The Fiction of Safe Withdrawal Rates
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Safe: adjective; protected from or not exposed to danger or risk
We all agree what the word “safe” means. That’s not the case, however, when that word is used in the context of withdrawals from a retiree’s investment portfolio. In that context, safe elicits a wide variety of definitions, from 4% or more all the way to my definition: There is no safe withdrawal rate.
In a November 2021 article, I explained why, in practice, the safe withdrawal rate is a fiction:
There is a fatal flaw that underlies the hundreds or thousands of analyses and academic papers that have been written (about the safe withdrawal rate). All are based upon “backtesting” to justify the 4% rule: All of them assume that the investor never sells any of the investments. Think back over your own experience. During a period of significant market declines or extreme volatility, has fear ever driven you to sell some of your own investments? If you’re a financial advisor reading these words, I ask you, Does the “never sell” assumption align with your own experiences with clients?
In a May 2020 article in USA Today, Bill Bengen, the originator of the 4% rule, pointed to historically high equity valuations and inflation as reasons retirees should reduce withdrawals below 4%. In anticipation of a likely recession, Bengen also advised retirees to reduce their exposure to stocks and bonds. Bengen was giving good advice. But the selling of securities, however advisable, was never an assumption baked into the calculations governing the determination of a safe withdrawal rate.
By October 2020, Bergen’s perspective on the safe withdrawal rate changed. He identified 4.5% as the maximum safe withdrawal rate for retirees at that time.
In November of 2021, Morningstar asserted that the 4% safe withdrawal rate should be reduced to 3.3% (2.9% for an all-equities portfolio). In December 2022, Morningstar changed its mind: Its “new” safe withdrawal rate was increased to 3.8%.
Morningstar’s projections assumed a 10% chance of portfolio ruin. But there was an important detail: The odds of failure are inconsistent among clients. Some clients are shown income projections assuming a 20% chance of failure, other clients a 5% chance of failure.
In an academic paper published in September 2022, four researchers – three from the University of Arizona along with one from the University of Missouri, stated:
A 65-year-old couple willing to bear a 5% chance of financial ruin can withdraw just 2.26% per year, a rate materially lower than conventional advice (e.g., the 4% rule).
Barron’s, in a December 2021 article, asked the question, “Forget the 4% Retirement Spending Rule. How Do You Feel About 1.9%?”
These are only a few examples of many that point to the lack of agreement about what is safe in the context of portfolio withdrawals. What is a retail investor to make of this? To whom should an investor listen? Isn’t it obvious that to a consumer the issue will appear confusing and inconsistent?
Some in the academic community have advocated for the use of “dynamic updating” in the context of a withdrawal strategy. The idea is that during periods of negative market performance, the retiree should reduce the amounts withdrawn from the investment portfolio. But those who advocate for dynamic withdrawals are divorced from the realities of an advisor-client relationship, especially when the client is a “constrained investor.”1
John Shrewsbury is a principal at GenWealth Financial Advisors, an RIA based in Arkansas. John’s firm has seen tremendous growth over the past decade, largely due to his focus on income-distribution planning. John is one of the planning profession’s most knowledgeable income planners. I asked John what he thought about the dynamic withdrawal approach, and this is what he told me:
That antiquated 4% rule is promoted by academics and it works on a spreadsheet but doesn’t work at the kitchen table when a retiree is trying to pay bills. Reducing income during a market downturn is unthinkable for a client, but that’s what is required for the rule to be effective.
A monumental error
The NASD (later FINRA) approved the use of Monte Carlo simulations with its publication of regulation IM-2210-6 Requirements for the Use of Investment Analysis Tools. That sanctioning was a monumental mistake. In practice, the purported high confidence rates typically illustrated in Monte Carlo simulations impart a false sense of security. Many advisors and retail investors have been lulled into believing that retirees will be just fine once armed with a retirement income projection illustrating a 90% or greater probability of success.
When NASD approved the use of Monte Carlo, it required the following:
- the member describes the criteria and methodology used, including the investment analysis tool’s limitations and key assumptions;
- the member explains that results may vary with each use and over time;
- if applicable, the member describes the universe of investments considered in the analysis, explains how the tool determines which securities to select, discloses if the tool favors certain securities and, if so, explains the reason for the selectivity, and states that other investments not considered may have characteristics similar or superior to those being analyzed; and
- the member displays the following additional disclosure: "IMPORTANT: The projections or other information generated by [name of investment analysis tool] regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results."
