The 4% Rule Might Not Work, This Retirement Expert Says. Here's His Strategy for a Downturn. - Barron's

Economist Wade Pfau has been thinking about retirement since he was in 20s. But not just his own retirement.

Pfau started studying Social Security for his dissertation while getting his Ph.D. at Princeton University in the early 2000s. At the time, Republicans wanted to divert part of the Social Security payroll tax into a 401(k)-style savings plan. Pfau concluded it might supply sufficient retirement income for retirees—but only if markets cooperated.

Today, Pfau is a professor of retirement income at the American College of Financial Services, a private college that trains financial professionals. His most recent book, “Retirement Planning Guidebook,” was published in September.

While many retirees are banking on a continuing rise in stocks to keep their portfolios growing, Pfau worries that markets will plunge and imperil this “overly optimistic” approach. He has embraced oft-criticized insurance products like variable annuities and whole-life insurance that will hold their value even if stocks crash, and he has done consulting work for insurers. He wrote another book, “Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement,” because these loans also can be used as “buffer assets” during market meltdowns.

Retirement

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Pfau, 44 years old, is already playing around with spreadsheets to analyze his own retirement plan. He recently built a model to determine when it is best to convert money from tax-deferred accounts to tax-free Roth accounts, partly because he wanted the answer for his own retirement accounts. We reached Pfau at his home north of Dallas. An edited version of our conversation follows:

Barron’s: The 4% rule says a retiree can safely withdraw that percentage annually from a portfolio, adjusted for inflation. Why don’t you think it will work?

Pfau: It’s not that I don’t think it will work. I think there is something like a 65% to 70% chance that the 4% rule works for today’s retirees rather than being a near certainty.

It’s a debate. Do you just stick with the historical data, or do you make the adjustment to say, ‘Wait a second. With low interest rates, you can’t have as high a bond return as we’ve had historically, and maybe you can’t predict as high a stock return as we’ve had historically either’?

What percent can people safely withdraw?

I think 3% would be a lot more realistic in terms of giving the same chance of success that we usually think about with the 4% rule.

Will people still have enough money to retire with a lower withdrawal rate?

One of the unrealistic assumptions of the 4% rule is that you don’t have any flexibility to adjust your spending over time. Someone could start retirement with a 4% withdrawal rate if they’re willing to cut back on spending somewhat if we do get into a bad market environment.

Anything else?

People need to be smart about their Social Security claiming decisions. It’s OK to spend down investment assets in the short term so you can delay Social Security benefits until age 70, at least for the high earner of a married couple. The boost you get from Social Security benefits by waiting will really reduce the need to take distributions from investments after age 70.

People also might look at ways to use home equity to support retirement spending, whether that’s downsizing the home or considering getting a line of credit through a reverse mortgage.

Isn’t tapping home equity to avoid selling stocks doubling down on a losing bet?

Using a buffer-based strategy such as home equity does buy into the idea that over long periods the stock market will perform at a reasonable level. If there’s no market recovery, it is going to be all the more harder to have any kind of sustainable retirement strategy.

Why are the first years of retirement most dangerous?

It’s the idea of sequence-of-return risk. I’ve estimated that if somebody is planning for a 30-year retirement, the market returns they experience in the first 10 years can explain 80% of the retirement outcome. If you get a market downturn early on, and markets recover later on, that doesn’t help all that much when you’re spending from that portfolio because you have less remaining to benefit from the subsequent market recovery.

What’s the solution?

There are four ways to manage the sequence-of-return risk. One, spend conservatively. Two, spend flexibly. If you can reduce your spending after a market downturn, that can manage sequence-of-return risk because you don’t have to sell as many shares to meet the spending need. A third option is to be strategic about volatility in your portfolio, even using the idea of a rising equity glide path. The fourth option is using buffer assets like cash, a reverse mortgage or whole life policy with cash value.