New life for an old rule of thumb – the four per cent withdrawal rate?

Let’s say you entered retirement with a large chunk of money – no monthly income other than government benefits.

How much can you afford to take out each year without risking running out of money in the future?

It’s an age-old question in retirement circles. Save with SPP once asked it of eminent retirement expert Dr. John Por who told us the answer is “unknowable,” since it would have to be based on “future interest rates, the stock markets, inflation, life expectancy and income needs.”

Writing for SmartAsset, Brian J. O’Connor says new research has found that the old “four per cent withdrawal” rule might be back in fashion.

So, what is the four per cent withdrawal rule, exactly?

“Created in 1994 by a financial planner named William Bengen, the four per cent rule posits that retirees can make a well-structured retirement fund last 30 years by withdrawing no more than four per cent of the balance in the first year of retirement, then adjusting subsequent withdrawals for inflation,” O’Connor explains.

With the volatile markets we’ve seen of late, some observers criticized the four per cent rule, arguing that in down markets, sticking to a four per cent withdrawal drives “returns risk.” In other words, if your investments are down, you are sort of “selling low” by withdrawing a set amount. Financial journalist Suze Orman, writes O’Connor, called for a more conservative three per cent withdrawal rate.

But, O’Connor continues, things are changing, and a recent Morningstar study seems to back the old four per cent idea once again.

“The investment analysis firm Morningstar has examined the safe rate of withdrawal for the first year of retirement for a few years running. Morningstar’s newest research finds that with the partial recovery of stocks, withdrawing up to four per cent is once again a safe starting point,” O’Connor notes.

Morningstar’s Amy Arnott tells O’Connor that these days, a four per cent withdrawal rate for today’s retirees has a 90 per cent chance of “still having funds remaining after a 30-year time horizon.” Research by Morningstar has made this safe withdrawal rate a moving target – in 2021, they recommended 3.3 per cent, and in 2022, 3.8 per cent.

As well, the research is based on a portfolio that has “20 to 40 per cent” exposure to stock.

The article concludes by noting that the shift in thinking to four per cent is driven by a drop in the long-term estimate for inflation and a rise in projected 30-year fixed income returns.

There’s another way of avoiding running out of money in retirement.

Members of the Saskatchewan Pension Plan can choose to annuitize some or all of their savings when they retire. With the annuity option, you can receive a payment on the first of the month, every single month for as long as you live. Want more flexibility? Check out SPP’s Variable Benefit, now available to all Canadian SPP members. You can take out as little or as much as you like with this option, and then can still consider annuitizing at a later date!

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Recently, Save with SPP got an opportunity to speak with long-time pension expert Dr. John Por, whose 40-year career in pensions includes consulting work with large U.S. and Canadian pension boards and offering expertise on pension risk policy. He has also researched the tricky “decumulation” stage in which savings are turned into retirement income.

Our far-ranging interview covered decumulation, spending in retirement, frugality, advice on saving for retirement, and annuities.

Decumulation

Dr. Por says common mistakes with decumulation – the stage where retirement savings are used to provide retirement income – can include problematic asset allocation, lack of appropriate goal setting, high investment costs and, often, setting a withdrawal rate that’s too high or taking out too much money early in retirement.

So is there a correct withdrawal rate?

“At one point in time, maybe 20-25 years ago, four per cent was said to be the right withdrawal rate,” he explains.

Decumulation “depends on future interest rates, the stock markets, inflation, life expectancy and income needs,” says Dr. Por. A “correct” rate “is therefore unknowable.”

“It depends on the reigning circumstances, both personal and market,” he explains. “Who could have predicted, even five years ago, the current existing zero or the negative real rate of bond returns?”

“The problem is, though we desperately want to find a magic formula, how can you do this – we don’t know how it will be (in the future); no one knows.”

Noting the volatility in the stock markets in just the last couple of years, he notes that “even a Nobel Prize winner professed not knowing where the markets will go in the next 10 years, or how to invest your money after retirement.”

“This, of course, has not kept the retirement or investment industry from providing copious, and often prudent, advice, it simply means that looking for a, or the, magic bullet, or the infallible sage, will not be successful,” he adds.

Spending in retirement

While decumulation carries a lot of unknowns, much more is known about how much retirees actually need, Dr. Por says.

He says research by noted pension actuary Malcolm Hamilton shows that people need far less “replacement income” in retirement than the 75 per cent figure bandied about by the industry. 

Hamilton has for many years said the research suggests not everyone needs to save “heavily” for retirement, because of the existence of government income programs for retirees and lower costs once you are retired. (Here’s a link to a Globe and Mail interview with Malcolm Hamilton.)

Dr. Por agrees, calling an overall 75 per cent rule “misguided.”

“While this may be true for low-income people, they are supported by the above-mentioned government programs, so for them the 75 per cent is not a stretch, people at higher income levels are not likely to need 75 per cent of their earned income to pursue an age-appropriate lifestyle,” he says.

“One of the most important steps to understanding (retirement spending) is… knowing how much money you need to survive,” Dr. Por explains.

Rather than going through “painful” pre-retirement budget forecasting, he recommends a simpler approach.

“How much do you save in a month? If the answer is zero, your retirement budget will be what you spend now, minus what you won’t have to pay in retirement.” This can include things like your mortgage, tax savings when you earn less, childcare and education expenses, Canada Pension Plan and Employment Insurance, and so on. 

