Don't Let Poor Planning Keep You From Crossing Retirement Home Plate
Why Early Retirees Should Reconsider the 4% Rule
Getting on base and ultimately crossing home plate are two very different things. Even after a fantastic at-bat, a subsequent mental lapse on the base path could end a scoring chance and possibly lose a game.
For individuals that have "reached first base" in saving enough to stop working, retirement success could require a whole different mindset than successfully saving for retirement. Actually, the first five years of retirement can mean the difference between winning and losing. Although retirement rules of thumb can be helpful with long-term goals, when it comes time to tap into retirement assets, retirees need flexibility and proactive risk awareness.
Let's look at the 4% rule. It can get you in the retirement ballpark, but you won't reach home plate without more coaching.
Basically, the 4% rule says that you should save twenty-five years’ worth of living expenses in order to fund thirty years of retirement. So if you’ll spend $40,000 in retirement, you should save $1 million in retirement assets. In this instance, the withdrawal rate is 4% of the portfolio ($40,000 is 4% of $1 million).
This method was based on a 1994 study and article by William P. Bengen that backtested seventy-five years of market data and optimum withdrawal rates in thirty-year increments from the mid-1920s to the 1990s. In each thirty year increment, based on a mixed portfolio, more than 90% of households could safely withdraw just over 4% of the portfolio, increased for inflation by 3%.
Hence, the 4% rule was born. Several decades later, a big problem has emerged with this rule as a rigid strategy during retirement. To achieve the necessary return to support 4% portfolio withdrawals, investors may need to take on significantly higher risk than in 1994, when the 4% rule was formulated. In the 1990s investors could achieve 6 – 7% annual returns with a fairly low-risk portfolio. At that time, low-risk short-term treasury bonds paid greater than 5%, compared to near 0% in 2016.
To achieve 7% in today's environment, investors may need a portfolio of mostly equities, and this creates volatility. Volatility is not friendly to retirees. If retirees experience a downturn early in retirement and take their withdrawal, the portfolio will not fully recover. This is called "sequence of returns risk". It can be devastating to retirement plans where investors take withdrawals during a market downturn, and cannot allow for recovery. The losses compound.
Let's take a quick example using a $1 million dollar portfolio with 4% inflation-adjusted withdrawals. One line shows linear growth of 7% over twenty years, the other shows a non-linear average growth of 7% with a downturn in early years and subsequent recovery.
The result is clear. The account that experiences early volatility is around $570k, where the account with linear growth is about $1.7 million. The non-linear account cannot continue to support 4% withdrawals. The 4% rule does not assume linear growth, but the existence of higher return fixed income investments reduced the sequence of returns risk.
Even as investing momentum changes late in the game, there just aren't enough scoring opportunities to overcome the early game deficit.
So What's the Solution?
Well, let's go back to the core goal of retirement. If nothing else, the goal of retirement is to not outlive your money. You need to fund your lifestyle without working. If investment accounts can't support sufficient withdrawals for retirement expenses, what are the other options? Let’s examine a few interesting ideas crafted by some of the most dedicated minds in retirement income planning.
- The Bucket Approach
This plays off of the 4% rule in that it seeks to use portfolio withdrawals as the main source of retirement funding for thirty years of retirement. Rather than having a static asset allocation for thirty years, the bucket approach breaks the portfolio into "buckets" based on three different stages of retirement.
Bucket #1 is low risk or cash investments to fund the first five years of retirement. This calls for five years of living expenses in cash so that any withdrawals won't come from an equity portion of the portfolio. If a downturn occurs, the portfolio will recover without the sequence of returns risk.
Bucket #2 is for years five through fifteen. This portion of the portfolio will be intermediate risk investments with some volatility risk.
Bucket #3 is for years fifteen through thirty and will represent the most aggressive portion of the portfolio with the longest investment horizon. Knowing that this money won't be touched for fifteen years, retirees can position it aggressively.
