By Louis Coke
In the early 1990's, US financial adviser William P. Bengen first articulated the idea of using 4% of starting capital as the safe withdrawal rate. The safe withdrawal rate is the rate at which an investor can erode their capital at a safe pace, to ensure the funds either match or out-live the investor. Does this rule of thumb still apply in today's world?
There are several factors that affect the withdrawal rate to consider:
Portfolio income also affects the withdrawal rate. For example, if a portfolio has a dividend yield of 1% and your client requires 4% per year, the remaining 3% must be met by capital erosion. In a rising market this is generally not a problem as the portfolio value is increasing. However, in times of falling markets, we have a negative compounding effect, otherwise known as pound cost ravaging.
On the other hand, a portfolio with a natural yield of 3% only requires 1% of capital erosion. This reduces the negative compounding effect significantly.
In his 2015 study, US adviser and blogger Michael Kitces showed that the 4% rule works most of the time, taking into account inflation, assuming a 60/40 equity bond split, and figuring that the retiree has been drawing down on the pension for 30 years. Some two thirds of the time, the client finishes the 30-year retirement time horizon with more than double their starting capital. In fact, the study shows that less than 10% of the time the retiree finishes with less than the starting principal amount.
From the above analysis you may be tempted to look at portfolio options that carry an attractive level of dividend income. While this can be a valid choice, investing for income does require some skill to avoid ‘dividend traps' and unsustainable levels of income. In times when growth focused investments look good, there may be some relative underperformance from an income orientated strategy.
However, the inverse is also true – when economic and profits growth is scarce, a portfolio of income generating assets can outperform the wider market shines a light on defensive investments.
As with many decisions in investing, there is no obvious right or wrong answer to which strategy is best. However, a good understanding of both approaches is a very good start for the conversation.
One of the issues with aiming for the average of long-term returns is withdrawing during a negative year, compounding erosion of the portfolio. If these negative years are clustered around the early years of drawing down on a portfolio, this can erode the capital value to such a point that the fund will be exhausted. This is known as ‘Sequencing Risk'.
In a further post, Kitces notes the correlations between the safe withdrawal rate and various timescales. The key to this is that the first decade of retirement seems to have the most significant effect on whether the conventional 4% safe withdrawal rate is appropriate.
Think about it: it makes sense. A bad market in the first or second year of a retirement portfolio may not be too damaging as the relatively large portfolio can still benefit from the subsequent rise in asset prices. Similarly, a bad market when the portfolio has been paying out income for a long time (20 years let's say) is potentially less damaging because the portfolio the client doesn't need the money for many more years. The real driver of sequencing risk are the inflation-adjusted returns achieved over the first decade of retirement.
There is also the question of which funds fuel the withdrawals. In good markets it may make sense to reduce the equity content and in bad markets it may be most prudent to realise funds from fixed income or alternative assets. At this point the relationship and lines of communication between the financial adviser, discretionary fund manager (if used), and client are key. We find that this discussion can offer real added value to the client and can make a meaningful impact on the longevity of their pension fund.
In conclusion, we have established a few main points for consideration when it comes to assessing the 4% rule:
While we're primarily looking at pensions in retirement in this article, the same logic could be applied to other cases. For example, life interest trusts (popular in the UK) seeking to produce a return for a life tenant and a degree of long term capital growth for the remaindermen.
Louis previously worked in the Charles Stanley London office and began his career in our Valuations department before moving on to Equity trading, then Investment Management. He passed the CISI Masters in Wealth Management qualification in 2010. Louis was named by CityWire as one of the Top 30 Investment Managers under 30. Find him on LinkedIn.
