For decades, financial advisors have counseled clients that they should be able to safely withdraw 4% of their assets each year as a means of providing income, while maintaining an account balance large enough to keep income flowing through retirement.
While some of the underlying thinking behind the so-called 4% rule was prudent, it was hatched in an era in which interest rates were much higher, capital markets less volatile and, most important, Americans had shorter lifespans.
Given today's market volatility and changed retirement landscape, it's safe to assume that the 4% rule may be obsolete. To validate this assumption, we set out to determine whether this rule was sufficient to compensate for the many financial risks that retiring baby boomers and subsequent generations will carry with them into later life.
The answer came back: a resounding no.
New research and modeling, unveiled in a white paper and developed in partnership by our respective firms, reveals that this longstanding rule of thumb puts retirees at significant risk of running out of income should they achieve even an average lifespan — a national dilemma, given that a record 4.5 million Americans will reach the age of 65 in 2024.
The analysis centered on the variables that most affect people's income in retirement: how long they are expected to live, how healthy they are going to be, equity market volatility and the rate of inflation. Here's what we found, based on today's numbers:
Longer life spans make for longer retirements. The average life expectancy for a 65-year-old male is an additional 19 years and an additional 22 years for a female of the same age. Combined, there is a 50% probability that one member of a male-female couple age 65 will survive 27 years or until around age 92; a 25% chance of one person reaching age 97; and about a 5% chance of them living to age 100.
In addition, a third of all 65-year-olds today will live past age 90, with about 1 in 7 living beyond age 95. Making this even more challenging is an average standard deviation of around 10 years for both male and female life expectancy. Given these figures, coupled with the tendency of most individuals to believe they can "beat the average," a reasonable retirement planning horizon might be in the 30-to-35-year range, or to ages 95 to 100.
One in 2 retirees can expect a remainder-of-life health impairment. There is a roughly 50% chance of a 65-year-old adult having some level of physical or cognitive impairment over the remainder of their life. The fact that many insurers no longer sell traditional morbidity-based, long-term care policies is evidence that older-age health needs are viewed as a largely uninsurable risk.
Even modest inflation rates can significantly affect a retiree's purchasing power. A 2% annual inflation rate necessitates doubling of an individual's retirement income over 35 years to maintain purchasing power. By comparison, a 3% inflation rate would shrink this to 23.5 years and require income to nearly triple during a 35-year retirement — or by age 100 for a person who retired at age 65. Even a 1% rate would necessitate a 41% increase in retirement income over 35 years.
Volatile equity markets can sap a retirement portfolio of its long-term ability to produce income. While equity markets have generally risen, there have been multiple periods of volatility. A significant equity market correction — defined as a decline of 20% — within the first 10 years of retirement increases the risk of running out of income during their remaining lifetime, something economists call sequence risk. The key question is whether that increased risk is acceptable for a typical American retiree.
The analysis determines that even for an individual utilizing both a conservative 60/40 equity-to-fixed-income investment mix, along with a moderate 4% withdrawal rate indexed for inflation, there is a significant risk of running out of income should they achieve even average life expectancy while enduring an equity market correction during their first decade in retirement.
Those who experience a 20% equity market decline sometime within the first 10 years of retirement— a likely outcome given the crash coinciding with the financial crisis of 2008-2009, as well as the December 2018 and current COVID-19 selloffs — are particularly vulnerable to running out of income. Our analysis found that the risk of running out of income under this reasonable scenario was:
What this means is that many Americans entering retirement face a considerable — some would say unacceptable — level of financial risk from the trifecta of longevity, equity market volatility and the uncertainty of older age health costs and long-term care.
Given that pensions have virtually disappeared, leaving millions without a source of protected lifetime income, the good news is that other financial products that can fill the gap already exist.
While many of today's investment offerings — such as target date funds, mutual funds and exchange traded funds — are often used to generate retirement income, the fact is that annuities are the only financial product that was designed for and specifically provide protected lifetime income.
This study demonstrates that the 4% rule is no longer a safe or effective way for retirees to plan for retirement income.
The variables that most affect people's retirement income have each changed significantly. For many Americans looking for a new strategy that accounts for these changes, protected lifetime income from annuities is the smart choice.
— By Colin Devine, principal at C. Devine & Associates and education fellow for the Alliance for Lifetime Income, and Ken Mungan, chairman of Milliman and a member of the Alliance for Lifetime Income.