Foolishness of the 4% rule

MK62

Deleted_User said:

The UK's Office of National Statistics disagrees......they say that the chances of a 65yo British male reaching 100 are 2.9%.   (that is, only 2.9% of 65yo British males alive today, will make it to 100)

Its completely irrelevant.  Sick 65 year olds have different life expectancies and annuity rates.  They wouldn’t even need a longivity insurance.  

 I provided expectancies for healthy Americans from actuaries, the stats that matter for annuities:  https://www.longevityillustrator.org/  Its a 10% chance of getting passed 98. Average life expectancy is 3 years longer for Brits, so will be higher percentage although I don’t have numbers for healthy Brits.  And ones chances could be even higher if he is well off and understands money, which a lot of people on this board do.  

Your chart gives no detail about the % of 65yo who are considered to be in excellent health......for all we know it could be 5% excellent, 90% average and 5% poor.........not really representative if it only applies to a small percentage of 65 year olds.......even if it's 33%/33%/33%, it'd still mean it only applied to one third of 65yo Americans.

Also, while 2 years may not make much difference at 55, at 98 it does.......in the UK, a 65yo female has a 10% chance of making 98yo......it's less than half that for 100yo.

That said, whether it's 5% or 10% is irrelevant really, as neither could be described as an excellent chance in my book.........if I told you a withdrawal plan had 10% chance of making it to 100, would you describe that as an excellent chance?

OldScientist

bostonerimus said:

Wade Pfau et al did a paper that ran some simulations using recent low bond yields and P/E based stock return estimates and historical statistics to put some sensible variation on annual returns. The results are not pretty; when the 4% rule is followed many failure rates are over 50%. A solution suggested is to replace bonds with an annuity, but the stocks are still a problem. But if you die early your annuity purchase will be helping your fellow man who lives longer than you and annuities are such awful value right now. Maybe they are the best of a bad lot, although I still prefer cash for now. It was studies like this that convinced me to NOT to use the 4% rule and replace it with my own 0% rule...A variable withdrawal rate would also help

https://www.financialplanningassociation.org/sites/default/files/2020-09/JUN13 JFP Finke.pdf

Thanks for the link - that paper appears to have passed me by (although some of Pfau's other work assumes relatively low returns) - I've just reproduced some of his results in my own code, with reductions from average returns of 0.5, 1.5, and 2.5%, the failure rates (4% withdrawal, 30 years, 60/40 US) are 9%, 28%, and 45%, respectively. VPW survives rather well, even though the income does drop to 1.2% at times. If (and that is a big if) you believe that the next 30 years of returns are going to be grim, then even today's relatively low annuity rates would be rather attractive.

bostonerimus

This is a good discussion! What it highlights is that today’s retirees need to be careful applying rules of thumb produced by models using historical data from the US. In particular the effects of low interest rates and bond yields must be considered when planning drawdown from a pension pot today.

Also we need to be careful to use numbers that are appropriate to the UK and not borrow from the many US resources available that support their more mature DC pension drawdown environment. This also applies to annuities. U.K. payout rates and longevity tables must be used. Right now in the US a 65 year old male can get a life time Annuity with a payout rate of 6%, which fully 1% more than the 5% on offer in the UK. I could also easily buy a deferred annuity and I’m not sure how available they are in the UK.

This also points out just how Increasingly vital the SP will be for many people In an era of low interest rates and maybe volatile stock markets.

bostonerimus

OldScientist said:

bostonerimus said:

Wade Pfau et al did a paper that ran some simulations using recent low bond yields and P/E based stock return estimates and historical statistics to put some sensible variation on annual returns. The results are not pretty; when the 4% rule is followed many failure rates are over 50%. A solution suggested is to replace bonds with an annuity, but the stocks are still a problem. But if you die early your annuity purchase will be helping your fellow man who lives longer than you and annuities are such awful value right now. Maybe they are the best of a bad lot, although I still prefer cash for now. It was studies like this that convinced me to NOT to use the 4% rule and replace it with my own 0% rule...A variable withdrawal rate would also help

https://www.financialplanningassociation.org/sites/default/files/2020-09/JUN13 JFP Finke.pdf

Thanks for the link - that paper appears to have passed me by (although some of Pfau's other work assumes relatively low returns) - I've just reproduced some of his results in my own code, with reductions from average returns of 0.5, 1.5, and 2.5%, the failure rates (4% withdrawal, 30 years, 60/40 US) are 9%, 28%, and 45%, respectively. VPW survives rather well, even though the income does drop to 1.2% at times. If (and that is a big if) you believe that the next 30 years of returns are going to be grim, then even today's relatively low annuity rates would be rather attractive.

