Do the Retirement Rules Really Need to Change?
There’s risk in trying to predict an unpredictable future
Retirement discussions are prominent in our line of work. While we work with clients in all stages of life, more often than not it’s a life event that triggers a need to work with a financial advisor. The most common of these life events tends to be retirement.
Oftentimes the discussion about retirement focuses on the fear and very real possibility of running out of money in retirement. What often gets overlooked in these conversations is the risk of not spending enough money in retirement. While this seems counterintuitive to what most clients are looking for, this happens because many clients have been so good at saving through the years, they haven’t learned to be comfortable with spending. This isn’t about spending recklessly, it's about enjoying life and enjoying what you’ve worked hard to accumulate in a responsible manner.
Unfortunately retirees these days are at a clear disadvantage versus retirees of the past. With interest rates so low ( U.S. Aggregate is yielding 1.56%) and recent inflation readings so high, it’s easy to see why retirees are so nervous about spending in their golden years. Factor in longer life expectancies and there is a real concern for how to replace income in a low interest / high inflation environment. It’s easy to see why some retirees may be hesitant to spend with these factors working against them.
Making matters even harder are articles like this from the Wall Street Journal this past weekend. In it they respond to reader questions on the subject of distributions in retirement. Historically the number given out for retirement distributions has been around 4% - give or take. A very well-respected firm quoted in the article, Morningstar, came out with a study moving the distribution amount down to about 3.3% at the start of retirement. Another expert quoted in the article said that number should actually be about 2.5%. As they go on to explain how they came up with these numbers (mainly through future return predictions), they were all based on the a historical “benchmark” for a retirement portfolio of 50% stocks and 50% fixed income which the 4% rule was built on. No one tackled the most pressing question I had - why are we stuck in the past while using data to predict a future no one can truly predict?
As I read the reasoning behind these ultra low and conservative distribution rates, it reminded me of a quote from the book Alchemy by Rory Sutherland. The book reads “The need to rely on data can also blind you to important facts that lie outside your model...big data all comes from the same place - the past.” These models and predictions are based on past data or assumptions for future stock market returns, but could the future be harder to predict? We need be able to adapt to a changing world - primarily one where you can only get 2% of yield without taking undue risk in a world of 5% inflation.
So why are financial predictions, whether about future returns or retirement distribution rates so problematic to investors & retirees? It’s because our human operating systems aren’t naturally built to be good long-term investors. We are both highly emotional and by averse to risk & losses. While these traits helped us evolve to the most advanced creature in the world today, they still work against us being good long-term investors.
Oftentimes we read studies or forecasts with a ton of research, data, and anecdotes to back it up. They all sound good and make perfect sense, but blindly following them can lead to adverse results. As Sutherland writes:
“In theory, you can’t be too logical, but in practice, you can. Yet we never seem to believe that it is possible for logical solutions to fail. After all, if it makes sense, how can it possibly be wrong?”
This last quote rings true to many conversations I’ve had with clients and prospects over the years. Investors sometimes make poor long-term decisions based on logical short-term solutions.
Your early years of retirement are meant to be some of the best years of your life. If all of a sudden you're thinking you can only spend 2.5% of your nest egg vs. 4% or 5% of which you initially felt was safe, you could look back in 20 years and really regret how you approached retirement and the money (or lack of money) you spent. I’m not recommending to spend recklessly, but there must be other solutions available, especially at the start of retirement - most likely your most active and highest spending years.
This is where working with an advisor can be beneficial, especially in retirement. The updated 3.3% and 2.5% distribution assumptions are rooted in old ways of thinking that having a 50/50 stock to bond portfolio in retirement is the most appropriate. And for some this might be. But if you step back and look at both your financial goals and the history of the stock market - is this type of conservative portfolio truly necessary? This worked 15-20 years ago when CD’s were yielding 5% and 6%. But today? That type of allocation probably won’t work for you. If you’re in your 60’s, starting retirement and have a 20-30 year time horizon - could you benefit from having more invested in stocks?
By elongating your time horizon, stocks become less risky. This isn’t to say in any given year there isn’t a ton of risk in stocks because there most certainly is. But if we can change our mindset a bit and work against our own operating system, keeping the long-term perspective in mind can help overcome some of the current factors working against retirees and their distributions - mainly low-interest rates and high inflation. If you look at the chart below from JP Morgan, having a 10-year time horizon in stocks the worst 10-year period the stock market had was a negative -1% annual return over the past 70 years. Not great, but also not devastating. If you go out 20-years, the worst rolling 20-year return for stocks is an annual 6% return. Pretty good. If we can shift our time horizon, the risk metrics change as well.
We need to adapt to the times in front of us - with interest rates where they are we won’t be able to live on yield alone. So how do we replace retirement income while still enjoying these early years of retirement? It has to be in terms of total return. While it's a simple concept on paper, the mechanics of it for someone looking to live on a steady stream of income is harder to conceptualize. With a total return framework, we can expand past the historically conservative portfolios and look to utilize more equities in a retirement portfolio. While on the surface this certainly presents itself as more risky, if you can expand your investment time horizon, based on the chart above, it doesn’t need to feel more risky. When it comes to a newly retired individual or couple, we need to continue to take a long-term view while adhering to short-term cash flow needs and risk factors.
Human behavior is oftentimes the biggest predictor of investment and retirement success. Having the appropriate guardrails in place to protect for the long-haul is key and working with the right financial advisor can help you in this journey. Before settling on a lower distribution rate and a retirement you maybe didn’t envision, explore how you can take the current environment and prudently save and invest for a long and fruitful retirement. Focus on what’s in your control and doing what you can to temper the human operating system. Minor shifts in mindset and behavior can make all the difference in truly embracing what the golden years were meant to be - a time to live out your dreams.
Written by: Ryan Bouchey