Trim expectations and spending or work longer as 4pc rule might not be relevant
In a world of low structural investment returns, retirees need to reconsider the assumption that they can draw down 4pc a year of their savings.
Known as the 4pc rule, this popular guideline is running smack into what looks to be an extended period of low returns in stocks and bonds.
Obviously, this is important not just for retirees, who may have little choice but to cut back on consumption, but also for savers, who will need to save more or work longer to safely meet their targets.
It equally applies to foundations and endowments, which struggle with how much they can fund and still keep contributing in perpetuity.
For all investors, a low-return world is one in which high fees are especially damaging.
Popularised by financial adviser William Bengen, who did the original research behind the idea in the 1990s, the 4pc rule holds that an investor who wants her retirement assets to last for 30 years should draw down 4pc of the principal in the first year, increasing drawdowns annually by inflation.
Bengen found that those who drew down 5pc a year on a simple portfolio of S&P 500 stocks and treasury bonds had a 30pc chance of their assets being exhausted before their target date. Later research, using a more diversified portfolio, ratcheted drawdowns up to 4.5pc.
However, these assumptions were based on historical equity returns which outpaced inflation by 6pc or more and which, simply put, may not be repeated.
There are a fair number of problems with the 4pc rule, some good, like increasing longevity, and some bad. Among the worst is that the rule, and its acceptance, is running foul of the low-return world in which we now live and which may continue for a good part of the next 30 years.
Credit Suisse this week released its Global Investment Returns Yearbook for 2013, which included a study by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School on the dynamics and implications of a low-return world.
"To maintain the real value of a perpetual endowment, the withdrawal or spending rate should not exceed the expected real return on the assets," the authors wrote.
"We have estimated that over the next 20 to 30 years, global investors, paying low levels of withholding tax and management fees, can expect to earn an annualised real return of no more than 3pc on an all-equity fund and 2pc on a fund split equally between equities and government bonds.
"These figures sit uneasily with a 4pc rule."
That rather bleak outlook is a huge contrast from the past 60 years.
Since 1950, global investors have earned north of 6pc above inflation annually on both their stock and bond investments.
It is unlikely we'll see those sorts of returns over that extended period for a very long time.
At the heart of this is low interest rates. Real interest rates – yields minus inflation – are now in negative territory in most major markets.
That's a bad sign for bonds, because not only is the value of the investment diminishing in purchasing power terms, risks are also lopsided to the downside.
Real rates could theoretically go lower, but there is a lot more room for higher inflation, which will cut the capital value of bonds.
The study estimates that real interest rates may not turn positive for six to eight years, meaning many investors are looking at negative real returns on bonds and cash over an extended period.
This also isn't a great environment for stocks: the lower that real interest rates are historically, the lower equity returns are in the five years that follow.
With low rates here for several more years, the authors are estimating equity returns to be only 3pc to 3.5pc above inflation over the next 20 to 30 years.
That compares to a 6pc-plus real return since 1950, even including the past decade of lost returns.
For those in retirement or close to it, the upshot, sadly, is that you probably need to trim expectations and expenditures or extend your working life.
For those of us still in the asset-building stages of life, the simple reaction is to save more and not make any early retirement plans.
For all groups, it is time to take a very close look at what you pay for investment management services. Paying out 1.5 or 2pc a year is a lot easier to tolerate when you are clearing 6pc annually above inflation.
Paying that amount over the next 30 years might easily mean giving up 30pc or more of your gain annually for investment services.
That's crippling, especially on a compound basis. Investors – and wealth managers – who figure this out quickly will enjoy the greatest long-term success. (Reuters)