Safe withdrawal rates for retirees
Nicholas Grove  |  02/02/2016Text size  Decrease  Increase  |  

Nicholas Grove: I'm Nick Grove from Morningstar and today I'm joined by managing director of research strategy, Anthony Serhan, who in a recent paper suggested that Australian retirees should perhaps rethink their withdrawal rates. Anthony thanks for joining us.

Anthony Serhan: Great to be here.

Grove: First off Anthony, what is this 4 per cent rule we hear so much about and where did this come from?

Serhan: It's great starting point. It's where we really started with this. And you have to go back 22 years. It came from an article put into the Journal of Financial Planning in the US by William Bengen, who really wanted to solve this question of, "Geez, I've got all these clients retiring--he was a financial planner--How much can they actually draw down?" So that's where it started. But I think as with anything and we love things that can be simple, don't we-- 4 per cent sounds good? What we miss out on is some of the detail about where that rule came from.

So first of all it was a US study. So it was looking at US returns--stocks 50 per cent, bonds 50 per cent, that sort of a portfolio--it was historic data they were using and there are two other really important points: one, the 4 per cent is only used once. You use that to determine what you can spend in the first year of retirement then that dollar amount is indexed to inflation. So that's the first thing to understand, and secondly, when he was doing this he really was focusing on this idea of a safe withdrawal rate. So he was saying this 4 per cent number is really the minimum you can look at over a 30-year period assuming markets perform at some of their worst. So he is really locking in on that certainty idea.

Grove: This 4 per cent rule that he came up with, given the way markets are today and given that we are in a completely different country, does this 4 per cent rule still have any sort of application for Aussie retirees?

Serhan: I think there were a number of things we wanted to do when we looked at this work and try to do in an Australian context. The first thing was to address one of the practicalities of life and that is there are fees. Now whether you are paying somebody to manage your portfolio, whether you are paying an accountant, whether you are paying somebody to administer the portfolio, there are costs. So what we did first of all was introduce a fee of 1 per cent per annum into our analysis. And secondly, we looked at the Australian returns as opposed to US returns. So if you do a similar thing: Assume a 30-year period, 50 per cent Australian shares/50 per cent Australian bond rates with the fee level, the 4 per cent number drops to around 2.5 per cent.

But if you want to take that a step further, which is what we did and say more realistically let's think about projected returns or what are returns likely to be taking into account where equity markets are today, where interest rates are today, and also a more diversified portfolio, it's still 50 per cent equities but you've got a mix of Australian and international assets in there. When you do that, if you still want to be 99 per cent certain that withdrawal rate number comes out at around 2.9 per cent and if you are prepared to say lower how certain you want to be to around 8 per cent, the number comes up to 3.9 per cent. So you still get that range there, so look in an Australian context there are some definite things you've got to allow for.

Grove: In your paper Anthony you talk about this concept of probability of success or the success rate. Can you just elaborate on this a bit?

Serhan: I think it's really important and it's a really important concept for people to get around. I guess one of the things everybody maybe felt a little bit let down about during the financial crisis was this idea that, hang on we always talk about what average annual returns are going to be, you didn't tell me you can get something like this. And probability of success is one way of starting to think about a range of returns. You think about it: We say over the next 20 years we expect equity markets to do say whatever it is 6 per cent or x per cent per annum. If you are saying, okay, I'm prepared to work with that, what you are saying is you are a pretty optimistic person. Because the reality is with any expected return it will come true in 50 per cent or you will get that in 50 per cent of the circumstances. So you are saying that those 50 per cent are probably going to be some of the more favorable conditions. The reality is you can look at that range and you can play with different certainty levels. You say look maybe I'm happy at 50 per cent or maybe I'm happy at 99 per cent--I want to be dead certain that whatever I'm putting into here is going to come out. Well the reality is somewhere in between. That's what this paper does--it shows you a range of successful probability and success levels.

Grove: Just finally Anthony, given the findings from the paper what do you think is the best course of action at the moment for Australian retirees?

Serhan: I think there are a few key lessons there. First of all look, equity markets I think are still going to provide reasonable returns against cash over the next 20, 30 years but in our numbers those projected returns are probably two percentage points lower from what they have been historically. So, get used to this idea that returns are going to be lower. You have some choices, you can spend less, you can save more or you can satisfy yourself with a lower level of probability.

Our safe withdrawal rates, they are similar to what we've seen in the past but they are lower and importantly these withdrawal rates will be even lower if as the data shows us that people keep living longer. That's good news, isn't it? We are going to live longer. Well, maybe you've got to take that into account when you are thinking about how much you are spending today. Also the other thing we noticed was the safe withdrawal rates we were coming at with are lower than the minimum required withdrawal rates from an allocated pension. So a few things for people out there living off their allocated pension--if they want more certainty about their money lasting their lives you may need to save money outside of the allocated pension, or more importantly, you may need to put aside some of your annual payments from your allocated pension to another investment that's going to be there and something you can draw upon.

The other great thing out of this study, once again it shows the benefits of diversification. So a good balanced portfolio--make sure you have it. But the other thing that strikes you is, well, while simple rules are great, the reality is we are all different and we need to look at this stuff one by one and reviewing this taking into account your own requirements, your own preferences is still going to be the best way of working your way through retirement.

Grove: Of course. Anthony thanks very much for your time today.

Serhan: Thank you.

Grove: I'm Nick Grove from Morningstar. Thanks for watching.

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