It’s a common-sense issue, he says. Individuals must decide “how much is necessary (spending) versus how much you would like to have.”

This knowledge is crucial for retirees, who have extremely limited options in dealing with income shortfalls, he explains. 

Working Canadians needing more money could “work harder – get a job that pays better, spend less, save more, take more investment risks, etc.… but when you are retired, you don’t have the same tools,” he explains.

 “Lifestyle becomes the main tool, you can cut back on your lifestyle (to save money), which is difficult,” he says. “Another tool still at your disposal is taking on more investment risk in retirement, but, if you’re not successful, it would easily lead to a further diminished lifestyle,” Dr. Por adds.

Frugality 

At 74, Dr. Por says he is “still engaged” and “living frugally.”

In this context, he defines frugality as bringing your lifestyle and realistic earning capability (and not your hoped-for future earnings) into a healthy balance. 

Living frugally is a key way to make your money last longer, and also that when in financial trouble, the cutback would be smaller thus less painful. Big expenses in the early years of retirement should be avoided, he says, because you may need your retirement savings for decades. “

While at age 65 it is hard to envisage how long you may live” he explains, “you may easily live beyond age 90.”

For example, he adds, if you are married, “the probability that either you or your spouse will live to age 93 is about 50 per cent. You can live for a very, very long time.” 

Working after retirement is a way to support your retirement spending and to keep your mind active, he says.

“Some people still work part-time after they stop working full time. You don’t realize how important your work is … not that many people spend their time well in retirement,” he says.

“Apart from the income work provides, it also structures your day, can add meaning to your existence after retirement (admittedly not everybody needs it), and equally important, it helps you maintain your links with the outside world and friends,” he says. His observation is that most people (especially men) form the majority of their extra-family relationships through work, and once they retired such contacts tend to fade away over time,” he says.

Dr. Por recommends that everyone consider living frugally at any age; he sees it as a great lifetime habit to get into.

Saving for retirement

While some people suggest you should save for retirement from early in life until the end of your career, Dr. Por says that view isn’t usually realistic.

“You can’t save in your 30s and 40s – you are paying for your kids’ education, your mortgage. So, save what you can, if you can, but (know) you may not be able to,” he advises. “No heroism is called for, as you also have to live a reasonable life.”

The optimum time to save “is in your 50s, and then, you can save 20 to 40 per cent,” he says. By then, “your children will be out in the world, your mortgage is paid… you can save.”

For savers, equities add the most value, but of course, it depends on the environment you happen to fall into. Bonds don’t provide as much income and growth, Dr. Por explains.

Pay close attention to investment fees, he advises. “With exchange-traded funds (ETFs), you can control costs – the management expense ratios are low.” However, financial advisers may not suggest this investment because they can make higher commissions on other products, Dr. Por says.

“Even a fee of one percent can, over 30 years, reduce your available assets significantly,” he says.

What you want to avoid is being forced to sell securities when the market is down, thus Dr. Por likes the concept of having a cash reserve to tide you through periods of market decline. 

“If you take on extra risk… by putting more money into equities, you should also have a cash reserve fund worth three to five years of spending,” he says. If equities perform well, you may wish to extend such cash reserves to cover longer periods. Overall, Dr. Por says, a chief problem with retirement saving is that most people “look at it as an investment issue,” and become focused on today’s investment risks, interest rates, equity return rates, and so on. Instead, you should be thinking about the income your investments will generate when you stop working. 

What’s going on today with investment risks and other factors “is not relevant 30 to 50 years out,” when you will be drawing income from your investments, he advises. Your focus should be on that long term, and not on volatility or return rates in a given year, Dr. Por says.

Annuities

Dr. Por talked about the “annuity paradox”. While financial experts like annuities, most people refuse to follow such advice. Most people shy away from the idea of taking a large lump sum of money – say $1.5 million – and turning it into an annuity that pays $60,000 a year. He noted that when he mentioned the concept to his wife (a highly educated professional, an MD), she refused the idea saying that “… if we die soon for whatever reason the children will get nothing.”

Also, retired people want to have cash available for future expenses, and, not always unreasonably, are afraid of inflation, and the potential extinction of the financial institution, which issued the annuity. 

But, he added, “annuities later in life is a good idea”. When you are getting too old to run your money – say by your late 70s or 80s – that’s the time to consider an annuity, he says. The older you are when you convert to an annuity, the cheaper the annuity is to buy. And today’s low interest rates make the conversion to annuities expensive. “The interesting phenomenon is though”, he added, “that when interest rates were exceptionally high, say in the late 1990ies, people still did not buy annuities, nor did the advisers promote the idea.”

Finally, he noted the importance of discipline. He speaks from experience, and says that had he followed all the major precepts mentioned in this piece, he would be now in a much better financial position himself. “Know your needs, be prudent in your expectations, live frugally, create a plan or direction and stick to it while making adjustments, if needed,” he advises.  

We thank Dr. Por for taking the time to speak with us.

Celebrating 35 years of operations, the Saskatchewan Pension Plan is a full-service retirement plan. SPP will invest the money you contribute, and at the time you retire, gives you the option of converting your invested savings into a lifetime annuity. Why not check out SPP today?

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