We live in a fairly complex world where simple sometimes feels better. To that end, many financial principles can be summed up through basic axioms. The “Rule of 72,” for example, provides a basic formula for how long it will take for a sum of money to double, assuming a constant rate of return. Another example is the “4 Percent Rule,” which is a financial planning principle aimed at ensuring individuals do not run out of money in retirement. This rule of thumb advises that withdrawing 4 percent of one’s initial retirement portfolio, and adjusting it for inflation thereafter, should be sufficient to cover withdrawals for 30 years1
The potential danger with “rules of thumb” lies in the assumptions, which can make a huge difference in the outcome. To dig a bit deeper into how this applies to the 4 percent rule, consider the following assumptions made by the proponents of the rule:
- The portfolio is invested 50 percent in equities, and 50 percent in government bonds, which says nothing for individual risk preferences and comfort level;
- Returns on the various asset classes are in line with longer-term averages, and are fairly level each year.
To address the first assumption, the biggest problem that many retirees face today is the ongoing decline in yields on government bond instruments across the globe, which has ramifications for other categories of fixed income investments. Generally, an investor who buys a 10-year US Treasury note and holds that asset to maturity should expect to realize an annualized return roughly equal to the yield at the time of the purchase. As of this writing, the 10-year US Treasury yield is approximately 1.49 percent, versus over 5.2 percent in June 2007.2 With retirees’ portfolios needing to generate income, such a fall in yields for newly purchased bond instruments creates the need for additional returns to meet financial goals over the long term. This has caused market participants to find creative ways to generate yield from their portfolios.
The second assumption relates to the “even” return of an asset class over time. While this certainly has merits from a projection perspective, investors need to be mindful that actual experience is likely to look different from the average level. Using the S&P 500 as an example, dating back to 1928, the average annual return on the S&P 500 has been approximately 11.4 percent. More than 46 percent of those years posted returns below that 11.4 percent average, while 54 percent of years were above the long-term average.3
What this means is that too large of withdrawals in years where markets fall below expected long-term returns has a negative effect on future portfolio values, as those withdrawals do not have the potential to recoup investment losses by staying invested.
To sum it all up, the basic challenge for retirees is to ensure portfolio returns are sufficient fund portfolio withdrawals, without taking too much risk in the investment portfolio in order to achieve those returns in any given period of time. Our portfolio management team firmly believes that managing risk in clients’ portfolios over the short term is critical to avoiding large negative surprises.
While “rules of thumb” may help in starting a conversation, we believe that this cannot replace tailored, individual financial planning. While the markets are giving investors a fairly tough environment to generate historical-like returns from some asset classes, we believe that there are still areas of the investment landscape to generate additional returns without taking undue risk. Ultimately, markets cycle and the potentially lower return environments we expect now should give way to better return environments in the future.
2 Source: Thomson Reuters EIKON
4 Standard and Poors Corporation
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