When it comes to retirement planning, the 4% rule has stood as a tried-and true method of drawing retirement income from an investment portfolio without depleting the principal of the portfolio prematurely.This rule states that a retiree can usually withdraw about 4% of the value of his or her portfolio each year, provided that the portfolio is allocated at least 40% in equities. However, this traditional strategy has recently come under fire from retirement experts who claim that this rate of withdrawal is no longer realistic in the current economic environment.
A panel of retirement planning experts with Morningstar, a company that provides independent research on both individual securities and the financial markets, recently released a paper that indicates that it is impossible for retirees to be able to withdraw 4% of their portfolios each year and expect them to last for 30 years.
The authors back this assertion with data showing the stark difference between current and historical interest rates. They show that the Ibbotson Intermediate-Term Government Bond Index posted an average annual total return of approximately 5.5% per year up to 2011. However, current interest rates are closer to 2%, and the authors feel that this is not likely to change any time in the near future.
This change has caused a substantial divergence between financial reality and the historical assumptions that are built into the simulated computer-based models used by many financial planners. The Morningstar experts maintain that these assumptions can no longer provide an accurate projection because we have been in a period of extended diversion from historical averages, and mathematical assumptions that are based on the historical average will therefore be substantially inaccurate, at least during the initial years of the projection.
What’s the Problem?
They point out that the annual returns earned in a portfolio during the first few years will have a much larger impact on the total return received by the investor than the returns that are earned in later years. Therefore, if a retirement portfolio that is invested heavily in bonds in today’s market remains invested for the next 30 years, then it will likely earn less than half of the average historical rate for the first few years. If the portfolio only grows by an average of 2% during that period and the investor withdraws 4%, then the principal in the portfolio will be materially reduced for the remainder of the withdrawal period, thus substantially increasing the possibility that the portfolio will become prematurely depleted. The experts recommend that retirees adjust their withdrawal rate to 2.8% per year for the foreseeable future in order to avoid this dilemma.
Of course, many retirees will not be able to live comfortably on a withdrawal rate of less than 3% per year. Those who are faced with this dilemma have three basic alternatives to choose from: They can either continue to work for a few more years and continue adding to their retirement savings; they can invest their savings more aggressively in hopes that it will grow enough to make up for the shortfall; or they can learn to live on less income per year. Of course, the first alternative will pose the lowest amount of risk in most cases, but this option can also be the most distasteful in many cases.
Reallocating the portfolio may be a more workable alternative, as long as care is taken to limit the amount of risk being taken. Those who are seeking current income can look at vehicles that only offer moderate risk, such as preferred stock and mutual funds or ETFs that invest in bonds or other income-producing securities. In some cases, retirees may be able to live on a lower amount of income, at least for a few years, especially if their homes will be paid off soon.
The Bottom Line
Some combination of these alternatives may be the best choice for many; a part-time job, some judicious changes in the portfolio and few cost-cutting measures can go a long way toward preserving that nest egg. For more information on retirement planning and how you can maximise your savings, consult your company retirement plan representative or financial advisor.
This story was originally published by Investopedia.
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