Tuesday, January 15, 2013

New research article: The 4% Rule is Not Safe in a Low-Yield World

I've completed a new research article along with Michael Finke and David Blanchett. It is called, "The 4% Rule is Not Safe in a Low-Yield World." The subject matter of the article will not be entirely new to readers of my blog, as I have been pushing for quite a while against the indiscriminate use of historical averages when simulating the potential success of different retirement income strategies. In the article we expound and that point, and we also look at what might happen if interest rates do go up at some point in the future. We find that with sequence of returns risk, this may not be as helpful to current retirees as seems to be implicitly assumed by many people. 

Our main points include:

The safety of a 4% initial withdrawal strategy depends on asset return assumptions. 

Using historical averages to guide simulations for failure rates for retirees spending an inflation-adjusted 4% of retirement date assets over 30 years results in an estimated failure rate of about 6% with Monte Carlo simulations.  Looking at overlapping periods from the historical data, 4% always worked.

The modest 6% failure rate rises sharply if real returns decline. 

As of January 2013, intermediate-term real interest rates are about 4% less than their historical average. Calibrating bond returns to the January 2013 real yields offered on 5-year TIPS, while maintaining the historical equity premium, causes the projected failure rate for retirement account withdrawals to jump to 57%. The 4% rule cannot be treated as a safe initial withdrawal rate in today’s low interest rate environment.

Next, it seems as though many people may wish to assume that today’s low interest rates are an aberration and that higher real interest rates will return in the medium-term horizon. Although we find little evidence to support this assumption, we estimate how a reversion to historical real yields will impact failure rates. 

Because of sequence of returns risk, portfolio withdrawals can cause the events in early retirement to have a disproportionate effect on the sustainability of an income strategy. 

We simulate failure rates if today's bond rates return to their historical average after either 5 or 10 years and find that failure rates are much higher (18% and 32%, respectively for a 50% stock allocation) than many retirees may be willing to accept. What's more, this is really a best case scenario because we do not account for any potential capital losses which investors my experience with a sudden rise in interest rates, and because we have not added any portfolio fees into the analysis.

Here is a more detailed look about how different return assumptions impact these failure rates:
 

The success of the 4% rule in the U.S. may be an historical anomaly.

What should one do about this? Exploring this question is really one of the fundamental purposes of this blog. Retirees may wish to consider their retirement income strategies more broadly than relying solely on systematic withdrawals from a volatile portfolio.