NASD mandated the following disclosure appear when Monte Carlo projections were used:
NASD Rule 2210(d)(1)(D) states that "[c]ommunications with the public may not predict or project performance, imply that past performance will recur or make any exaggerated or unwarranted claim, opinion or forecast.”
Not for a minute do I believe it was done with intent, but the practical result of the widespread use of Monte Carlo simulation has been a massive violation of the spirit and letter of number 4, above.
A very important article
On January 10 of this year, Massimo Young and Wade Pfau published an important article that conclusively exposed the fallacy of safe withdrawal rates and Monte Carlo projections in the content of retirement income withdrawals. I hope that when 2023 concludes, this article will have been the most read among all the articles published this year by Advisor Perspectives. If you have not already read the Young-Pfau article, I urge you to do so. The article stated the following:
Using their financial planning tools, advisors calculate the “probability of success” of a given withdrawal strategy; if the probability is high enough, advisors may feel comfortable communicating that the plan is “safe.”
Of course, I agree with this assertion; it addressed the false sense of security arising from Monte Carlo simulations that I mentioned above.
Young and Pfau pointed out that the results of a Monte Carlo analysis are entirely dependent upon the capital market assumptions (CMAs) fed into the software program. Young and Pfau have performed a public service by unmasking the truth about Monte Carlo analysis, showing it to be anything but scientific.
Young and Pfau cited Horizon Actuarial Services’ 2022 Horizon CMA Survey, an annual survey of CMAs used by 40 large investment firms. Among those firms were Goldman Sachs, JP Morgan, Blackrock, UBS, and Morgan Stanley. The rates of returns for various classes of investments assumed by the 40 firms varied widely. For example, 20-year returns assumed for bonds varied between 2.42% to 5.82%. Stock returns ranged from 5.15% to 10.63%.
The effect of divergent CMAs is to produce confidence rates that vary markedly. Young and Pfau stated, “Even relatively small errors in the inputs – 1 or 2 percentage points – will generate meaningful differences in what advisors might consider a ‘safe’ withdrawal strategy.”
Young and Pfau also provided this pearl of wisdom:
As an alternative to this (Monte Carlo) approach, advisors could consider other ways to generate retirement income that do not rely so heavily on forecasts of returns, volatilities, and correlations.
The authors also stated:
But there are other options, such as the time-segmentation approach or the income-flooring approach, which rely on contractual protections like bond ladders and fixed annuities to secure cash flow. While these approaches have their pros and cons, they do have the advantage of not relying as much on forecasts of future returns.
The unfortunate impact on guaranteed income annuities
The popularity of Monte Carlo simulations has produced a terrible outcome: RIAs are reluctant to embrace guaranteed income annuities. But now we know that the unscientific, arbitrary and often misleading results of Monte Carlo simulation do not deserve to be the basis for something as high stakes as providing a retiree’s income.
I remind advisors of these two important principles:
- No retiree stops needing income; and,
- In retirement it’s your income, not your wealth, that creates your standard-of living.
Financially, nothing is more important to a retiree than the continuation of income. Therefore, I have aggressively promoted my constrained-investor framework. I’m convinced that RIAs should show how they can help their clients as they draw nearer to and enter retirement. RIAs would benefit from a more meaningful and efficacious method to assess and serve the income-planning needs of retirees. This is the key to a massive business opportunity. In a previous article, I outlined the outstanding business results RIAs will enjoy with the adoption of a new worldview.
RIAs will be more financially successful, will retain and attract more investment assets, and will produce superior financial results for their retiree clients when they embrace new thinking that begins with the acknowledgment that, in practice, the safe withdrawal rate is a fiction.
Wealth2k® founder David Macchia is an entrepreneur, author, IP inventor and public speaker whose work involves improving the processes used in retirement income planning. David is the developer of the widely used The Income for Life Model®, and the recently introduced Women And Income®. David has authored many articles on the subjects of retirement income planning, macroeconomics, and financial communications. He is the author of two books, Constrained Investor®, and Lucky Retiree: How to Create and Keep Your Retirement Income with The Income for Life Model®.
1To determine if someone is a constrained investor, calculate the ratio of their minimum annual living expenses (net of Social Security and pension income) to the value of their investment assets. If that ratio is greater than 3%, they are a constrained investor.
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