Beyond The 4% Rule Read online

  BEYOND

  THE 4%

  RULE

  BEYOND

  THE 4%

  RULE

  The science of retirement portfolios

  that last a lifetime

  Abraham Okusanya

  MSc, CFP, AFPS, Chartered MCSI

  To Funmi and Adorabelle, the centre of my universe.

  ISBN-13: 978-1985721647

  ISBN-10: 1985721643

  First published in the United Kingdom in 2018 via CreateSpace

  Copyright © 2018 Abraham Okusanya

  All rights reserved. No part of this book can be reproduced without the written permission of Abraham Okusanya.

  For further information please visit www.beyond4percent.com

  Book Design: Sheer Design and Typesetting

  Contents

  Introduction: retirement reinvented

  Annuity: the beginning of the end?

  1.Skin in the game

  2. The hidden dangers

  3. What doesn’t work

  4. Safe withdrawal rate: how safe?

  5. Busting the myth of U-shaped retirement spending

  6. SWR 2.0: the power of flexible withdrawal strategies

  7. Estimating probability of success

  8. Adapting sustainable withdrawal strategies to longevity

  9. Asset allocation and sustainable withdrawal rate

  10. All together: baking the layer cake of sustainable withdrawal rate

  About the author

  Timeline, the sustainable withdrawal rate software

  FinalytiQ

  This project would have been impossible without my insanely brilliant team at FinalytiQ/Timelineapp.co and our incredible clients, who help us to keep the lights on.

  I owe a debt of gratitude to my book designer Megan Sheer and editor Anthea Christie for knocking the book into shape with masterful finesse.

  If I have seen further, it is by standing on the shoulders of giants including Bill Bengen, Michael Kitces, Prof Wade Pfau, Dr David Blanchett and others in the financial planning community, too numerous to mention.

  INTRODUCTION

  Retirement reinvented

  ‘Science is a process. It’s not pretending it has the right answer, it merely has the best process to get closer to that right answer.’

  – Seth Godin

  Retirement planning used to be so simple. Until the 1880s, most people didn’t retire. People worked till they dropped. Workers – especially men – literally died with their boots on.

  Then in the 1880s, the German Chancellor Otto von Bismarck presented a radical idea of financial support for older members of society. The German government created what was in effect the first retirement system: state-sponsored financial support for people over 70.

  It’s rumoured that von Bismarck’s motive was to get rid of government opposition. But the idea caught on, not just in Germany but also in the UK and the US. And by the early 1920s, the proportion of employed men over the age of 65 had dropped significantly.

  By the 1930s, many industries promised their employees some sort of pension in retirement. These were the forerunners of what’s known today as defined benefit pension schemes.

  But as people lived longer, the cost of providing defined benefit schemes soared out of control. It became difficult for employers to afford defined benefit pensions and individuals gradually became more responsible for saving for their old age.

  Enter defined contribution schemes. Individuals simply built up savings for their old age (known as accumulation). They often had support from their employers and they got tax relief from the government.

  After doing this during their working lives, most people never had to worry about how to convert their pot of money into income for the rest of their lives. There was a simple solution – an annuity!

  People simply handed their pot of money to an insurance company, who offered them a guaranteed income for the rest of their lives in return.

  Annuity: the beginning of the end?

  ‘. . . but if you observe, people always live for ever when there is an annuity to be paid them; and she is very stout and healthy, and hardly forty. An annuity is a very serious business; it comes over and over every year, and there is no getting rid of it.’

  – Jane Austen, Sense and Sensibility (1811)

  Pension rules since the 1990s offered some flexibility in terms of how people drew income. Still, over 90% of people bought an annuity with their pension pot. It became the de facto retirement income product for people saving into a defined contribution pension.

  Annuities were really great products. They probably still are for many people. For most of the period between 1950 and 2000, annuity rates for a 65-year-old were in double digits.

  Annuities don’t work in a vacuum. A retiree hands over their pension pot to an insurer in exchange for an income for a lifetime. The insurer then lends that money to the government (after taking a cut) by investing in government bonds (also known as gilts). The interest they receive from gilts is what they use to meet their obligation to the retiree.

  It doesn’t matter how long you live, your annuity pays an income until you die. Some annuitants will live for a long time and get more from their annuity than they paid in. Others aren’t so lucky and they get a lot less. In effect, those who don’t live very long subsidise those who do. Plus insurers get a tidy profit.

  The financial crisis of 2008/09 marked a major turning point for the future of annuities in the UK. Like other central banks across the world, the Bank of England started money-printing programmes (also known as quantitative easing). This was an attempt to stabilise the financial system by purchasing gilts from the government.

