Executive Summary
The concept of safe withdrawal rates has been around for almost 20 years now, since it was first kicked off in the Journal of Financial Planning by Bill Bengen in 1994. Over the years, a number of developments have come along that has further elaborated upon and enhanced the body of research above and beyond its original roots. Nonetheless, despite significant advances in the theory and methodologies used to apply safe withdrawal rates in practice, one significant misconception remains, for some inexplicable reason: the idea that safe withdrawal rates are a pure auto-pilot program forcing clients to spend little from their portfolios, even in bull markets, such that the client is expected in any reasonable market environment to pass away leaving an enormous inheritance after a life of 'excessive' frugality. This misconception needs to end; it's not what the financial planning process is about, it's not what the research says, and it's not what is done in practice anyway!
The inspiration for today's blog post comes from a recent article by Walter Updegrave from Money Magazine, which discusses some recent interesting work from Bill Sharpe's Financial Engines service, and also Harry Markowitz's GuidedChoice service, about how to enhance retirement income. In the process, though, it egregiously misstates many of the issues associated with safe withdrawal rates, and appears to report only on the most basic version of the original research from nearly 20 years ago, ignoring virtually all of the research that has gone on in this area since then, especially in the past decade!
For instance, the article states early on:
But while that oft-cited strategy has advantages -- if you withdraw 4% of your savings the first year of retirement and boost that amount annually for inflation, chances are your money will last 30 years -- it also has a big inherent flaw.
You're imposing a series of predictable withdrawals on a stock and bond portfolio that can fluctuate in value.
That disconnect leaves you vulnerable in two ways. If the markets do poorly, especially early on, you could run through your savings too fast.
The assertion here is more than a bit ironic, given that... the entire foundation of this whole body of research was to set a withdrawal rate that would be low enough you would not run out of money, even if the markets to poorly while you’d invested in something that fluctuates in value! Quite literally, that was THE research question being studied in the early 1990s that started this 20-year body of research: What is the withdrawal rate that is low enough you will not run out of money, despite a potential poor sequence of market returns? To state this as a criticism of safe withdrawal rates, when in fact the whole point of "why 4%" is because it manages this potential risk, defies logic!
Now, one can make the case that maybe the 4% withdrawal research hasn’t studied enough scenarios, and/or that 4% isn’t the right threshold, and there are some who make the case that in at least some environments 4% might still be too high. But whether the 4% withdrawal rate research has "the wrong withdrawal rate" is a separate issue. The Money Magazine article seems to imply that systematic withdrawals can never succeed at any rate, because they might take withdrawals in a down market from which the portfolio never recovers. Which makes no sense; 4% may or may not be the right withdrawal rate, but clearly there must be some rate that is sustainable! Or is the article simply trying to imply that spending your money can cause you to run out of money? Ok, but that's not exactly news...
Of course, this simply explores the article's flaws in talking about safe withdrawal rates in down markets. The article also misstates the reality of safe withdrawal rates in bull markets when it declares:
Yet strong market performance could leave you with a huge portfolio late in retirement, which means you lived more frugally than you had to.
This statement simply defies the reality of how these rules are applied in practice – this is financial planning research, and an integral part of the 6-step financial planning process is ongoing monitoring of the plan, including monitoring for the possibility that portfolio growth is exceeding safe spending guidelines and that spending can be raised in the future. Granted, figuring out how to raise your spending because of excess market returns hasn’t exactly been a problem for the past decade anyway, but those who actually practice financial planning – including Bill Bengen, the father of this body of research – have never stated that safe withdrawal rates should be utilized as an autopilot program where clients don’t raise their spending in bull markets. That is a straw man argument that critics of safe withdrawal rates have cast against the studies, despite the fact that the studies never actually said it in the first place, the financial planning process doesn’t allow for it, and no practitioner ever does it that way!
Furthermore, there have been multiple studies in the past decade that have demonstrated methodologies to systematically adjust spending levels higher at pre-set thresholds when portfolio growth exceeds (or falls behind) expectations. These methodologies not only provide a deeper process for raising spending over time in favorable markets – showing a research framework that even further demonstrates how safe withdrawal rates are not intended to leave behind enormous sums while clients live excessively frugally for life – but further show that with even modest spending flexibility in up and down markets, the starting spending level rises north of 5% instead of ‘only’ 4%. See, for example, “Decision Rules and Portfolio Management for Retirees: Is the ‘Safe’ Initial Withdrawal Rate Too Safe” (Guyton, Journal of Financial Planning, October 2004) and “Decision Rules and Maximum Initial Withdrawal Rates” (Guyton & Klinger, Journal of Financial Planning, March 2006). Much of this work in turn is being translated into written withdrawal policies that delineate guidelines for raising and lowering spending in a range of volatility environments, to manage unfavorable return sequences while allowing spending to rise in favorable markets so that “excessive” frugality is not imposed; see for instance “The Withdrawal Policy Statement” (Guyton, Journal of Financial Planning, June 2010).
