Some Rules Are Meant to Be Broken

Copyright: halfpoint / 123RF Stock PhotoSam and Kelly (names changed of course) came to see me early last week. A very nice couple from West Falmouth, in their mid 50s. They are recent empty nesters with two kids in college. While they’re still years away from retirement, they’re thinking ahead. Sam has big dreams of what life will be like once they reach retirement age. To achieve those goals, Sam and Kelly will need to carefully build their investment system to make sure the money they need is available to them in their golden years.

Sam’s got a penchant for travel and wants to see the world with Kelly before they get too old. For now, he’s o.k. with getting away for a week or two each year, as their work schedules allow. Last year Sam and Kelly made it to Spain. This year, the couple is planning to visit Australia.

While Sam would just like to drop a pin on the map and go, Kelly is more practical. She loves to travel too but isn’t content with just picking a location and going. She likes to plan their itinerary almost down to the hour, to make sure they get the most out of their vacation dollars.

So, it was in character for Kelly to be thinking strategically and asking some tough questions when they came in.

Kelly mentioned that she heard that at retirement age, it is “safe” to withdraw 4% of retirement savings each year. And that sticking to that rule will ensure that their money will last throughout their retirement.

Kelly was referring to something called the 4% Rule. You see folks, for years, the conventional wisdom in the financial industry was that once you hit retirement age, you could safely withdraw 4% of your investments (adjusting that dollar figure for inflation every year) for 20 years without having to worry about running out of money.

Hmmm . . . not so fast.

The 4% Rule was an idea first put forth in the 1990s by a financial adviser named William Bengen. Bengen ran simulations modeling historical market behavior all the way back to 1926 to come up with the 4% figure, which, as mentioned above, for years was touted by economists and financial advisors.

But depending on who you talk to, that rule has changed, for a number of reasons. It is no longer the gold standard. Many believe that a “safe” withdrawal rate is closer to 2.5% – 3%, and some even less.

One reason is that life expectancies have increased. People are living longer lives. Many people spend more than ¼ of their lives in retirement. Think about that! Today’s retirees need their money to last longer than it needed to for retirees in the 1990s.

The 4% Rule is also not as effective today as it was previously because interest rates have been kept so low for so long. Historically, retirees could invest in CDs and bond funds and get a decent return. But with interest rates being kept artificially low, that is no longer possible.

Since retirees cannot turn entirely to those more conservative investments, many are forced into more volatile asset classes, such as equities or stocks. And we all know that there can be significant volatility in the markets.

Market volatility during the early years of retirement can have a significant impact on the long-term success of a portfolio, especially if distributions are being taken. The stock market goes up and down – cycling is inevitable. If you’re unlucky enough to retire during or immediately before a significant market correction, and you are drawing on a portfolio that has a few bad years in the beginning, the outlook is far worse than it is for someone with the same portfolio who experiences those bad years towards the end of their retirement. This is called the Sequence of Returns risk, and it is more pronounced when withdrawals are a larger percentage of the portfolio.

With the stock market returns over the past 18 months, it’s easy to get complacent and assume the good times will continue to roll. But if we’ve learned anything from the past, it’s that things on Wall Street can go off kilter when we least expect them to. When it comes to your retirement savings, you owe it to yourself to make sure you’re not taking unnecessary risk.

Understanding your portfolio’s drawdown is key to understanding your risk. Drawdown is a measure of volatility. It is the measure of the peak to trough decline in an investment’s performance during a defined period of time. When we calculated Sam and Kelly’s drawdown, we learned that in the past, there was a 47% swing from high to low. That’s a lot of potential risk, and assuming you just hold on takes a heck of a long time to earn it back. With their existing strategy, in a volatile market, Sam and Kelly ran the risk of losing almost half of what they’d accumulated for retirement. Having the potential for that much drawdown, I suggested that 4% would not be a very “safe” withdrawal rate for Sam and Kelly.

However, after we discussed Sam and Kelly’s acceptable level of risk, we repositioned their portfolio using an investment system focusing more on downside risk management. We settled with a back-tested strategy to somewhere around a 17-20% drawdown. That gives them a much higher probability of success should there be a significant downward shift in the market when Sam and Kelly near retirement age.

And instead of sticking hard and fast to the somewhat outdated 4% Rule, Sam and Kelly can certainly use other models to figure out what’s an acceptable withdrawal amount from year to year.

Sam and Kelly have a way to go before they reach their golden years. However, preparing now for the shift from the accumulation phase of their financial lifecycle to the distribution phase was a critical move for them. A major step in the right direction as they will need to be careful to make sure what they have worked hard to save lasts for those years. Whether that’s 4% per year, 3% or some other number, I have little worry that they will do well – after all, they’re already vigilant, educated investors.

And as I often say, you too, should be vigilant and stay alert, because you deserve more.

Have a great week folks!

Jeff Cutter, CPA/PFS is President at Cutter Financial Group, LLC, a SEC Registered Investment Advisor, with offices is Falmouth, Duxbury, and Mansfield. Cutter Financial Group provides private wealth and investment management advice incorporating low risk, low volatility financial strategies. Jeff can be reached at jeff@cutterfinancialgroup.com.

Cutter Financial Group LLC (“Cutter Financial”) is a registered investment advisor.

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