5% payout doesn’t look bad today, but in 30 years time it’s pin money. I like annuities for their longevity insurance, but they are inflexible (something that usually comes with insurance) and the lack of indexing in flat annuities means that their value in real terms is always falling.

[Deleted User]

If (and that is a big if) you believe that the next 30 years of returns are going to be grim, then even today's relatively low annuity rates would be rather attractive.

Beliefs are for the church.  The future is an event tree rather than a certainty.   We don’t know the future so we try to  design our portfolio to withstand most scenarios.  In that respect annuities don’t really compete with equity returns; they are an option for fixed income.  If one has lots of DB income then there is no need.  Delaying state pension is always the number 1 option.  But annuities are better than todays bonds and this difference is more pronounced than in the past. 

[Deleted User]

Interesting article. The whole talk will have been interesting but it’s clear where he is going with this.  He does not like simplistic solutions for a complex problem.  

Milevsky noted at the FPAC webinar how “optimal decumulation” is a time-consuming process that requires quant skills. He equated decumulation expertise to tax and legal expertise — areas that may be out of the realm of a financial advisor’s knowledge base and that require special advising.

https://www.investmentexecutive.com/news/industry-news/4-rule-is-no-longer-an-ideal-retirement-strategy-milevsky-says/

MK62

There is always the danger of over complication........

OldScientist

bostonerimus said:

OldScientist said:

bostonerimus said:

Wade Pfau et al did a paper that ran some simulations using recent low bond yields and P/E based stock return estimates and historical statistics to put some sensible variation on annual returns. The results are not pretty; when the 4% rule is followed many failure rates are over 50%. A solution suggested is to replace bonds with an annuity, but the stocks are still a problem. But if you die early your annuity purchase will be helping your fellow man who lives longer than you and annuities are such awful value right now. Maybe they are the best of a bad lot, although I still prefer cash for now. It was studies like this that convinced me to NOT to use the 4% rule and replace it with my own 0% rule...A variable withdrawal rate would also help

https://www.financialplanningassociation.org/sites/default/files/2020-09/JUN13 JFP Finke.pdf

Thanks for the link - that paper appears to have passed me by (although some of Pfau's other work assumes relatively low returns) - I've just reproduced some of his results in my own code, with reductions from average returns of 0.5, 1.5, and 2.5%, the failure rates (4% withdrawal, 30 years, 60/40 US) are 9%, 28%, and 45%, respectively. VPW survives rather well, even though the income does drop to 1.2% at times. If (and that is a big if) you believe that the next 30 years of returns are going to be grim, then even today's relatively low annuity rates would be rather attractive.

5% payout doesn’t look bad today, but in 30 years time it’s pin money. I like annuities for their longevity insurance, but they are inflexible (something that usually comes with insurance) and the lack of indexing in flat annuities means that their value in real terms is always falling.

With a UK MSWR~3.0% (assuming annual rebalancing and according to figure 30 of McClung, http://livingoffyourmoney.com/wp-content/uploads/2016/05/LivingOffYourOwnMoney_eBook_FirstThreeChapters.pdfcompared to ~3.7% for the US Shiller data set - figure 29 in same source), then even the RPI annuity option (with current UK rates of 2.7%, 3.6%, and 4.9% at 65, 70, and 75, respectively) may make sense where other reliable sources of fixed income (i.e. SP and DB) are either not available or insufficient. An annuity in the UK with a 3% escalation (currently priced at 3.3%) involves at least some inflationary risk but will give better longevity insurance than a level annuity, might be an alternative.

OldScientist

Deleted_User said:

If (and that is a big if) you believe that the next 30 years of returns are going to be grim, then even today's relatively low annuity rates would be rather attractive.

Beliefs are for the church.  The future is an event tree rather than a certainty.   We don’t know the future so we try to  design our portfolio to withstand most scenarios.  In that respect annuities don’t really compete with equity returns; they are an option for fixed income.  If one has lots of DB income then there is no need.  Delaying state pension is always the number 1 option.  But annuities are better than todays bonds and this difference is more pronounced than in the past. 