  This drove up prices on government bonds, and consequently yields were pushed to historical lows. Annuity rates took a beating.

  This led to a lot of bickering between financial commentators about whether annuities were good value for money. Some experts thought yes, others thought no. Then there were those who thought people should sell the one they already had!

  An increasing number of retirees developed a love-hate relationship with their annuity. Annuities became demonised, perhaps justifiably so, and this went on for some time.

  Then bang! In 2014, then-Chancellor George Osborne muttered a few words in his budget speech that would change the fortunes of millions of people in retirement, for better or worse.

  Fig. 1: Historical Annuity and UK Gilt Yield

  ‘I am announcing today that we will legislate to remove all remaining tax restrictions on how pensioners have access to their pension pots. Pensioners will have complete freedom to draw down as much or as little of their pension pot as they want, anytime they want. No caps. No drawdown limits. Let me be clear. No one will have to buy an annuity.’

  Those few seemingly harmless words essentially ended annuities as the default (real or perceived) option in retirement. In the following months, annuity rates fell to record levels. An increasing number of people are now choosing to drawdown their retirement savings without buying an annuity.

  Retirees must work out how best to make their retirement income last a lifetime. This is a huge challenge and one that this book is designed to tackle.

  The landscape changed for financial advisers too. For many, helping clients with retirement income planning isn’t anything new. They’ve been doing it for donkey’s years. So, you’d be forgiven for wondering why we need a new book on the topic.

  But the reality is that something dramatic happened in the UK retirement planning landscape when George Osborne uttered those words.

  Historically, the UK pension system had an inbuilt safety-first mechanism in its legislation and regulation. Even pension drawdown
products had a safety mechanism (the GAD rates and Minimum Income Requirement) which made it hard for retired people to run out of money. But Pension Freedoms ripped up the retirement income planning rulebook and put a major dent in this inbuilt safety-first mechanism.

  It’s further exacerbated by falling annuity rates and the closure of increasing numbers of defined benefit schemes. An increasing number of people reaching retirement age won’t have any inbuilt safety-first income beyond the State Pension. Their DC pot will be their main source of income after the State Pension.

  Advisers may well have been advising on retirement income planning for some time, but they’ve been thrown into uncharted territory by Pension Freedoms. It’s only right to question whether existing practices are still fit for purpose.

  Financial advisers working in this area also carry significant risk, particularly in light of the lack of a long-stop on financial advice. They carry the potential liability for retirement income advice to their graves. Poor outcomes could see clients seeking redress from advisers. And even long after the actual client has passed on, the heirs of their estate could potentially seek redress for unsuitable advice.

  What’s in the book?

  This book isn’t designed as a substitute for a financial adviser. On the contrary, it’s written with retirees and their financial advisers in mind. Both will benefit from the book.

  The book explores the two fundamental schools of thought on retirement income planning – safety-first and probability-based – and how each addresses the retirement income conundrum. It’s crucial to understand the strengths and the weaknesses of each. Ultimately, the question is, where do you place your trust for sustainable income in retirement? The guarantees of an insurance company or the capital markets? Is there such a thing as a middle ground?

  If you trust insurer guarantees, the answer is simple. Do it the traditional way. Buy an annuity. At least to secure your basic income.

  If you trust the capital markets, this book confronts the challenge of how to secure a sustainable income that lasts a lifetime from your portfolio. It delves into the details of the so-called 4% rule or, more precisely, safe withdrawal rates. This may seem to be a simple concept on the surface, but there are nuances. These include various income withdrawal strategies, asset allocation and the unavoidable question of how long before you pop your clogs.

  This book helps retirees and their advisers navigate the treacherous retirement income landscape, using sound empirical evidence and robust, practical application. There’s no trial-and-error.

  I hope you enjoy reading the book as much as I’ve enjoyed writing it.

  Happy reading.

  CHAPTER 1

  Skin in the game

  An increasing body of research highlights the fundamental difference between retirement income planning and traditional financial planning in the accumulation stage. But I find the old fable of the chicken and the pig better illustrates this remarkable difference.

  A Pig and a Chicken are walking down the road.

  The Chicken says: ‘Hey Pig, I was thinking we should open a restaurant!’

  Pig replies: ‘Hmm, maybe, what would we call it?’

  The Chicken responds: ‘How about ‘ham-n-eggs’?’

  The Pig thinks for a moment and says: ‘No thanks. I’d be committed, but you’d only be involved.’

  The lesson is that in a breakfast of eggs and bacon, the pig has a lot more to lose than the chicken. Retirement is the stage when an individual’s pension pot transitions from a chicken into a pig. It becomes a lot more than just a number on a statement. It’s what they rely on to pay their day-today bills, fund their lifestyle and enjoy their newly found freedom. The retiree has more skin in the game, so to speak.

