Outliving your savings and the 4% rule

December 19, 2013 - All News

Special to SAF
One of the rules of thumb about retirement often mentioned by financial planners is the 4 per cent rule. Like all rules of thumb, it is supposed to be a rough guide that gives you a quick fix without a lot of math.
In this case, the rule says you can withdraw 4 per cent of the cash from your investment accounts each year and preserve the capital. In that way you end up predeceasing your savings, rather than the other way round.
So, if you have $250,000 in an RRSP portfolio, you can safely take out $10,000, or $833 a month.
But is it true?
One of the best read personal finance stories this year looked at the rule and how it works. It claimed that had American investors followed this approach plan since 1960, assuming a balanced portfolio of 60 per cent stocks and 40 per cent bonds, they would not have run out of money until 2002, 41 years later. Put another way, if they started drawing on the money at aged 60, it would have lasted until they were 101.
The problem with a hard and fast rule is that it ignores a lot of important things. It doesn’t take into account individual spending habits. You may need a lot more money than 4 per cent, or a lot less. It ignores how long you expect to live and future rates of inflation, which nobody can know. It also ignores taxes. And, in an era of rock-bottom rates, is a 4 per cent rate of return reasonable? Why not 3 per cent? How about 5 per cent?
Some retirement experts comment on the rule:
• Moshe A. Milevsky is a finance professor at York University; his most recent book is The 7 Most Important Equations for Your Retirement:
If the rule means that you start by withdrawing 4 per cent of the value of the portfolio at retirement — and then adjust that by inflation every year regardless of how markets perform over time, then it is a horrible rule of thumb.
The spending rate over time should depend on the markets, interest rates, how your portfolio is performing and your attitude to longevity risk. You cannot pick a rule at the age of 65 [and say] that is how you will behave over the next 30 years.
• Fred Vettese is chief actuary of human resource consultants Morneau Shepell and co-author of The Real Retirement:
If your income needs to keep up with inflation, then your spending should depend on your real return. If inflation is 2 per cent and you think you can manage a 6 per cent return (not easy these days), then your real return is 4 per cent. As long as that’s all you spend, your income will rise with inflation for life.
More likely, though, seniors will have a more conservative asset mix and will do well to achieve a real return of 3 per cent, which is why some pundits recommend a 3 per cent spending rule.
It is my contention that your spending will rise more or less with inflation throughout your 60s but then slow considerably in your 70s and 80s. That being the case, you don’t need the income to keep up fully with inflation, especially considering that your CPP and OAS are inflation protected.
For that reason, I think a 4 per cent spending rule would be appropriate even if your real return is just 3 per cent.
• Keith Ambachtsheer is director of the International Centre for Pension Management at the University of Toronto’s Rotman School of Management:
The easiest way to think about [this] is to think about a conservative portfolio that pays you 4 per cent cash without having to sell any shares.
Say you have accumulated $500,000, which means your annual payout is $20,000. If the companies have sustainable businesses, that $20,000 should grow by 1 to 2 per cent above the rate of inflation over time, as will the value of your original $500,000.
Arguably, you could push the payout 1 to 2 per cent higher by selling 1 to 2 per cent of your portfolio each year if you have no interest in growing the original $500,000.
There is a big caveat: the simple model above is pre-tax and pre-expenses. If you’re paying a 2 per cent management expense ratio, your post-expense yield is only 2 per cent. If your marginal tax rate on that 2 per cent is 30 per cent, then your post-expense, post-tax yield is only 1.4 per cent, or $7,000 a year, rather than $20,000 a year.
• Tax expert Evelyn Jacks is founder of the Winnipeg-based Knowledge Bureau; her latest book is Jacks on Tax, Your Do-It-Yourself Guide to Filing Taxes Online:
A 4 per cent withdrawal requires a return of 6 per cent (to account for inflation of 2 per cent) plus an amount to account for tax… perhaps up to 50 per cent more. That would mean an 8 per cent return is required in those cases.
But it all depends on where the money is taken from and [your] tax bracket. A Tax Free Savings Account (TFSA) has no tax component; an RRSP withdrawal could attract tax rates of close to 50 per cent and OAS clawback zones. Withdrawals from non-registered accounts would bring different results and tax consequences.
In other words, a 4 per cent withdrawal requires earnings of just over 4 per cent to break even before taxes and inflation.
Doing the math is important so you don’t deplete the capital base. A professional trained in tax efficient retirement income planning can help layer income over a period of time to average down tax rates and make your investment returns go farther.
— Torstar News Service