The 4% rule of thumb equals the amount of capital that can be safely and sustainably withdrawn from a portfolio over time to provide as much retirement income as possible without exhausting savings.
Bill Bengen developed this rule in 1994.
There have been numerous other studies since and the rule has gained wide acceptance.
Essential to these studies is the expected returns from markets. By and large previous studies have been undertaken using US Equity market data.
Nevertheless, this raises several key questions: are returns from the US representative of other country’s expected equity market returns? and will the historical returns generated in the US be delivered in the future?
The 4% rule has been challenged in a recent article by Wade Pfau.
Pfau has expanded the research to include other developed nations (17 in total) and lengthening the analysis to 30 – 40 years.
- the 4% real withdrawal rule has simply not been safe;
- even with perfect foresight, only 4 of 17 countries had a safe withdrawal rate above 4%; and
- a 50/50 allocation to bonds and stocks had zero successes for the 17 countries.
At a minimum, investment outcomes can be improved from:
- Increasing levels of portfolio diversification e.g. the use of alternatives;
- A dynamic asset allocation approach that adjusts withdrawals to market conditions; and
- An appropriate rebalancing strategy.
Pfau’s article is well worth reading, he concludes “It may be tempting to hope that asset returns in the twenty-first century United States will continue to be as spectacular as in the last century, but Bogle (2009) cautions his readers, “Please, please please: Don’t count on it” (page 60).”
The most insightful observation
In my mind the most important insight from Pfau’s study was that safety of generating retirement income does not come “from conservative asset allocations, and the findings from this figure suggest that from an international perspective, stock allocations of at least 50 percent during retirement should be given careful consideration.”
More robust and innovative retirement solutions are required
We are living longer, and the concept of retirement is changing. New and more sophisticated investment solutions are required.
Thankfully the investment knowledge and approaches are available to provide a safer and sustainable level of retirement income.
These new strategies are based on Goal Based Investing, drawing on the insights of Liability Driven Investing (LDI) approaches employed by the likes of Insurance Companies and Defined Benefit plans.
The new generation of retirement investment solutions involve a more goal-based investment approach and something more akin Target Date Fund 2, which involves the adoption of a more sophisticated fixed interest solution.
From this perspective I like the EDHEC-Risk Institute framework which places a greater emphasis on generating retirement income.
EDHEC argue investors should maintain two portfolios:
- Goal-hedging portfolio – this replicates future replacement income goals
- Performance-seeking portfolio – this portfolio seeks returns and is efficiently diversified across the different risk premia – disaggregation of investment returns
Over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting replacement income levels. There is no predetermined path. Investment decisions are made relative to increasing the probability of achieving a level of retirement income.
The Goal-hedging portfolio is a sophisticated fixed interest portfolio of duration risk (interest rate risk), high quality credit, and inflation linked securities. Nevertheless, investment decisions are not made relative to market indices nor necessarily a view on the outlook for interest rates and credit, they are made with the view to match future replacement requirements, matching of future cashflows. This is akin to what Insurance companies do to match their future liabilities (LDI).
The investment framework developed by EDHEC has intuitive appeal and is robust in the context of developing an investment solution for the retirement challenge. It looks to address the shortcoming of many Target Date Funds.
The EDHEC framework is a more efficient framework than the rule of thumbs that reduce the growth allocations towards defensive/income, and the income component is invested into market replicating cash and fixed income portfolios.
Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the right goal, replacement income in retirement. The industry, by and large, has a too greater focus on accumulated wealth.
Accumulated wealth is important, but more importantly will it deliver the required replacement income in retirement.
In summary, the retirement investment solution needs to focus on generating a sufficient and stable stream of replacement income in retirement. This goal needs to be considered over the accumulation phase, such that hedging of future income requirements is undertaken prior to retirement (LDI), much like an insurance company does in undertaking a liability driven investing approach. Focusing purely on an accumulated capital value and management of market risk alone like many of the current Target Date Funds may lead to insufficient replacement of income in retirement for some investors.
Lastly, and not least, a good advice model is vital and technology also has a big role to play in the successful implementation of these strategies.
Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.
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