  Fig. 2: The chicken and the pig

  Sadly, when it comes to retirement income planning, a large part of the advice profession and the financial industry continue to think like chickens, when they should think more like pigs!

  We all need to understand the risks that are peculiar to this crucial stage.

  Planning your retirement income strategy is one of the hardest things you’ll ever do. Most people will benefit immensely from working with a financial adviser who truly understands the complexities involved. But not every financial adviser is a retirement income specialist. An emerging body of research points to the fact that retirement income planning should be considered a distinct discipline, with its own theories and practices that are based on rigorous empirical evidence.

  In the medical profession, general practitioners (GPs) treat most common and non-life-threatening conditions. They play an invaluable role in caring for their patients. However, they’re not allowed to cut people up. When it comes to dealing with issues relating to the intricate workings of specific organs or systems of the body, we call on specialists. After completing medical school, specialists complete additional training in a specific branch of medicine to become surgeons (of different kinds), paediatricians, obstetricians and other medical specialisms too numerous to name.

  The point is that retirement income planning is a specialist branch of financial planning. And retirees should only seek to work with specialists in this area. Why? Because the problems you’re trying to solve are different than during accumulation. More importantly, the consequences of misdiagnosis or mistreatment are infinitely greater. The risks, tools, theories and practices required for the job are therefore very different.

  Key retirement income risks

  The unique risks associated with retirement income planning sum up the distinction between the accumulation and retirement stages.

  a) Diminished earning flexibility

  Retirement happens at the tail end of your working life, long after earnings have peaked. Returning to work after retirement isn’t a viable option for many. The practical implication is that we want to take less risk with our savings as we become more reliant on our financial assets.

  b) Inflation risk

  A major challenge is how to prevent inflation – the thief that keeps on taking – from depleting the buying power of your income over what may be a 30-year retirement, or possibly longer.

  c) Decreasing cognitive abilities

  As people get older, their ability to make a financial decision is impaired. It’s estimated that financial capability declines at a rate of 1% to 2% per year from age 601.

  Fig. 3: Financial literacy score by age

  The chart opposite shows the average self-assessed confidence with financial literacy and actual financial literacy by age from 60 to 892.

  So, even though actual financial literacy declines with age, an individual’s confidence in their own ability to make financial decisions tends to remain stable as they get older. The difference between the two is dubbed the overconfidence gap.

  This makes it challenging for clients to understand the vagaries of managing a drawdown portfolio. It may even be challenging to give their adviser informed consent to manage it on their behalf.

  d) Longevity risk and unknown time horizon

  The fear of dying is right up there on the list of people’s biggest fears. But the fear of public speaking is apparently even higher. Maybe I’ve got this all wrong but if that’s true, then when the average person goes to a funeral, they’d rather be in the casket than do the eulogy. But I digress.

  For retirees, the greatest fear shouldn’t be of an untimely death, but of living too long! Indeed, research suggests that if there’s anything retirees fear more than death, it’s running out of money during their lifetime.

  Retirement income planning is particularly challenging because we’re planning for a finite, but precisely unknown retirement period. Without the proverbial crystal ball, it’s tricky to estimate how long you’re likely to live.

  It’s estimated that around 75% of people over age 65 live as a couple. The chance that at least one of a 65-year-old couple will live to age 100 is 24%.

  So it’s important to consider the survival
probability for couples, not just for the individuals.

  Given this long but precisely unknown time horizon, how do we make sure that a pension pot lasts a lifetime? It’s a particular challenge when a retiree doesn’t want to buy an annuity with all or most of their retirement savings pot.

  e) Heightened sequence risk

  Poor returns early in retirement can cause untold damage to your prospects of a decent income for life. Sequence risk is often confused with volatility, a traditional measure of investment risk. But it’s a distinct and visible risk – particularly at the retirement income stage.

  The best way to understand the impact of sequence risk on a retirement portfolio is to look at the impact of each year’s return on the overall outcome for someone over a typical investment lifetime.

  Suppose an individual spends 60 years invested in the capital markets. They pay into their portfolio for the first 30 years (accumulation) and they take money out for the last 30 years (decumulation).

  Fig. 4 overleaf3 shows the impact of each year of return over the entire investment period of a typical individual’s lifetime. The chart quantifies the impact of each year’s return and shows how much the success or failure of the overall retirement journey depends on the returns obtained in any year.

  The returns in the first decade of decumulation stage (years 31 to 40 on the chart) of retirement have a disproportionate impact on the overall retirement experience. So, the order of return is as important as the level of return.