Have you ever measured the size of a room by counting the number of steps it takes to get from one wall to another? Whether for positioning furniture or trying to center a carpet, rules of thumb like this can help you make quick decisions in life. But would you use the same method to determine how much flooring to order? Of course not. Precision and care are needed to make wise decisions and preventing irreversible, costly mistakes (ever needed to order MORE flooring?). There is nothing worse than feeling like you came up a little short, so would you take the same approach when planning your retirement?
In retirement planning, there is a rule of thumb that many have grown comfortable with called the 4% withdrawal rule. The rule provides a guideline of what a retiree could expect to withdraw annually from a standard 60% stock / 40% bond portfolio over their entire retirement. Sounds like a dream, enabling you to walk right into the retirement sunset, right?
Did you know that there used to be a 5% withdrawal rule? Before the 4% Rule was created in the 1990s, experts generally considered 5% a safe amount for retirees to withdraw each year. This means that retirees were projected to be able to withdraw 25% more money from their portfolio over their retirement. However, the rule shrank due to a change in future expected market returns.
The 4% rule is based on several factors but the most influential is projected market rates of return. Ideally, the 4% rule assumes that the financial markets, as a whole, should be able to deliver approximately a 4% total return into your portfolio annually to be able to live on comfortably, as you sail into the sunset.
Below is an illustration of returns for a standard 60% Stock / 40% Bond portfolio during two different decades, 1975 – 1984 and 2000 – 2009. You will notice from 1975 – 1984 (when stocks start cheap and grow over time), the average rate of return over that period is 12.7%, whereas from 2000 – 2009 (when stocks start expensive and decline over time) the average rate of return is 2.8%.
So, what becomes important when you retire is this – are stocks cheap or expensive?
When we cross into June 2019, we likely will have seen the longest economic expansion in U.S. history. Logic points that as the economy grows, so do stocks. If stocks have been appreciating over the last 10 years (and they have been), becoming more and more expensive, do you think that will continue unabated indefinitely? Nope, probably not.
For stocks, there are many forward-looking measures that examine what returns to possibly expect over the next 10 years given the price of stocks today. All measures point in the same direction, suggesting that we should expect below average returns in the stock market over the next 10 years. When we consider bloated valuations of stocks and low interest rates for bonds, prudent planning would assume a very modest (about 2 to 3%) return for a 60% stock / 40% bond portfolio over the next decade, not much different from what we experienced from 2000-2009.
So, what does this tell us? 1) the amount of money one can expect to withdraw from their portfolio depends on where we are in the business cycle and 2) if we retire when stocks are expensive, our portfolios will need more than a buy-and-hold strategy to maintain a safe withdrawal rate during retirement.
If you retire when stocks are expensive, an active risk-managed approach might be necessary to weather upcoming storms and adjust when risk in the financial markets is too high. Active risk and investment management should help determine the amount of risk in the financial markets and have a process in place when adjustments to portfolios are needed. By being able to anticipate the need for adjustments, we can increase the probabilities of successfully funding one’s retirement needs; both in favorable and unfavorable market conditions.
All in all, the most important point here is that retirement planning is never a one-size-fits-all solution. In the case of the 4% withdrawal rule, not only has the rule changed over time, but it is also not necessarily the best rule depending on market conditions. The rule uses an average of market return to show that the rule works, but as the table shown previously proves, the rule does not work over all time horizons.
If you would like to learn more about how we actively manage our client’s portfolios for risk in the financial markets and how we work to solve this problem for you, please feel free to give us a call at 337.233.7758 or email me at email@example.com.