Does the 4% rule for retirement income withdrawals still apply in today’s market?

Are you a professional financial adviser? Register for Globe Advisor then subscribe to the weekly newsletter on our newsletter subscription page. Get exclusive news and insights on the investment industry, top headlines of the week, and what you and your clients need to know.

Rising inflation and the combination of falling stocks and bonds this year is causing many investors to reconsider the reliability of the “4% rule” as a guideline for how much to withdraw from their portfolios annually.

People are also living longer, and markets may behave differently in countries like Canada compared to the United States, the market examined in the original study from 1994 who introduced this concept.

A recent study states that the 4% rule “is proving woefully insufficient for current pensioners”.

The report, by finance professors from the University of Arizona and the University of Missouri, says a retired couple face a 17.4% chance of ‘financial ruin’ or survival. to his money, using the 4% rule. It says a 65-year-old couple willing to bear 5% risk of financial ruin on a 30-year retirement can only withdraw $2.26 a year. This number drops to 1.95% when people born today retire at age 65.

The recent study is broader than the original, with a longer period, from 1890 to 2019, and analyzes performance in 38 developed countries, including Canada.

“The 4% rule is a stark example of the divergence between theory and practice in finance,” says the report, titled “The Safe Withdrawal Rate: Evidence from a Large Sample of Developed Markets.”.”

This is the latest of several studies examining the popular and oft-debated 4% rule. Still, many advisers say the guideline remains useful for retirees looking to assess how much money they might need to retire comfortably.

The original 1994 study, by American financial planner William Bengen and based on historical returns of a 50-50 portfolio of stocks and bonds from 1926 to 1976, indicates that retirees with a time horizon of 30 year-olds could withdraw 4% from their portfolios in the first year of retirement, followed by inflation-adjusted withdrawals in subsequent years.

“Four percent still isn’t a bad start,” says Steve Foerster, professor of finance at Western University’s Ivey Business School in London, Ont.

“It’s a guideline. What I don’t like is calling it a ‘rule’ because it involves rigidity,” he adds, citing a well-known principle that the amount a person should withdraw from the retirement depends on their lifestyle needs and desires.

Foerster also notes that Canadians have government programs, such as the Canada Pension Plan (CPP) and Old Age Security (OAS), to help them retire.

He says market conditions at the time someone begins retirement are also a consideration. For example, someone retiring this year, amid the stock and bond price rout, may be worse off due to what is known as sequence risk. It is the threat of having low or negative returns when withdrawing funds from a portfolio in early retirement, which can have a significant impact on the overall value of a longer-term portfolio.

Also, people who put money into high-interest savings accounts and guaranteed investment certificates (GICs) could benefit from higher interest rates this year.

Mr. Foerster says advisers should tell their clients about these factors, which could affect the “rules” of investing.

Other factors to consider

Jeet Dhillon, senior portfolio manager at TD Private Wealth Management in Toronto, says she tries to steer clients away from some of the rules of thumb in investing, like the 4% rule.

“Instead, we try to look at their personal situation because there are a lot of factors that affect it,” she says.

Considerations include a person’s spending needs and life expectancy, which may depend on their health and the longevity of their parents and grandparents. The right withdrawal rate also depends on the investor’s risk tolerance, particularly the percentage of assets they want in equities versus fixed income securities. Advisors must also consider the broader mix of assets available to investors today, such as investments in real estate and private company assets or whether they own their business.

Soaring prices for gasoline, groceries and other goods and services due to rapidly rising inflation this year are also affecting how much retirees will need to withdraw to cover expenses.

Ms Dhillon also encourages retired clients to withdraw less from their stock portfolios when markets are down and to spend less or withdraw funds from an emergency savings account until the market recovers. .

“Cash flow management is critically important,” she says.

Ms. Dhillon says all of these considerations will inform a general guideline of a “reasonable and sustainable withdrawal rate” for retirees and people saving for retirement. Also, the answer may change from year to year.

“A plan isn’t something you do once and forget,” she says. “Good advisors will look at that plan and see how a client follows” year over year.

A good strategy “returns to performance”

Ian Calvert, Certified Financial Planner, Vice President and Director of Wealth Planning at HighView Financial Group in Oakville, Ont., believes the 4% rule is “an appropriate number to work with” for investment planning.

He says a retiree with a well-designed portfolio should still be able to generate cash flow of around 4% per year, even in the face of a market correction.

“Capital goes up and down…but accounts that were properly structured from the start were able to maintain their withdrawal rates throughout this year,” he says. “It means having a portfolio where you don’t have to sell stocks in a negative market.”

Instead, he says retirees can still withdraw what they need as long as it’s not entirely dependent on capital appreciation.

“A good retirement planning strategy… comes down to performance. It could even exceed 4%, depending on the client’s asset allocation,” he says.

The current market correction has also reminded investors that their plans may be too risky. Calvert says it’s a chance for advisors to help clients revise their plans into something more appropriate.

“The problem you see sometimes is, ‘Here’s a wallet that I think will make money’,” he says, “when it should be, ‘Here’s a wallet designed to support what you must withdraw.'”

To learn more about Globe Advisor, visit our home page.