Opinion: ‘Worst-case scenario’ warning for retirees and the 4% rule

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A new study brings a fresh warning for retirees hoping to rely on the so-called “4% rule” to make their money last until they die.

Those expecting to retire soon may face a “worst-case scenario” as a result of elevated stock prices and record low bond yields, warn Jack De Jong, finance professor at Nova Southeastern university, and John Robinson, a financial planner in Honolulu (the pair are co-founders of a financial planning business, Nest Egg Guru). Many need to slash their spending as a result.

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And the pair calculate that many of those who retired 20 years ago, at the lowest peak, and relied on the 4% rule may already be in trouble.

The so-called 4% rule was coined by financial planner William Bengen in 1994. Using historical data, he estimated that a new retiree should be able to make their money last for their remaining years if they followed a simple two-step process.

First, in the initial year of retirement, spend no more than 4% of your portfolio’s value. And second, in all subsequent years, increase that spending only in line with inflation.

For those who retired around 2000, the “4% safe withdrawal rate will likely fail well before 30 years for most asset allocations,” De Jong and Robinson calculate. Those retirees were devastated by the “nightmarish. lost decade” for stocks from 1999 to 2009, which included two devastating crashes. “Much of the conventional planning wisdom, including the vaunted “4% rule,” failed investors during this period.”

And even though U.S. stocks boomed after 2009, it was too late for many retirees, they report. Anyone who had spent 4% of their portfolio in 2000 raising it in line with inflation each year afterward, had spent too much of their savings by 2009 for them to recover.

This is what’s known among financial planners as “sequence risk.”

There are some caveats here, which are in the fine print. The pair assumed retirees increased their spending 3% a year over the past 20 years instead of simply in line with the official CPI. Also, more significantly, they assumed retirees were also paying 1% a year in fees, taxes and other costs. In other words, the 4% rule was more of a 5% rule.

I ran my own model using a spreadsheet, the official CPI, and the returns from a rough-and-ready benchmark of a balanced portfolio, the Vanguard Balanced Index Fund 
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which is 60% U.S. stocks and 40% U.S. bonds. In my calculations, those who retired in 2000 and applied the 4% rule, raising spending no more than in line with the CPI, are still OK today, 20 years on. They’ve actually got about 88% of their initial portfolio left. But this assumes no taxes, fees or other costs. If you’re paying 1% of your portfolio value a year, you’ve been almost wiped out by now. Yes, costs — including fees — can make that much difference.  

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What’s ominous for today’s likely retirees is that current math looks even worse than it did in 1999, at the peak of the last stock market mania.

That’s because retirees typically hold a portfolio of stocks and bonds. And while stocks are not quite as expensive today as they were in 1999, bonds are much more so.

Back then 10-year U.S. Treasury bonds paid interest rates that were about 6%, or twice the rate of inflation. So people who put their money in bonds were getting well paid.

Today the same bonds pay interest rates of just 1.6%–or less than the rate of inflation.

The lost decade after 1999 “does not represent a ‘worst-case’ scenario because the bear market in stocks was accompanied by an extension in the decadeslong bull market in bonds,” write DeJong and Robinson. “A worst-case scenario would be one in which the lost decade for stocks began and lasted over a period when interest rates were at historic lows and either stayed low or rose in conjunction with high inflation.” And that, they add, may be what retirees face now.

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In the summer of 2000, when the stock market was just around its bull market peak, I had lunch near London’s Covent Garden with my late friend Peter Bennett. He simultaneously called the Nasdaq
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“the most obvious short of my entire life,” and inflation-protected Treasury bonds known as TIPS, which then promised guaranteed interest rates of inflation plus 3% a year, “an absolute gimme.”

To conventional wisdom at the time he sounded crazy on both fronts. But his clients soon had cause to thank him.

Where can nervous investors hide today?



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