The 4% Safe Withdrawal Rate May Not Work With Near Zero Interest Rates. Here’s Why..

Since it was conceived back in the 1990s, the safe withdrawal rate – at 4% per year – has become something of a gold standard of retirement planning. The basic theory is that a balanced portfolio, with a mix of both stocks and bonds, can be expected to produce returns sufficient to support a 4% annual withdrawal rate throughout retirement.

Because the overall return on the portfolio is expected to exceed 4% annually, the retiree would enjoy the income without fear of outliving his or her money.

The strategy was hatched in 1994 by William Bengen. He back tested the theory to include periods of financial instability, including the 1973-1974 recession, and two bear markets during the Great Depression of the 1930s. The data showed that despite declines in the financial markets, the 4% safe withdrawal rate held up over the long term.

But in recent years, and with the advent of historically low interest rates, the safe withdrawal rate is increasingly being called into question. After all, even in the financial declines included in Bengen’s analysis, interest rates were considerably higher than they are now and acted as a counterweight to falling stock prices.

Are lingering doubts about the strategy legitimate, or is it mostly fear mongering against the backdrop of the COVID-19 virus and the economic disturbances it’s created? And if there are serious doubts, are there any credible safe withdrawal alternatives for retirees?

How the 4% Safe Withdrawal Rate has Fared in the Past Ten Years

The 4% safe withdrawal rate is not only useful in projecting retirement income, but it also serves as a valuable retirement withdrawal guideline.

”Many clients are under the belief that they can pull out 8-10% because that is what they are told the stock market averages,” says Tony Liddle, CEO at Prosper Wealth Management. “The 4% rule can be a real eye opener to clients at truly how much money they need in their accounts to retire comfortably. But while the 4% rule is great for approximating, it really only works for clients who are retiring at or around 65. People who are looking to retire early or who are looking to leave large legacies will find that the 4% rule it too simple for their specific plan and should not use it even for approximating their retirement as they will likely fall very short of any goals they had.”

True to the theory, the 4% safe withdrawal rate has proven itself once again over the most recent 10 years. Yes, interest rates have fallen to historic lows. But gains in the stock market have more than offset those lackluster returns.

Based on the returns on the S&P 500 in the past 10 years, the 4% safe withdrawal rate looks like a solid bet going forward. Even if interest rates remain where they are now, a retiree relying on the strategy will do just fine – as long as the stock market continues to cooperate.

Working an Example Based on Recent Returns

Consider the following:

A portfolio with a classic allocation of 60% stocks and 40% bonds would produce an average annual return of about 8.9 %.

Based on a $1 million retirement portfolio, this is broken down as follows:

  • 60%, or $600,000, invested in stocks through the S&P 500 with an expected return of 14.432% would produce an annual income of $86,592.
  • 40%, or $400,000, invested in a 10-year U.S. Treasury note at 0.68% would produce an annual income of $2,720. (The average yield on the security over the past 10 years would have been something over 2%, but we’re assuming the current rate is the one that will be locked in for the next 10 years.)
  • The total return on the $1 million retirement nest egg will be $89,312, or just over 8.9%.

At 8.9% – and assuming the stock market continues to power forward throughout your retirement – you can easily withdraw 4% per year. And you’ll still have enough return left over to produce an average annual growth rate approaching 5%. That’s well ahead of the roughly 2% current inflation target, which means your portfolio will grow in real terms.

But is that an overly optimistic scenario? After all, the 14%+ return on stocks over the past decade has been higher than the 90-year average of 10%. A decade of lackluster returns in stocks, in combination with very low interest rates, could put the strategy in jeopardy in the next decade.

The Interest Rate Outlook is Unlikely to Change Any Time Soon – And May Even Get Worse

Interest rates have been stair-stepping down for several years. The general assumption may be that low rates are a temporary phenomenon, with the primary objective of stimulating the economy. But low interest rates are looking increasingly permanent. That won’t bode well for retirees, particularly those with a more conservative investment profile.

Already, Federal Reserve Chairman Jerome Powell has confirmed the Fed will hold interest rates near zero through 2023. That raises the likelihood the yield on the 10-year Treasury note – and other fixed income securities – isn’t unlikely to increase much from where it is right now. Translation: interest on fixed income securities won’t make a significant contribution to retirement portfolio returns.

The situation could even become decidedly worse if the Fed pursues a policy of negative interest rates. While that may seem impossible right now, it’s important to realize that interest rates below 1% seemed equally impossible just a few years ago, but here we are.

”The US Fed has resisted cutting rates below zero so far,” warned Forbes Contributor, Vineer Bhansali. “In my opinion, it is only a matter of time before either current Fed Chairman Jerome Powell or the one to follow him announces negative interest rates in the US, not because they want to, but because they are forced to… The massive amount of money that is being globally thrown at the economy and the markets will result in this negative rate outcome as the path of least resistance and an unintended consequence of too much liquidity in all the right — and all the wrong — places.”

At least at this point, negative interest rates are still speculation. But neither can they be discounted when long-term investing, especially for retirement, hangs in the balance.

The Nightmare Scenario for Current Retirees

If in fact interest rates remain at the current historically low levels, or go full-on negative, will the 4% safe withdrawal rate continue to be reliable?

The most obvious complication is counterbalancing low income yields. That will require retirees to put greater emphasis on higher risk equity investments. Where once investors favored stocks through their working years, shifting to safer fixed income assets for retirement, a large position in equities has virtually become a requirement.

“In today’s environment of low fixed-income yields the expected return on the portfolio is hampered,” cites Michael Frick at Avalon Capital Advisors in Irvine, California.

