In a world of lower returns and lengthened life expectancies, long-held rules may no longer apply
Retirement arguably the most critical financial-planning exercise for most people; the wisdom of building up a nest egg for when you’re too old to work is beyond debate. What’s debatable, though is how wise it is to follow rules of thumb — and whether those rules will always be worth following.
“Retiring now is pretty dangerous,” David Blanchett, head of retirement research at Morningstar Inc, recently told the Wall Street Journal. “[A]mong those who make forecasts, there is an expectation for lower returns.”
Because of changing investment expectations, retirement-planning rules that scholars and advisors have vouched for need to be tweaked. For example, there’s the 4% rule, which tells people to withdraw 4% from their nest egg in their first year of retirement, and dial it up annually to match inflation without a big risk of going broke.
That strategy used to work for investors with 60-40 allocations in large-cap stocks and intermediate-term US bonds over a 30-year retirement. But in more recent simulations run by researchers using forecasts of future returns, it failed almost half the time. According to Wade Pfau, a professor at the American College of Financial Services and one of the study’s proponents, 3% is the new safe starting point; retirees who need more can adopt different dynamic strategies, which basically involve loosening their purse strings when needed and tightening them later to compensate.
Another rule tells people to amass a certain dollar amount — say, 10 times their current salary — before retiring. But according to Blanchett, that simple approach can make investors complacent during bull markets, causing them to save less or retire early as they get closer to the “finish line” and potentially get burned by a market reversal.
Instead, he recommended that investors avoid looking at their balances and just save a consistent amount annually. According to Blanchett, someone with a 60-40 balanced portfolio of stocks and bonds and 30 years until retirement should target 16.6% of their annual income yearly, while those who are 40 years away from retiring should set aside at least 8.8%.
Finally, there’s the “glide path” theory of asset allocation, which says retirees should start with a significant allocation in stocks, but gradually bring it down as they age to protect against market declines. But research by Pfau and Michael Kitces, director of wealth management at Pinnacle Advisory Group, has found those who reduce their stock exposure to 20% to 30% in the first few retirement years and carefully increase it to 50% to 70% over time are likely to make their money last longer.
“Of course, if stocks fare well in the early part of retirement, those who use the conventional approach will come out ahead,” the Journal said. “But the new approach provides better downside protection in the years right after retirement, when retirees are most vulnerable to financial losses. “