So the bottom line is that while there are some issues with safe withdrawal rates, and some valid criticism and discussion about whether the 4% rate itself is a little too high or too low, exactly when spending levels can be raised, and how much higher they can start if you're willing to lower them temporarily, to make a blanket statement that withdrawal rates cause clients to run out of money in poor return sequences and simultaneously lead them to generate excessive wealth in bull markets is to inappropriately ignore or misstate the actual research, the financial planning process, and ongoing realities of a financial planning advisory relationship.
So what do you think? Do you apply a safe withdrawal rates framework with your clients? Are your clients still running on auto-pilot in the exact same way they started years ago? Or do you monitor and adjust client spending on an ongoing basis with your clients?
You’re trying to have it both ways, Michael. Either the SWR varies with changes in valuations or it is stable. If it varies, the 4 percent rate is nowhere close to safe at times of high valuations. If it is is stable, the SWR can never go higher than 4 percent, no matter how low valuations go.
The reality, of course, is that valuations affect long-term returns and, thus, the SWR varies with changes in valuation levels. But the Stock-Selling Industry has been pushing Buy-and-Hold for 30 years since Shiller showed that valuations affect long-term returns. How does the industry backtrack on these claims given how much financial damage they have done to millions of middle-class investor?
This is as much a political question today as it is an economic one or an investing one. We need to decide as a society how we are going to make the transition from the failed Buy-and-Hold Model to the research-supported model that I believe will replace it (Valuation-Informed Indexing).
Rob
Rob,
I don’t understand your first point here. I explicitly state in the blog that the 4% safe withdrawal rate may be too high in some (valuation) environments, with a link directly back to the PassionSaving valuation-based SWR calculator.
Michael:
You are one of the good guys re this issue (and a good number of others). I am of course grateful for the link and for all the good you have done in this area.
The thing that troubles me is that you say that 4 percent “MAY be too high.” I presume that what you mean by that is that 4 percent may work. That is of course true. But is there any question whatsoever that 4 percent is NOT safe? At the top of the bubble, the data said that retirements using a 4 percent withdrawal had only a 30 percent chance of surviving 30 years. Is there any reasonable person alive who would say that a retirement with a one in three chance of working out is “safe”? Those retirements are high-risk retirements. The words “risky” and “safe” are antonyms, not synonyms.
There shouldn’t be any controversy over the calculation of numbers. Everyone is this field should acknowledge today that the Old School SWR studies misstate the realities by failing to take valuations into consideration. In any other field of human endeavor, the experts in the field would be doing everything they could to publicize how dangerous these studies are and to let people know about the correct numbers.
That doesn’t happen in this field because stock investing is so emotional an endeavor and lots of experts don’t want to hurt the feelings of their clients by letting them know that they have followed dangerous strategies. We need to change that. I would like to see more and more people coming forward asking at a minimum that NUMBERS be reported accurately. Is there any question in anyone’s mind today as to whether valuations affect long-term returns (and thus SWRs) or not?
Again, I applaud you for being one of the leaders in helping out re this matter. My concern is that the efforts that those of us who have been trying to steer things in a good direction have been taking have not been good enough for nine years now. The economic crisis is a serious thing. We need to do more. We need to be MORE frank with people. We need to start moving forward to the better places that are very much open to us once we all begin reporting what the data says ACCURATELY and FRANKLY and PLAINLY.
My words are not directed at you in particular, Michael. They are directed at everyone in the field. They are directed at ME. I need to work up the courage to work this harder too. We all need to be working together to get from where we are today to where we all deep in our hearts want to be tomorrow.
Rob
Michael,
In a previous post, you wondered how the financial planning field could reach out to those who gobble up the Dave Ramsey/Suzy Orman books, and why the industry was having trouble reaching the vast majority of Americans who bought enough of these books to make them successful best sellers.
A big part of the appeal of those books is the simplicity and generality of the content, which might include some version of the 4% rule in the retirement section. The solution you suggest in this post is that careful monitoring of withdrawal rates is necessary, in order to take into account market fluctuations and changes in valuation.
While that might be true, it implies that a client work with a planner in an ongoing, detail-oriented fashion. I think that’s a wonderful premise. But there is a reason why millions of people have bought the books and haven’t rushed into the waiting arms of a financial planner: the 4% rule is easy to explain and to understand, while “monitoring market valuations” is not.
Until the language of explaining how market valuations decisions are made can be distilled into the language of the mass audience, the 4% rule will continue to hold sway.
Mr. Kitces,
You had me hanging on every word, and loving every bit of your critique. Right up until you actually linked to the mist dishonest and discredited CRANK ever to wander across a financial blog.
I am shocked and aghast that you would not only make reference to such a flake, but actually link back to his homepage.
Well, there goes your own credibility, right out the window when you associate yourself with what has often been described as a mentally unhinged loon, intent only on gaining the very notoriety that your acts encourage. Would you give a suicidal person a gun?
Sheesh.