Specifically, the bucket strategy calls for 21% in cash, 39.5% in moderate risk, and 39.5% in aggressive risk. Here's an example. Using the numbers above, assume retirees have a portfolio of $1 million and want $40,000 per year increasing for inflation at 3% per year.
Bucket #1: Years 1 - 5 - Low Risk Investments/Cash – $210,000
Bucket #2: Years 5 - 15 - Moderate Risk – $395,000
Bucket #3: Years 15 - 30 - Aggressive Risk – $395,000
Under this strategy, you always have the next five years covered. But every five years, you'll have to "readjust" your buckets for the remaining retirement years. In each five year cycle, there is a clear goal for the next third of your retirement.
This strategy can be somewhat complicated and individuals should consult help from professional advisors and managers.
- The Reverse Mortgage
If the core goal of retirement is to not outlive your money and withdrawing into a bear market during early retirement has a negative compounding effect, it makes sense to seek other sources of income so that investment portfolios can bounce back from downturns.
One major source of income can be home equity. Many retirees have substantial equity in their homes and do not wish to downsize. One method to tap the equity in your home to create income is through a reverse mortgage. Despite some negative connotations due to the early stages of reverse mortgage offerings, fairly recent changes and regulations in this area have actually made reverse mortgages an increasingly attractive option for retirement income.
Dr. Wade Pfau, a Ph.D. in retirement income and blogger at RetirementResearcher.com, is a proponent of the responsible use of reverse mortgages. Pfau wrote an article in the Wall Street Journal outlining the benefits of reverse mortgages for retirees that need to fund living expenses without straining their portfolios.
The rules of reverse mortgages differ between carriers and, like many loan transactions, there are fees associated with loan origination. The decision to use a reverse mortgage for retirement income will depend greatly on individual circumstances, and individuals should consult their financial planner.
- The Annuity
Along the lines of using a reverse mortgage, purchasing an annuity can provide a stable and reliable income to fund retirement expenses during volatile markets.
Annuities, also similar to reverse mortgages, have a somewhat negative reputation because they're aggressively "sold" by brokers and can have a myriad of hidden fees and penalties for surrender. But depending on individual circumstances, and if used responsibly, annuities can play an important role in a well-designed financial and retirement plan. Moshe Milevsky, a professor at Toronto's York University and scholar of retirement income planning, is a proponent of variable annuities. Milevsky argues that variable annuities can provide a hedge against a sequence of returns risk during early retirement.
Variables annuities work as follows: A retiree purchases an annuity and the money will be invested in an equity portfolio to create upside. For additional cost of .5% - 1% per year, the retiree may purchase a guaranteed rider to ensure a guaranteed rate of return of, say, 5% per year. So at the very least, the annuity will pay 5% but could pay higher depending on returns from the underlying investment. This allows early retirees to draw from guaranteed annuity proceeds rather than the investment portfolio in a downturn, and hedges against a sequence of returns risk.
Overall, the 4% rule is an extremely helpful tool during the accumulation years of a retirement plan. It supports proactive retirement planning and a goals-based approach. But when retirement starts, retirees should adjust their plans to address the realities of current market conditions. Rather than robotic 4% withdrawals, retirees should adopt flexible and dynamic plans that consider every option in order to give them the best chance of crossing the retirement home plate.
If home runs or even base hits were that easy, innings would never end. In the real world, bats go cold, and the small ball may score the base runner and win the game. Retirement strategy is no different.
Disclosure: Claro Advisors, LLC ("Claro") is a registered investment advisor with the U.S. Securities and Exchange Commission ("SEC"). Information contained herein is for educational purposes only and is not to be considered investment advice. Claro provides individualized advice only after obtaining all necessary background information from a client. Information contained herein is taken from sources believed to be reliable, but cannot be guaranteed as to its accuracy. It is for informational and planning purposes. Nothing herein shall be construed as an offer or solicitation to buy or sell any securities. Nor is it legal or accounting advice. Investing carries risks and expenses and involves the potential loss of investment. Past results are not indicative of future results.