rule in the Financial Post in July, saying that it might be too low, since at least a couple of recent historical scenarios applying an 8% withdrawal rate did not run out after 25 years. However, he does advocate caution and recommends sticking with the lower 4% rate. He cites as the key reason that rates of return on investments are likely to be much lower in future - in the order of 3% real (after-inflation) return in a diversified portfolio. That's compared to the Credit Suisse Global Investment Returns Yearbook 2014 reported historical average for Canada of 5.7% for equities and 2.1% for bonds from 1900 to 2013, or 3.9% in a portfolio containing half of each.

A world of 1% lower returns - Our own recent look at prospective future returns for Canada and for the USA (especially!) and other foreign countries found much the same probable return as Vettese proposes. Using the ranges of future return estimates in our posts, which end up straddling Vettese's 3% real return, we figure a portfolio of 50% equity (1/3 each of Canada, USA and other Developed plus Emerging Markets together) and 50% Canadian bonds, will likely produce 2.8 to 3.1% annual compound real return.

Effects of 1% less on the Maximum Safe Withdrawal Rate - Vettese does not demonstrate in the newspaper article the exact impact on the maximum sustainable withdrawal rate retirees can adopt. But other researchers in the USA have done so and included a longer 30 year retirement period (is even that enough for people retiring early and living longer?). The results suggest some caution is in order for the 4% rate.

In a newly-published paper Retirement Risk, Rising Equity Glidepaths, and Valuation-Based Asset Allocation, Michael Kitces and Wade Pfau find that in the past when stock markets were over-valued, such as is the case right now, the maximum safe / sustainable withdrawal rate for a US stocks and (10 year government) bonds portfolio fell short of the 4% rate, no matter which of various asset allocation investment strategies they tested.

A table of their key results is shown below. Note the majority of values under 4.0% for SAFEMAX (the maximum withdrawal rate that doesn't run out of money) in the right hand "Overvalued" column, which we have highlighted by a blue rectangle. Such results based on index values do not take account of fund MERs that further reduce returns by 0.1 or 0.2% even for the lowest fee funds.

(click on image to enlarge)

As a result, we believe a safer withdrawal rate for a 30-year retirement is closer to 3.5% nowadays for a traditional portfolio made up of stocks and bonds.

This and other research points out several other useful ideas for investors contemplating their retirement investment strategy:

• Fixed 60% stocks, 40% bonds or T-Bills (aka cash or short-term bonds up to a couple of years maturity) does quite acceptably - Kitces and Pfau: "... an annually rebalanced static 60% equity exposure is still remarkably effective as a retirement asset allocation". For the investor wishing to keep retirement investing simple, this is a comforting thought. Another conclusion from other research (like William Bengen's seminal book Conserving Client Portfolios During Retirement, is that equity allocations in a range of 45 to 65% do about equally well, especially as retirement duration lasts 20 years and longer. Conversely, very low equity allocations, like 10% stand more chance of running out at withdrawal rates of 4%, or to put it another way, they can sustain only much lower withdrawal rates. The reason is that bonds provide a much lower return than equities.
• Successful retirement income portfolios include at least 30%, up to 70% equity. A fairly even mix of equities, which produce higher returns, and bonds (or T-Bills/cash) which reduce volatility, gives the best chance of success through all types of market environments.
• A rising equity glidepath, where the equity allocation starts low (30% in their testing) and is increased 2% per year over the first 15 years of retirement to reach an eventual 60%, or a strategy that switches amongst 30-45-60% equity allocation according to market valuation, are best suited to the present high-valuation market environment. 
• "... declining equity glidepaths [from 60% equity at retirement steadily down to 30% after 30 years] provide the worst outcomes"! The idea that you should progressively reduce the equity allocation during retirement is unhelpful in an over-valued market environment. Nevertheless, such a strategy is not disastrous as there is always a substantial allocation to equity.
• Cash / T-Bills / Short term bonds (< 2 year) work better in providing safety than bonds (10 year government) as can be seen in the table above. Sacrificing lower return from cash is more than compensated by the much lower volatility. This is particularly so in today's environment where bond returns are already low.

Flexible withdrawal rate rules - 4% growing by inflation is used as the base case to test portfolio resilience but there is no obligation to take and spend 4% or any fixed amount out of the portfolio every year. Next week we'll review various retirement withdrawal alternatives and discuss how the forced withdrawals from registered retirement accounts fit into the picture.

Bottom line - Meantime, investors need to keep in mind that returns are likely to be lower than past historical averages and that spending from retirement portfolios needs to be reduced in consequence.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.