Beware of old retirement rules of thumb—they may lead to poor planning practices.
So say some advisors, who caution that few advisors stop to consider that they may need to adjust their assumptions about income generation in retirement.
As a result, retirement strategies fall short because they underestimate the cost of generating retirement income, says Phil Murphy of S&P Dow Jones Indices. As investors and advisors attempt to juice their portfolio income, their plans become more prone to interest rate, duration and, most of all, sequence of returns risk, he says.
“The retirement industry has to do a better job of getting people’s awareness and mind-set refocused,” says Murphy. “You have to have a certain amount of wealth to buy income, but there are other factors. As we watch account values go up, interest rates are often going down, and the increased value of our accounts still don’t buy as much income as they did a year ago.”
Yet the industry still approaches retirement portfolio construction by first estimating a withdrawal rate during retirement, then calculating how much a person would need to save in order to generate that much income using current assumptions about interest rates and market returns.
Earl Schultz, founder and president of Allentown, Pa.-based Strategic Wealth Advisory, says that retirees are best served by rejecting hard-and-fast withdrawal estimates created by rules of thumb, like ones that estimate that the average retiree will spend between 3 percent and 5 percent of their nest egg each year in retirement.
The rule is most commonly stated as the 4 percent or the 4.5 percent rule, says Schultz, and was established in the mid-1990s, during a period when markets were averaging 12 percent to 15 percent returns each year.
“We’re in a totally different environment and economy right now,” says Schultz. “If advisors are still applying rules that held true in the 1990s, they might not be providing recommendations in the best interest of their clients.”
These withdrawal rules were also established without considering expanding lifespans throughout most of the developed world, notes David Blanchett, Morningstar’s head of retirement research.
Married couples aged 65 now have a 40 percent chance that one partner will live longer than 20 years in retirement, according to Blanchett.
“There’s also a huge gap today in life expectancies for wealthier Americans versus less-wealthy Americans,” says Blanchett. “You can’t rely on these statistics that refer to all Americans in general. There’s a higher likelihood that advisors’ clients will beat the averages.”
Blanchett is still a proponent of using the 4 percent rule for retirement planning as a simplified way to present a plan proposal to clients. An average person can understand the need to save 25 times their anticipated annual expenses for retirement, he says.
Advisors can then use a Monte Carlo analysis to determine the most appropriate savings rate and portfolio allocations and create a detailed financial plan, says Blanchett, but many investors would be intimidated by the complexity of such plans—thus a 4 percent rule remains a decent, rough translation.
At Financial Advisor’s recent Inside Retirement conference in Dallas, an alternative rule of thumb was proposed by Russell Hill, chairman and CEO of Halbert Hargrove Global Advisors, and Sam Pittman, a senior researcher at Russell Investments: the personal funded ratio.
A personal funded ratio looks like an illustrated balance sheet, with a person’s total anticipated assets on the left side, and a person’s total anticipated expenses and liabilities, which Pittman referred to as “claims,” on the right. In essence, the ratio reports whether a person would be able to annuitize all their anticipated future liabilities.
“It allows you to pretty quickly and accurately assess whether a financial plan is feasible or not,” said Pittman. Plan assets would include resources like Social Security, future savings, increases in portfolio value, retirement accounts, business values and real estate values. “On the liabilities side, it’s up to the clients. If the client wants to spend $60,000 a year through retirement, but maybe they want $20,000 extra for 14 years, we would take that ratio of those assets to those needs and determine whether the plan is funded or not.”
Liabilities also include the tax liability of the client’s investment portfolios, businesses and Social Security payments.
If the ratio is more than 1.0, or 100 percent, then the client’s retirement plan is funded, and if it is under 1.0, the retirement is underfunded. Pittman says that the risk that a client can afford to take, or needs to take, within their portfolio can be determined by the difference between the client’s ratio and 1. As the personal funded ratio approaches 1, advisors should become more conservative with portfolio allocations to preserve the capital that clients have already served.
Hill argued that the personal funded ratio could be easier for advisors to use and more easily understood by clients.
Indeed, in a recent Financial Advisor article about financial jargon, the term “Monte Carol simulation” was mentioned as confusing for clients and not necessarily helpful in explaining the effectiveness of their retirement plans.
“With a Monte Carlo simulation, you’re projecting outward and analyzing what happens with the plan, but you’re also making assumptions about what the returns will be,” said Pittman. “You’re assuming that an investment strategy will remain static. With a funding ratio, you’re not making any assumptions about what will happen in the future, you’re using current and prevailing interest rates to discount anything.”
As with Monte Carlo simulations, the personal funded ratio is only as good as the information an advisor feeds into it, but the ratio creates a context for advisors to discuss asset allocation, saving and spending with clients.
Using a personal funded ratio also gives advisors a tool that doesn’t assume an indefinite planning horizon for clients, said Pittman. Theoretically, the ratio could be expanded to consider the lifetime assets and expenses for a married couple or a family across generations using actuarial assumptions for longevity, health, inflation and interest rates.
“We notice that you have a lot of trouble getting specifics out of clients,” said Hill. “At least in the context of the ratio, you can have fearless conversations—earless meaning unpleasant, and unpleasant meaning that the conversations actually mean something to the client.” One example, he said, would be convincing them that a lifestyle change might be necessary for a successful retirement.
Wealth managers have done similar work for clients in the past to show clients whether they were financially independent, or whether they would have enough money to fund their retirement and leave behind money for their family as part of their estate, Hill said.
Halbert Hargrove also uses the personal funded ratio to determine whether an annuity is in a client’s best interest, said Hill.
“Our clients in general don’t like annuities,” Hill said. “Many know that there’s a lot of academic work that says they should have annuities, but they still don’t like them.”
However, such products should be considered for some clients, says Schultz.
“An annuity has one job description: to provide you guaranteed income that you can never outlive,” says Shultz. “The academic studies offer a compelling argument that if you use a portion of your retirement assets in annuities, you inevitably end up with greater longevity of assets.”