THE 4.4% SAFE WITHDRAWAL RATE
How much retirement income is considered ‘safe’? I recently read a whitepaper(1, pg1) that put the traditional 4% rule into doubt as a safe withdrawal rate of assets while in retirement. The 4% rule is a commonly used guideline in retirement income planning. Traditionally, safe(1, pg7) is described as: if a retiree owned a diversified portfolio, they could start their retirement by withdrawing 4% of their assets and adjust that withdrawal for inflation – and by sticking to this plan, the retiree had little to no chance of outliving their money, or failure. Failure in these strategies is defined as the retiree completely running out of the money.
Traditional calculations(2, pg2) driving the historical defense of the 4% rule are typically gathering data as far back as 1926, and have been updated as recently as 2012. Within those calculations(2, pg4), the average stock return over 30 years was 10.3% and the average bond return was 6.2%. Today’s retirees face very different challenges because of the current market environment. Not only have general equity assumptions(1, pg8) recently been adjusted downwards, but the yields(1, pg8) on the bond portion are currently at an all-time low level. These same bond allocations, a stable fixture of retirement over the past 40 years, are now facing increased interest rate risk (as rates rise, prices fall) than ever before.
Because of these challenges, the safe withdrawal rate for an individual retiree today has been adjusted to, give or take, around 3.0%(1, pg11). Think about the conversations you hold with a client who has built a $1M portfolio, in order to provide at least an 90% certainty(1, pg11) that you will not run out of money, you can only draw $30k a year from that portfolio. Adding that with your social security and potentially a pension, you may be looking at gross income of $50k-$60k a year. After taxes, assuming 25% federal and 5% state tax, you are left with $35k-$45k of spendable income. Traveling, golfing, shopping, paying the bills, and generally feeling comfortable with your spending may not feel like that same $1M portfolio you saved up.
Because of all this, some retirees today are turning to annuities, annuities that produce 4.0% to 5.0% withdrawals with 100% certainty that the income payments will not stop during their lifetime. Common logic would say that higher income withdrawal rates with 0% chance of income failure would make a lot of sense. The primary problem is that many of the annuities in our industry are not adjusted for inflation. Let me introduce the 4.4% withdrawal rate: this highlights a new generation of annuities that offer income payments linked to the CPI-U, allowing a retiree to receive income adjusted for inflation AND guaranteed for life. Don’t be deceived that 4.4% is only 1.4% higher than 3.0%, in terms of cash flow, that is nearly 50% more for your client to spend. By allocating a percentage of a client’s assets into an inflation protected income annuity, you may successfully increase the total withdrawal rate across the entire portfolio, while decreasing the withdrawal rate from the portion of a client’s portfolio exposed to the market. Ultimately, there is no one size fits all solution. A diverse set of retirement income producing assets are often the best solution for any individual retiree. If a client can afford to draw only 3.0% of their portfolio(1, pg11), they may feel comfortable retiring without lifetime guarantees, but for those clients who are seeking more income with a guarantee, an annuity offering 4.0% to 5.0%, with inflation protection, it may be a necessary to help ensure their income lasts as long as they do.
Dan Slater, FSA, MAA
1 Source: Morningstar: “Low Bond Yields and Safe Portfolio Withdrawal Rates”, Blanchett, Finke, Pfau. January 2013
2 Source: SSRN: “Revisiting Retirement Withdrawal Plans and Their Historical Rates of Return”, © 2010 O’Flinn Schirripa
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