Retirement income is the new buzzword. New sales initiatives are being planned by seemingly every fund company on the planet, and there’s no end in sight. Every week sees the launch of some new income product. There are two, probably inter-related, reasons for this. One is the buyers right now are generally leery of equities. That will probably be temporary. If the stock market gets going again, risk appetites could change in a hurry. The second reason is that the front-end of the post-WWII baby boom is hitting retirement age. The desire for retirement income in that demographic cohort probably won’t be temporary. The trailing edge of the baby boom will likely keep demand for retirement income high until at least 2030.
Much retirement income planning is done with the trusty 4% withdrawal rule. Often, however, investors don’t understand how many assumptions go into the idea that a portfolio can support a 4% withdrawal rate. The AdvisorOne article Retirement in a Yield-Free World makes some of those assumptions more explicit. The 4% rule is based on historical bond yields and historical equity returns—but when you look at the current situation, the yield is no longer there. In fact, many bonds currently have negative real yields. Stock market yields are also fairly low by historical standards, leading to lower expected future returns. Here’s what the author, professor Michael Finke, had to say:
Estimating withdrawal rate strategies without real yield is a gruesome task. So I asked my good friend, occasional co-author and withdrawal rate guru Wade Pfau, associate professor at the National Graduate Institute for Policy Studies, to calculate how zero real returns would impact traditional safe withdrawal rates.
When real rates of return on bonds are reduced to zero, Pfau estimates that the failure rate of a 4% withdrawal strategy increases the 30-year failure rate to 15%, or just over one out of every seven retirees. This near tripling of retirement default risk is disturbing, but it is not technically accurate because we also assume historical real equity returns.
If we use a more accurate set of equity returns with a market-correct risk-free rate of return, the results are even more alarming. The failure rate of a 4% strategy with zero bond yield and a zero risk-free rate on equities is 34% over a 30-year time horizon. If real bond rates of return do not increase during a new retiree’s lifetime, they will have a greater than one in three chance of running out of money in 30 years.
The bottom line is that low expected returns may not support a 4% withdrawal rate as easily as occurred in the past. (There may be a couple of more efficient ways to withdraw retirement income than the 4% rule, but the basic problem will remain.)
The practical implication of lower expected returns for future retirees is that they will have to save more and invest better to reach their goals. Retirement income will not be so easy to come by, and behavioral errors by investors will have a greater impact than ever before.
We may not like what Bill Gross calls the “new normal,” but we’ve got to deal with it. What can clients and advisors do proactively to ensure the best shot at a good retirement income stream?
- encourage savings. Maybe boost that 401k contribution a few percentage points and hector the client for regular investment contributions.
- diversify by asset class, investment strategy, and volatility. Don’t put all your eggs in one basket. It may become important to pursue returns wherever they are, not just in stocks and bonds. Diversifying your equity return factors may not be a bad idea. We love relative strength, but value and low volatility mix well. And it’s probably not a good idea to put all of your assets into cash or highly volatile categories.
- get help. There’s a wealth of evidence that good advisors can make a big difference in client outcomes. A steady advisor may also reduce the chance of bad investor behavior, which can be one of the biggest barriers to good long-term returns.
Investing, even in good times, is not an easy endeavor. With low or non-existent real yields, it may be even tougher for a while.