I love it when someone takes a complex question and answers it with something simple. The danger with elegant simplicity, though, is that people forget the details that sit behind it, and what question it was actually answering. This was one of the catalysts for the recent Morningstar research paper ‘Safe Withdrawal Rates for Australian Retirees’ that I co-authored with David Blanchett and Peter Gee. The ‘4% rule’ is often referenced in understanding what you can spend in retirement given a certain amount of savings, but where did it come from, and how relevant is it today?
1. What is this ‘4% rule’ we hear so much about, and where did it come from?
The ‘4% rule’ actually started in 1994 with an article published in the Journal of Financial Planning by William Bengen. He was a US-based financial planner who wanted to answer questions about how much his clients could spend in retirement. The way people interpret the 4% rule can vary, so let’s set out some important parameters that underpin the number:
- 4% of the portfolio is used to calculate the first year’s payment only, and each subsequent year that amount is adjusted for inflation
- it assumed a minimum 30-year retirement period
- historical return data from 1926-1994 was used, based on a portfolio comprised of 50% US equities and 50% US bonds
- 4% was selected as ‘safe’, because at that level there was no past period where that rate would have exhausted all assets by the end of the 30-year period. So it was not a number based on an average return, but rather one that assumed returns at the very low end of the spectrum.
Before taking this framework forward, I’d like to tip my hat to Mr Bengen, who 22 years ago wrote a thoughtful and practical paper. The 51 simulations that he ran do not quite match up with the Monte Carlo simulators of today, but the paper still captured many important concepts.
An inflation-adjusted, constant income stream is pretty intuitive when you think about the way you want to plan retirement.
2. Does this 4% rule apply to Aussie retirees today?
The methodology can still apply in Australia today, but there are some important areas of improvement. First, we’ve included a fee assumption. Whether you’re paying for someone to manage the portfolio, an advisor, an accountant, an administration platform, or some combination of these, there are costs. For our calculations, we’ve assumed an annual fee of 1% per annum. If you repeated the same study as above with the 1% fee, using Australian share and bond returns, but increase the return history to 1900–2014, that 4% would have come out closer to 2.5%. Why lower? Apart from the impact of fees on the returns, the Australian equity market has been more volatile than the US, and our inflation higher in the 1970s and 1980s, so you need a lower withdrawal rate to weather the worst-case scenario.
The full paper also shows that Australia has experienced some of the highest historical returns from markets when compared to 19 other countries. While the US has led the world in retirement research, we need to be careful about localising those results. Australia has outperformed historically, but it’s arguable whether this will continue.
The next step was to replace past returns with our long-term expected returns, which take account of where equity markets and interest rates are today. In addition, if you diversify the portfolio further to include a mix of Australian and international assets, you get different answers again. If you want 99% certainty, the initial withdrawal rate is 2.8%, helped by the portfolio’s reduced volatility. If you’re prepared to lower that probability of success down to 80%, then that initial withdrawal rate can increase to 3.9%.
3. What is the probability of success or ‘success rate’?
This idea of a ’success rate’ is incredibly important. While it may be complex mathematically, the underlying principle isn’t. It speaks directly to the sort of trade-offs we all have to make. Quite often, people talk about ‘expected returns’, and use these to build their plans. Even if someone has made a good forecast, an expected return will only have a 50% probability of coming through, and the final result may be higher or lower. You might be happy around this level, or you may want to be more certain that the path you’re taking will meet your minimum goal. In our analysis, the goal is to make sure that whatever initial withdrawal rate you use, your account balance will run out exactly at the end of that period. Pick a success rate that you can be comfortable with, from the conservative 99% certainty, to the more optimistic 50% level, or somewhere in between.
4. What is the key message for Australians?
Equity returns over the next 20-30 years are likely to remain attractive relative to cash, but we’re projecting them to be 2% lower than history. We need to adjust our expectations and plan accordingly.
Safe withdrawal rates for retirees now need to start at 2.5%, not 4%. Withdrawal rates could be even lower if life expectancy continues to increase. So we need to accept either spending less in retirement, OR saving more for retirement, OR running a greater risk of moving on to the aged pension sooner. It’s important to understand the trade-offs, and where you’re sitting.
The mandatory minimum withdrawal rates for account-based pensions in Australia are set higher than the safe minimums in our paper. The way these two rates operate is different after the first year, but the impact of the higher relative withdrawal rates still needs to be considered. Just because you’ve been paid an amount from an allocated pension doesn’t mean you have to spend it. Some retirees will need to invest some of their pension payments outside tax-concessional superannuation to ensure they still have savings in the future.
Once again, the benefits of a diversified, balanced portfolio shine through in the study. Adding equities can help a portfolio, but only if you accept a lower probability of success. Most of the incremental benefit to withdrawal rates of adding equities is achieved when 50 – 70% is allocated to growth assets.
Lastly, while the paper provides some useful pointers, the reality is that we’re all different, and reviewing your own personal circumstances will give you a much better answer to what you need in retirement than a rule of thumb.
Anthony Serhan, CFA, is Morningstar’s Managing Director Research Strategy, Asia-Pacific. For a full copy of the report and data, click here. This material has been prepared by Morningstar Australasia Pty Ltd for general use only, without reference to your objectives, financial situation or needs. You should seek your own advice and consider whether the advice is appropriate in light of your objectives, financial situation and needs.