“Therefore, clients might allocate more toward stocks which can support the annual 4% withdrawal rate – but at a higher risk which might be above the client’s risk tolerance.”

Indeed, William Bengen’s research was based on a 55% stock allocation in retirement, going as high as 75%. That’s well above the risk tolerance level of many retirees.

“For some investors,” Frick continues, “a 4% annual withdrawal rate might be too much or too little depending on their unique financial factors, such as living expenses, debt servicing, portfolio allocation, and retirement frugality. Furthermore, living expenses and portfolio returns usually do not remain constant, even in retirement years. So, utilizing a rigid 4% withdrawal rate from an investment portfolio with varying annual returns to cover fluctuating living expenses might not be the best approach.”

Frick recommends the 4% safe withdrawal rate as a starting point only, subject to modification based on each retiree’s unique circumstances.

Expanding the Investment Mix as a Workaround for Low Interest Rates

Thus far we’ve been discussing interest yields on the 10-year U.S. Treasury note, which is consistent with Williams Bengen’s research. It’s a safe, conservative interest-bearing investment, that fits well within a current retiree’s portfolio. After all, many retirees do have a strong preference for completely safe investments, including certificates of deposit which also have historically low yields.

But with interest rates as low as they are now, retirees may have to look beyond Treasury notes and CDs. There are income-generating investments and fixed income equivalents that pay higher yields, but also involve an element of risk. In most cases however, that risk is lower than relying primarily on capital appreciation on equities alone.

“Fortunately, smart retirees have diversified portfolios holding asset classes with positive returns. Many weathered previous financial storms well with mid-single digit returns,” reports Tom Diem, Certified Financial Planner at Diem Wealth in Fort Wayne, Indiana. “Today, many retirees are attracted to fixed annuities. The idea here is to beat the bank and have the potential to match inflation plus one percent. Some are attracted to dividend paying stocks and it’s not hard to find a group or index with current yields above 3% as of this writing. Both ideas involve risk. The annuities have interest rate risk if rates go up and dividend stocks still have market risk. This is why working with an advisor can pay its own dividends. Your advisor should be able to construct a portfolio that fits within your risk tolerance while providing needed liquidity.”

Fixed Income’s Other Mission in a Portfolio

Diem also highlights an issue often overlooked in fixed income allocations within retirement portfolios: portfolio liquidity.

“Today’s retiree must think about the management of their portfolio over the course of their retirement and not just a current snapshot,” Diem continues. “Consider the venerable 60/40 Equities and Fixed Income investment mix. In the fixed income component by itself there are several years of withdrawals plus inflation. In an extended market downturn, there would be additional funds for rebalancing the portfolio.”

Based on this view, the fixed income allocation in a retirement portfolio is about much more than just generating income. It would also serve a critical function in enabling a retiree to rebuild a battered portfolio after a serious decline in the market.

Dynamic Withdrawal Strategies – a Viable Alternative?

Dynamic withdrawal strategies are frequently suggested as the best alternative to the 4% safe withdrawal rate. But while it has the ability to prevent retirees from outliving their savings, the income stream it produces is far less predictable.

“I do think the 4% withdrawal strategy can still work, but may be harder to achieve with fixed income rates so low,” advises Jonathan P. Bednar, II, CFP, at Paradigm Wealth Partners in Knoxville, Tennessee. “I like to use dynamic withdraw strategies at our firm. This allows you to set the 4% initial withdrawal strategy, hypothetically $40,000 on a $1 million account, but provides flexibility to change depending on the market.”

Bednar continues: “If there is a time where the market is in a prolonged downturn we would need to adjust the withdrawal percentage down to say 3.5% OR if the market is going up you have the potential to raise it to 4.5%. If the market continues to go down, you may need to cut again to 3% or vice-versa. The idea provides some “guardrails” so that as the market advances and declines you have a strategy in place to adjust your spending and withdrawals in a dynamic way to help maintain a comfortable portfolio value to supplement your retirement income needs.”

The dynamic savings withdrawal strategy certainly has more flexibility in underperforming markets. But with interest rates as low as they are, how could retirees adequately adjust in either a prolonged stagnant market or an extended bear market?

The options may be more limited and complicated than they have been in the past.

Final Thoughts

While it’s true stocks have provided an average annual return of 10% going all the way back to the 1920s, there have been entire decades where that hasn’t been the case. Should we experience a similar episode in combination with nearly non-existent interest rates, retirees may be forced to consider forgoing withdrawals in an attempt to preserve retirement capital. Though it’s true we’ve experienced bear markets in the past, even extended ones, it’s never happened in combination with interest rates below 1%.

With the uncertainties threatening the economy due to COVID-19, and the extraordinary strategies being employed by the Federal Reserve, we may have crossed into uncharted territory.

Since there’s no way to know what the future holds, the best strategy is flexibility.

Prepare for a worst-case scenario. Have sufficient cash reserves outside your retirement portfolio to cover your living expenses in a particularly bad year in the financial markets. Also, expand your fixed income horizons into annuities and high dividend stocks that are offering higher yields than Treasury securities and CDs.

But perhaps most important of all, don’t panic! The 4% safe withdrawal rate has proven effective up to this point. Even if it breaks down for a time, it’ll likely prove to be no more than temporary. We are in the middle of an unusual time in history, but all such episodes ultimately return to something that looks like normal. And when it comes to retirement planning, the long-term always counts more than the short-term blips.

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Since it was conceived back in the 1990s, the safe withdrawal rate – at 4% per year – has become something of a gold standard of retirement planning. The basic theory is that a balanced portfolio, with a mix of both stocks and bonds, can be expected to produce returns […]

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