Example #4,080,875 in the re-hashing of the 4% rule’s drawbacks and reviewed as an example of what my last post ranted against. Neglects portfolio construction, asset selection, rebalancing, and more. Ends where the industry pieces always seem to end up: private annuities.
After my recent post about the problems I see with endlessly rehashing the limitations of the 4% rule and the refusal to consider, much less test, alternatives, I wanted to provide an example and add it to the Risk Parity resource list I’m assembling.
This one is from Michael Finke, Professor of Wealth Management at the American College of Financial Services, and appears on Thinkadvisor.com, an industry website for financial planners and advisors published by ALM Global. The context for this article is important - this is an industry publication whose goal is to provide “financial advisors, registered investment advisors and wealth managers with comprehensive coverage of the products, services and information they need to guide their clients in making critical wealth, health and life decisions.” This is not meant to impugn their knowledge, expertise, or perspectives - but do remember that this article is advice for the angler, not the fish (you!).
The article starts off with the usual funeral dirge for the 4% rule, noting the publication of Morningstar’s “State of Retirement Income” report just a few weeks prior which found that, basically, the 4% rule should be the 3.3% rule. The Morningstar report also identified a problem in the 4% rule as being excessively rigid, and noted that retirees would be better off following flexible retirement spending rates. Noted, though I wouldn’t say the original proponents of the 4% rule were ever saying the 4% should be a blood oath that you sign with the devil - merely that it was a rough number to let you know what you could live off in retirement. Flexible spending rules are indeed better than inflexible, so point granted, but I feel like this is a bit of a strawman attack on the original message.
Why the 4% Rule “Doesn’t Work”
The next section is where the argument departs a bit. In order to prove the point that the 4% rule is “dead,” Finke offers some tests which then fall short, underscoring his contention. The problem is that one of the alternatives he considers is 100% TIPS. Yikes! Finke writes: “If you measure success rates of the 4% rule using the traditional 30-year sustainability yardstick, safe investments have a zero percent chance of success.” Yes, of course, but that’s not the original portfolio tested in the 4% rule! That one is based on a 50/50 portfolio, which isn’t even close to being best practice for maximizing perpetual withdrawal rates. It is a bit of a bait and switch: say something isn’t going to work, then find the worst possible version of it and show that it doesn’t work, even though the original version didn’t propose such a bad alternative.
Next, there is a reference to a paper by his colleague Wade Pfau in which Pfau found that the 4% rule was mostly a story about the US stock market, and not necessarily applicable elsewhere. Pfau found that the 4% would have failed in 13 of 17 other countries, and would have been a complete disaster in Russia, Germany, and Japan. I’m planning on reviewing Pfau’s paper later, but briefly. I’d note that the real test is whether a total international equity approach would work since nowadays, investors have access to dozens and dozens of markets - the old days of being geographically limited are over. In addition, the experience of Russia, Germany, and Japan is certainly scary, but actually even more so than Pfau (or perhaps Finke) would think. None of the alternatives to the 4% rule, including the 3.3% rule, the 2.3% rule or the extreme step of transforming all of your nest egg into a private annuity would have survived Bolshevism or the Second World War either!
A third line of argument against the 4% rule is that the various tests Finke and Pfau (and others) have done have shown that the portfolios are fragile and may not be as robust in other economic environments. True, but does that lead to testing other asset allocation models? They keep on repeating tests of the 60/40 and do not consider alternatives, then say the 4% is by definition insufficient. But why ignore including small-cap value, gold, managed futures, or other non- or negative-correlated asset classes? Urgh. This is a perfect example of people who sit around the campfire complaining about the smoke but refuse to think about a chimney.
Finally, Finke talks about the problem of investment fees and how they can doom the 4% rule, but here the estimates are unnecessarily high. Finke is assuming 1% AUM fee and then .25 to .75% in ongoing investment fees. True, those are high. Don’t pay that much.
You’ll Never Guess What’s Better than the 4% Rule…
All of the evidence against the 4% rule for Finke points to the conclusion, where Finke suggests using…(you’ll never guess)... private annuities (!) to match a retiree’s required spending.
In order not to turn Finke’s argument into a straw man myself, his more nuanced argument is that retirees should think in terms of required spending and preferred spending, the former being shelter, electricity bills, health care, etc. with the latter being travel, dog grooming, eating out, etc. He suggests using contractual arrangements to satisfy the former, and suggests stock/bond investing are fine for the latter, since a retiree could cut back on them, if necessary.
For the record, I don’t think this is an inherently bad suggestion, and I don’t want to write off annuities for everybody. Certainly, I don’t feel any attraction to them, which is a function of my personality as well as my age (48), and the idea of paying 2 or 3% to move my portfolio’s success percentage from 99% to 99.5% doesn’t seem worth it. I’d sooner go for TIPS or short-term Treasuries, and “take my chances” as opposed to handing over a huge chunk of money to an insurance company and hope it doesn’t go under.
That being said, I reserve the right to change my mind as I age, and I do have a family friend for whom a private annuity really is the best option. She received an inheritance just north of half a million dollars and purchased a deferred annuity to kick in when she turned 65. The thing is: she can get very anxious and is functionally innumerate, both by personality and by the fact that she had a massive brain tumor removed a few years ago which affected her cognitive abilities. The annuity makes sense for her as she knows she has X amount every month from Social Security and Y amount from the private annuity. Month to month, it is just a matter of knowing that she needs to live on less than X+Y per month, and that’s fine. It’s not mathematically optimal, but all things considered, it’s probably the best solution for her. In a situation like this, I can see Finke’s point.
Keep in mind, though, that Finke is constructing an argument to help financial advisors make this case as strongly as possible, even to people who may not resemble my family friend. The last little bit of the piece is a justification of the fees, providing language of how an advisor might convince someone that a 3% is appropriate for the risk an insurance company is taking on. Finke was quick to note that investment fees can be high, but doesn’t mention annuity fees, only noting that in one case they can ruin a portfolio but in another case, are merely fair compensation for services rendered.
If you only read one part of the piece, I would recommend the last six paragraphs – it’s a great peek into the talking points that a savvy financial advisor will use to catch their prey, er… I mean, their clients.