With Pfau's paper, there are a number of questions

1) Are average US (and probably global) stock and bond returns going to be 2.5% lower in the next century than the previous one?
2)  Are US stock and bonds returns going to be 2.5% lower than the current average in the next 10-40 years (i.e. for recent or soon to be retirees)?

Considerations:
My use of the word 'believe' is founded on two further questions, is it possible and is it likely?

1) This is definitely possible and may even be likely (there are currently a number of problems to be solved, e.g. transitioning fuel sources, environment, ageing population,  etc.) - if so, it reduces the US MSWR from about 3.7 to 2.6% - so plan accordingly (and current US annuity prices look really attractive) .

2) This is definitely possibly and is looking highly likely (at least for the next decade or so given the high correlation of future interest rates with current ones presented Pfau's paper). Does this mean that the outcome will be worse than the current historical worst case? Looking at 1965-1995 (around the worst time for retirement), the S&P500 returned 4.8% real (i.e. about 3.8% below the average for US stocks), while US treasuries returned 2.6% real (i.e. average). Given this, conditions in the immediate future may not exceed the current worst case. Just for fun, I reduced the historical bond returns by 2.5% but left stock returns the same and got an MSWR~3.2%. Again, US annuity rates (with 3% COLA, 65 year old male the rate ~4.1%) look fairly attractive.

So, for the current (US) retiree is the SWR 2.6%, 3.2%, 3.7% or 4.0% (subtract 0.5-0.7% for UK given our higher inflation during the worst case retirements)? For me, illustrates why an unwavering index-linked withdrawal for essential spending is unwise.

I think we are agreeing here!

DT2001

MK62 said:

Deleted_User said:

The UK's Office of National Statistics disagrees......they say that the chances of a 65yo British male reaching 100 are 2.9%.   (that is, only 2.9% of 65yo British males alive today, will make it to 100)

Its completely irrelevant.  Sick 65 year olds have different life expectancies and annuity rates.  They wouldn’t even need a longivity insurance.  

 I provided expectancies for healthy Americans from actuaries, the stats that matter for annuities:  https://www.longevityillustrator.org/  Its a 10% chance of getting passed 98. Average life expectancy is 3 years longer for Brits, so will be higher percentage although I don’t have numbers for healthy Brits.  And ones chances could be even higher if he is well off and understands money, which a lot of people on this board do.  

Your chart gives no detail about the % of 65yo who are considered to be in excellent health......for all we know it could be 5% excellent, 90% average and 5% poor.........not really representative if it only applies to a small percentage of 65 year olds.......even if it's 33%/33%/33%, it'd still mean it only applied to one third of 65yo Americans.

Also, while 2 years may not make much difference at 55, at 98 it does.......in the UK, a 65yo female has a 10% chance of making 98yo......it's less than half that for 100yo.

That said, whether it's 5% or 10% is irrelevant really, as neither could be described as an excellent chance in my book.........if I told you a withdrawal plan had 10% chance of making it to 100, would you describe that as an excellent chance?

If you go to the link you get a personalised quote which is more relevant to your own planning. There is the caveat that the more factors that are pertinent to you the better the ‘forecast’ will be.
It is a step up from a generalised life expectancy table.

If you compile the factors that appear relevant to life expectancy (e.g. smoker, location, wealth, family history, current health etc etc) you can get a better estimate of your life expectancy which you then use to help formulate your retirement plan.
It maybe then that annuities are an important part of your plan or nigh on irrelevant. Whether the purchase is at retirement, 10 years after or if you survive to a certain point.

We used an annuity for my mother when she was 70 following my father’s death for the exact reason that Mordko suggested - certainty of income - it was funded by about 20% of her available capital at that time. The rest of her capital was used to cover one offs until she downsized (not in my original plan but equity release was). It was a punt as she had indifferent health (still going 20 years later, just) but it served it’s purpose.

As Mordko says annuities CAN be part of your plan even in today’s scenario. Is your strategy to have enough income until you die or to maximise income with the inherent dangers that entails.

I would reiterate my believe that flexibility and diversity are key in income and expenditure. Having been self employed for 25+ years I think helps the mindset needed.