Wednesday, June 29, 2011

The Sustainable Withdrawal Rates Fantasy

Sustainable Withdrawal Rates (SWR) is a strategy for spending personal savings in retirement. It is sometimes referred to as the 4% Rule and it’s intended to create your own homemade fixed annuity without having to hand your principal over to an insurance company. Here’s how it would work.

You retire with a million dollars and invest it in a portfolio of stocks and bonds. You withdraw $45,000 (4.5%) to pay for the first year of retirement.  The second year, you withdraw $45,000 plus an additional amount that would cover the previous year’s rate of inflation.  SWR proponents say you can keep doing this for at least thirty years and not run out of money. 

In fact, the studies seem to show that you could end up with a lot of money.  Maybe even more than you started with.  And there’s “only” a 5% chance that you would go broke before you die.  Does that sound wonderful or what?

The strategy is based on statistical studies said to show that a retiree can invest his savings in a portfolio of stocks and bonds, withdraw 4.5% of the initial portfolio value[1], and continue to withdraw that same dollar amount annually with a 95% probability of funding at least thirty years of retirement.

But, they don’t show that at all.

Imagine you asked me how safe it would be to walk across the highway in front of my house.  I tell you that I watched 100 people try to cross in the last five years and “only” five of them were run over.  You might conclude that you have about a 95% chance of crossing safely.

Now imagine that I add, as you walk away, that I only watched people cross the highway who refused to check for oncoming traffic and ignored any cars they saw coming toward them after they began crossing.  I can’t tell you anything about the results for people who tried to avoid getting hit, I say, because I didn’t count them.

You would probably think that I was a little nutty, and then wonder why my statistics would be meaningful to you in any way.  You, after all, look both ways before you cross a road and if a car approaches while you’re still crossing, you damned well try to get out of its way. If we measured the fatality rates of pedestrians whose highway-crossing strategy was to dart into traffic without looking, common sense tells us to expect that they would be struck more often than pedestrians who would do everything possible to avoid danger. Otherwise, none of us would bother looking.

The SWR studies have a similar flaw.  They assume that a retiree would continue spending the same amount every year even when it would be obvious that they were about to go broke.  Consequently, they don’t predict the number of retirees who would go broke using this strategy. They show the probability of successfully funding at least 30 years for a retiree who would refuse to reduce spending to avoid going broke.

If I could clearly see that I would go broke if I didn’t cut back my spending, I would cut back my spending.  How about you? 

The logic of the SWR studies is flawed by what statisticians call the “unrepresentative sample fallacy of inductive reasoning”. A mouthful to be sure, it means that the sample we measure doesn’t represent the population for which we want to generalize.

An extreme example would be measuring the heights of players on an NBA basketball team and concluding that the average American is 6’ 6” tall and can dunk a basketball. Measuring the bankruptcy rate for people who would do nothing to avoid going broke and asserting that the rest of us share the same odds is another extreme example.

How to Improve Your Chances of Dying Broke

We would expect the probability of financial ruin for retirees who would try to avoid bankruptcy to be lower than for retirees who would simply continue spending until they
were broke and bankruptcy rates bear this out.

A 95% probability of successfully funding retirement in the SWR studies is a different way of saying there is a 5% chance of failure, and failure in these studies is defined as depleting one’s savings before retirement ends. That’s a 5% chance that the SWR retiree ends up bankrupt during retirement. Broke. Penniless. Ruined. Or, as Ray Charles so elegantly put it, busted.

While the SWR strategy predicts about a 5% probability of financial ruin with 4.5% withdrawals, according to Elizabeth Warren, a Harvard expert on personal bankruptcy, the bankruptcy rate for Americans aged 65 and older was recently about 0.43%[2]. That’s about 1/12th of the rate of financial ruin promised by the SWR strategy for this age group.

Let me say that in a different way. The SWR studies predict that retirees who employ the strategy are about 12 times more likely to go broke than the typical American of retirement age.

