A safe withdrawal rate?

One of our industry’s most used rules of thumb is the safe withdrawal rate for drawing down retirement savings. A 4% starting withdrawal rate has long been considered sustainable. A safe withdrawal rate should leave enough wiggle room to ride out financial market volatility and allow for some inflation protection.

But recent research warns against relying on this rule. Although many insiders consider this warning a form of scaremongering, I think it’s just prudent planning.

Those who use the 4% rule in practice would benefit from a forward-looking sustainability analysis that incorporates inflation, fees and taxes. For instance, today’s bond market prices imply expected inflation of about 2% annually. Add that to the 4% withdrawal rate and you have a required return of 6% a year, net of all fees. The weighted average mutual fund management expense ratio is about 2% annually, pushing the required return to 8% a year.

Virtually every portfolio being tapped for regular cash flow requires a healthy bond allocation to limit volatility. But with Canadian investment-grade bonds yielding 2.3% annually, that volatility dampening is costly. Holding 40% in bonds, for example, contributes 0.92% to total portfolio returns. If the target is 8% a year, that leaves the 60% stock component to fill in the remaining 7.08% a year.

That target might seem reachable, but with only 60% of the portfolio in stocks, the equities’ slice will need to post returns of about 12% per annum for this portion of the portfolio to contribute the required amount to the total portfolio. That already high hurdle increases by at least one percentage point annually when accounting for taxes.

Viewing required returns in this way, it’s clear why the “4% rule” no longer is viable. Something in the 2%-3% range better reflects today’s reality. I have sat in front of many of our firm’s clients over the past year to deal with and communicate this challenge.

Investors already have reduced their expectations significantly. But, as shown above, even modest-looking targets can be unreachable – particularly because many investors are more gun-shy after the most recent bear market. It’s easy to see why financial advisors are looking to higher-yielding fixed-income investments to juice portfolio yield. But if the financial crisis offered any lesson, it’s that reaching too far for yield can be dangerous.

Liquidity, investment risk and product structural risks plague many private offerings, such as private lending and mortgage funds. And spread and yield compression have made high-yield bonds and emerging-markets debt expensive.

Others look to stocks to play a bigger income-generation role. But many dividend-paying stocks are richly valued. Some consider securities such as real estate investment trusts as bond substitutes – a compliance and investment no-no.

But the answer is simple. Clients need to adjust expectations and/or add to their risk exposure (in stocks, bonds or alternatives) with their eyes wide open – that is, knowing that higher returns are possible but not certain.

Any increased risk should be taken on only after diligent education and in the context of well-thought-out investment policy constraints. IE

Dan Hallett, CFA, CFP, is director, asset management, for Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.