Mark to market: Is this commonly cited retirement rule irrelevant?
Mark answers a reader question about spending in retirement.
Question:
Hi Mark,
I’m really confused about why your articles go on and on about the “4% Rule”......it just doesn’t seem to have any real bearing on actuality, particularly in a SMSF, maybe more so in an industry fund?
It has absolutely no bearing on any of our calculations --- we are only governed by the mandated minimum pension amount we have to take out per year, once in pension mode, what our investments have returned in real dollars in that year, whether it covers whatever percentage we are up to according to our age aggregation, and whether our income received is over or under the percentage amount we have to take, whether we want to or not! Without having to realise any assets to meet our payment obligation of course.
Can you tell me why “the 4% Rule” really matters? I must be missing something surely!
I just don’t see the relevance........I keep reading your articles, thinking to myself, “it must be really important, or I’m really thick”, but it’s just not there.
Answer:
This is a good question. It is based on the following video which was interestingly on retiring on just dividend income.
I will start with a very brief definition of the 4% rule. For more please read Shani’s excellent article that goes through all the assumptions behind the 4% rule in greater detail. I’ve also written an article about the Monte Carlo simulation which forms the basis of the 4% rule.
The worst thing that can happen to a retiree is quitting work and having markets plunge and inflation soar. Think of the 4% rule as insurance. Like any insurance it can seem useless if whatever you insure against doesn’t eventuate.
Anyone who has retired in the last decade plus probably is questioning the relevance of the 4% rule just like the member of the Morningstar community that asked the question.
What do you think about the approach being taken by this member of the Morningstar community? Write me at [email protected] to share your views.
Is the 4% rule valuable?
While the 4% rule may not seem relevant to many people who are already retired I think it is valuable for people who are still planning for retirement.
The 4% rule is a one size fits all rule which means there are a laundry list of assumptions embedded within it. There are assumptions about returns, inflation, asset allocation, retirement lengths and spending patterns.
Ironically the number of assumptions mean this ‘universal’ retirement rule doesn’t apply to any individual retiree. The least important part of the 4% rule is the conclusion that 4% is a ‘safe’ withdrawal rate.
The value of the 4% rule is unlocked if you know how it works. Understanding the underlying assumptions and why each of them may not be accurate is the catalyst needed to grasp all the puts and takes in retirement planning.
Below is a small sample of two of the more nuanced assumptions in the 4% rule that have informed the way I think about retirement. I’ve also included a misnomer I often hear from retirees.
Assumption 1: Each asset in your portfolio will be proportionately sold to fund retirement withdrawals
This was the reference in the question to the 4% rule being applicable to industry funds and not SMSFs. Regardless of the type of super provider this assumption does not reflect real life.
Each investor to a certain extent is free to choose which assets to sell. This can partially mitigate sequencing risk which occurs when an investor is forced to sell low early in retirement to meet withdrawals. Selling low limits the upside from a recovery which means retirement savings run out faster.
Picking which investments to sell is valuable. But in really challenging market conditions everything tends to go down. Everything but cash. That is why I advocate for a bucket portfolio using cash to combat sequencing risk.
Assumption 2: Spending levels will remain at an inflation adjusted consistent level throughout retirement
Everybody knows this assumption does not reflect reality. Retirees typically spend more early in retirement when they are active and less over time as health deteriorates. There is generally a spike in spending at the end of life.
Simply looking at inflation data and applying it to retirement spending is also problematic. Many retirees have very different spending patterns than the ‘typical’ Australian which is represented in the consumer price index.
The ability of retirees to flexibly adjust their spending is an underappreciated tool to combat sequencing and longevity risk.
My colleague James Gruber makes a compelling case that many retirees spend too little money in retirement. Many of these differences between real life and the 4% rule assumption may be the cause.
A misnomer about withdrawal rates
The final point to consider is the notion that spending is driven by the mandated minimum pension amount. The ATO may mandates how much you need to take out of super. There is no mandate on how much you need to spend.
This is terminology issue. A safe withdrawal rate is really a safe spending rate. There is an obvious incentive for the tax authorities to get money out of superannuation. As the ongoing debate over the DIV296 tax proposal is showing there is a view that super is being used to amass a level of wealth that is inconsistent with retirement spending needs. That is the driver of the ATO rule. Not your best interests.
Whether you end up spending more or less than the mandated minimum pension amount I would encourage you to come up with a plan that is right for you. This is not a decision you want to outsource to the ATO.
Have a question? email me at [email protected]
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