Rethinking the 4 percent rule

February 7, 2013

By James Saft

(Reuters) – In a world of low structural investment returns retirees need to reconsider the assumption that they can draw down 4 percent a year of their savings.

Known as the 4 percent rule, this popular guideline is running smack into what looks to be an extended period of low returns in stocks and bonds.

Obviously, this is important not just for retirees, who may have little choice but to cut back on consumption, but for savers too, who will need to save more or work longer to safely meet their targets. It equally applies to foundations and endowments, which struggle with how much they can fund and still keep contributing in perpetuity.

For all investors, a low-return world is one in which high fees are especially damaging.

Popularized by financial advisor William Bengen, who did the original research behind the idea in the 1990s, the 4 percent rule holds that an investor who wants her retirement assets to last for 30 years should draw down 4 percent of the principal in the first year, increasing drawdowns annually by inflation.

Bengen found that those who drew down 5 percent a year on a simple portfolio of S&P 500 stocks and Treasury bonds had a 30 percent chance of their assets being exhausted before their target date. Later research, using a more diversified portfolio, ratcheted drawdowns up to 4.5 percent. However, these assumptions were based on historical equity returns which outpaced inflation by 6 percent or more and, which, simply put, may not be repeated.

Now, there are a fair number of problems with the 4 percent rule; some good, like increasing longevity, and some bad. Among the worst is that the rule, and its acceptance, is running afoul of the low-return world in which we now live, and which may continue for a good part of the next 30 years.

Credit Suisse released this week its Global Investment Returns Yearbook for 2013, which included a study by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School on the dynamics and implications of a low-return world. (here)

“To maintain the real value of a perpetual endowment, the withdrawal or spending rate should not exceed the expected real return on the assets. We have estimated that over the next 20-30 years, global investors, paying low levels of withholding tax and management fees, can expect to earn an annualized real return of no more than 3 percent on an all-equity fund and 2 percent on a fund split equally between equities and government bonds,” the authors write. “These figures sit uneasily with a 4 percent rule.”

SHRINKING RETURNS

That rather bleak outlook is a huge contrast from the last 60 years. Since 1950, global investors have earned north of 6 percent above inflation annually on both their stock and bond investments. It is unlikely we’ll see those sorts of returns over that extended a period for a very long time.

At the heart of this is low interest rates. Real interest rates – yields minus inflation – are now in negative territory in most major markets. That’s a bad sign for bonds because not only is the value of the investment diminishing in purchasing power terms, risks are also lopsided to the downside. Real rates could theoretically go lower, but there is a lot more room for higher inflation, which will cut the capital value of bonds.

The study estimates that real interest rates may not turn positive for six to eight years, meaning many investors are looking at negative real returns on bonds and cash over an extended period.

This also isn’t a great environment for stocks; the lower real interest rates are historically, the lower equity returns are in the five years that follow. With low rates here for several more years, the authors are estimating equity returns to be just 3 to 3.5 percent above inflation over the next 20 to 30 years. That compares to a 6 percent-plus real return since 1950, even including the last decade of lost returns.

For those in retirement or close, the upshot, sadly, is that you probably need to trim expectations and expenditures, or extend your working life. For those of us still in the asset building stages of life, the simple reaction is to save more and not make any early retirement plans.

For all groups, it is time to take a very close look at what you pay for investment management services. Paying out 1.5 or 2 percent a year is a lot easier to tolerate when you are clearing 6 percent annually above inflation. Paying that amount over the next 30 years might easily mean giving up 30 percent or more of your gain annually for investment services.

That’s crippling, especially on a compound basis.

Investors – and wealth managers – who figure this out quickly will enjoy the most long-term success.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

2 comments

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We threw out the 4% rule a few years ago. The world has changed and the sooner people realize that, the better.

Couldn’t agree more about investment expenses.

We now withdraw about 2% annually. Can still cover all the bases. You know something James? We’ve found we’re happier not buying a lot of “stuff” we don’t need anyway.

Posted by Missinginaction | Report as abusive

A 2% management fee is half of my return, and I am taking a majority of the risk! Plus there is (an inevitable) dearth of good managers out there. This means we have to hold investments and not investment products unless for special purposes. I am burning @1.5% per annum, luckily my wife has a modest income otherwise we would be burning too quickly.

Posted by Har | Report as abusive