Is the ‘4% Rule’ of Decumulation 100% Wrong?

For more than 30 years, the “4% rule” stating that retirees should draw down 4% of their retirement savings every year has been an industry guideline for “safe” decumulation. But steady withdrawals could put some long-lived retirees at risk of depleting their assets.

Last year, a Prudential Financial study found that more than 80% of surveyed registered investment advisers used the 4% rule as a go-to approach to retirement income, and a separate Cerulli Associates study found that only about 20% of surveyed RIAs recommend variable annuities or other insurance products that could generate lifetime income.

Prudential expanded its lifetime income strategies by offering insurance overlays in January through Fiduciary Exchange LLC’s marketplace, then announced last month a collaboration with LPL Financial Holdings Inc. to sell insurance overlays for managed accounts on LPL’s platforms. Unlike traditional annuities, which transfer assets to an insurance company, insurance overlays allow a client’s assets to stay put and preserve liquidity and flexibility.

The method works, according to Prudential. In a recent paper, “Override the ‘4% Rule’ in Managed Accounts,” co-authors David Blanchett, Prudential’s head of retirement research, and Daniel Gutman, vice president and head of wealth solutions at Prudential Financial, used a Monte Carlo analysis to find that a portfolio with an insurance overlay generated approximately 10% more income than an uninsured portfolio.

According to Blanchett and Gutman’s calculations, a portfolio with a higher level of insurance coverage has a higher rate of reaching its goals. An uninsured 30-year portfolio would have an 80% chance of maintaining a 4% withdrawal rate. The same portfolio with 10% allocated to an insurance overlay would have an 82% chance of success. One with 50% insurance would have an 89% chance.

With a hypothetical 40-year portfolio, the range is even broader: An uninsured portfolio would have a 51% chance of being prepared for a 4% initial withdrawal rate; the same portfolio with 10% insurance would have a 58% chance of success; and one with 50% insurance would have a 76% chance of success.

When 220 RIAs were surveyed by Prudential in April, 61% of respondents said they were likely to recommend an insurance overlay, 68% said insurance overlays would lead to increased risk tolerance in client portfolios, and 85% expected insurance overlays to make clients more interested in allocating savings to lifetime income.

Funds and Ladders

Last week, another challenge to the 4% rule was proposed by statistician Stefan Sharkansky, whose website, Personal Fund, provides cost analysis of mutual funds and exchange-traded funds to financial advisers. Such funds are key to Sharkansky’s approach for managing longevity risk, based on the “annually recalculated virtual annuity” method originally devised by researchers in 2015. Sharkansky argued in a paper in the Financial Analysts Journal, “The Only Other Spending Rule Article You Will Ever Need,” that retirees with a ladder of inflation-protected bonds and a stock market index fund can draw a variable income in retirement without depleting their funds.

Variability matters to Sharkansky, who argued that retirees with a steady 4% withdrawal rate and no ladders of bonds can risk shortchanging themselves while remaining vulnerable to market volatility. An ARVA portfolio combines a steady, riskless asset—like a ladder of Treasury inflation-protected securities—with variable, riskier assets, like stocks and conventional bonds. The TIPS ladder produces guaranteed income, while the riskier portion provides a growing investment account from which the retiree makes withdrawals. Retirees’ portfolios can be “recalculated” based on changing needs and life expectancy, and withdrawals are adjusted based on portfolio market value.

Comparing the ARVA strategy to a more traditional portfolio of stocks, bonds and cash, Sharkansky found that ARVA provided retirees higher average incomes. The more traditional portfolio had favorable median worst-case scenarios when compared with the ARVA approach, but ARVA’s TIPS ladder offered more protection for lower-performing portfolios.

While Sharkansky concedes that ARVA’s high probability of living within one’s means comes with a lower chance of leaving a larger bequest, he said that retirees who wanted to build a bequest could set aside more of their savings or set a longer time horizon for their portfolio.

When researchers M. Barton Waring and Laurence B. Siegel first presented the ARVA approach in 2015, they wrote: “There is no magic formula that will stretch dollars available to equal dollars ‘needed.’ However, one can improve tremendously on current practice.”