The Yale Study 

A number of studies refer to a 1973 Harvard University study to determine how much their managers could safely withdraw from their endowment fund without eroding the principal. Though I have been unable to locate a copy of that oft-quoted study, it is reported that the answer was determined to be about 4%.  (The 2008 Yale Endowment report does state their spending policy is limited to 4.5% to 6% annually.)

Some argue that this supports the SWR findings, but this seems a better argument that 4% is not a safe withdrawal rate for retirees.

If the Harvard endowment, with its unequalled investment management talent, lower costs, non-profit tax status, and broader range of investment opportunities earns only enough to support 4% annual withdrawals, should individual retirees expect to sustain the same level of spending? Perhaps, but only if they are able to match or exceed the investment returns of the Harvard endowment. Most individual investors and money managers don’t even match average  market returns over the long term.

The Harvard endowment can also solicit new contributions from donors, an option I suspect is rarely available to retirees.

One would expect the Harvard endowment investments to outperform those of the typical retiree; otherwise, some extremely well paid investment managers would be fired. The consequences of major investment losses would also seem to be less severe for Harvard, since a retiree would be left penniless with few prospects of avoiding welfare, while Harvard can always go out and solicit donations from wealthy alumni. And, of course, the Harvard Endowment’s assets provide a larger margin of error— retirees with $26B in assets can probably feel good about spending $1.2B (4%) annually with little fear of bankruptcy.  Those of us with significantly smaller portfolios need to be more careful.

With greater risk and lower expected market returns, we should expect retirees to be able to spend somewhat less than Harvard’s 4%.

The 2007-2008 Stock Market’s Rebuttal of SWR

In the 2007-2008 market crash, many retirement savings accounts dropped nearly 50% in value. The financial press began to call 401K accounts “201Ks”. Workers who had planned to retire soon were forced to delay those plans, some for several years. People who had already retired and had planned to live off 4.5% withdrawals from their stock and bond portfolios were forced to reduce their standard of living or to try to re-enter the workforce. The shortcomings of the SWR strategy became brutally obvious.

SWR advocates have recently tried to explain to countless retirees whose SWR-based retirement plans were obliterated by the 2008 market downturn that the 4% Rule was never more than a rule of thumb.  Rules of thumb can be handy guidelines when we don’t have a lot at stake.  “Show up twenty minutes before the movie starts and you’ll probably get a ticket” works pretty well, while “fasten the engine to the wing with a handful of the biggest bolts you can find”, not so much.

Financial plans that fail in retirement can mean destitution with few options for recovery.  Retirees deserve better than rules of thumb.

A Few Other Rebuttals

In a paper entitled “The 4% Rule-- At What Price?”, written by Nobel Laureate, William Sharpe and others, the authors showed that the SWR strategy is much more expensive than its alternatives. In its conclusion the authors state, “Despite its ubiquity, it is time to replace the 4% rule with approaches better grounded in fundamental economic analysis.”

David Babbel of The University of Pennsylvania’s Wharton Business School refers to these strategies as fantasies.

Or, consider Dallas News finance columnist, Scott Burns.  Burns, who was an avid supporter of the SWR strategy for years as a columnist, recently co-authored a book with Laurence J. Kotlikoff entitled Spend ‘til the End in which he now refers to the 4% Rule of Thumb as a “Rule of Dumb”.

Sustainable Withdrawal Rates strategies, though wildly popular in the financial press and among many financial planners prior to the 2007-2008 market crash, are voodoo economics and misapplied statistics.  Unfortunately for many people who neared retirement in 2006, and many others who had recently retired and expected to fund their golden years with the SWR strategy, the books, advertisements and web calculators that promote the strategy were quite effective.

Don’t fall for it.

12 There are several “Sustainable Withdrawal Rate” studies and each calculates slightly different probabilities, but all project about 4% to 4.5% safe withdrawal rates for thirty years.

[2] Generations of Struggle, D. Thorne, E. Warren and T. Sullivan, AARP, June, 2008.

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