Financial advisors relying on the classic “4% rule” for their clients’ retirement income have a better than even chance of failure, according to newly published research.

Titled “The 4 Percent Rule is Not Safe in a Low-Yield World,” the study by Michael Finke, Wade Pfau and David Blanchett argues that advisors make a grave mistake in basing their clients’ retirement plans on historical returns that may be an anomaly.

Investment companies often include in their disclosures that “past returns do not guarantee future results,” but to the study’s co-author, Michael Finke, that’s not just rhetoric.

In an interview with AdvisorOne, Finke, who is agnostic on what future returns will be, cites research by Rob Arnott to the effect that demographics have a determining effect on asset demand.

“It’s really a demographic storm,” says Finke, an AdvisorOne contributor who heads the Personal Financial Planning program at Texas Tech University. “You have the largest cohort of people who are in early retirement, and you also have the emergence of countries that have higher savings rates and are becoming wealthier and wealthier.”

The result, he says, is a capital glut that is having a depressing impact on yields in the U.S.

“We’re trying to acknowledge what present reality looks like and apply that reality to the retirement income plan,” Finke (left) continues. “There’s no reason to believe that the market for assets in the 21st century is going to look like the market for assets in the 20th century.”

Yet that’s exactly what advisors who follow the 4% rule are doing, since that withdrawal rate is only “safe” based on returns seen in the 20th century.

“Most planners take some comfort in knowing that a 4% inflation-adjusted withdrawal rate wouldn’t cause a retiree to run out of money in a 30-year retirement,” Finke says. “Previous studies that supported the 4% rate used historical yield data that don’t look anything like what new retirees are facing today.”

Indeed, according to his study, Monte Carlo simulations based on historic returns for a 30-year retirement give a 4% withdrawal rate a failure rate of just 6%, which many advisors consider reasonably safe.

“What many don’t realize is that portfolio returns during the first years of retirement have a disproportionate impact on failure rates,” Finke continues. “We estimated what would happen if bond yields, and equity returns corrected for a low-yield risk-free rate of return, persisted in the future.”

The researchers’ study notes William Bengen, the planner who originated the 4% rule, based his calculations on average real bond returns of 2.6% and average real stock returns of 8.6%. But bond yields as of January 2013 are 4% less than their historical average.

The Tipping Point

Based on current low yields, the study’s authors find that “if we calibrate bond returns to the January 2013 real yields offered on 5-year TIPS, while maintaining the historical equity premium, the failure rate jumps to a whopping 57%,” concluding that “the 4% rule cannot be treated as a safe initial withdrawal rate in today’s low-interest-rate environment.”

In other words, advisors must take into account that the real return on risk-free (i.e., TIPS) investments is negative today. Finke thus reiterates the key finding of the study: “Using current TIPS rates, which are the most accurate current inflation-adjusted bond yield, we find that failure rates rise beyond 50% using the 4% rule.”

To advisors who would challenge this argument on the assumption that today’s low rates will eventually climb higher, Finke and his co-authors looked at portfolio failure rates under scenarios in which bond yields returned to their historical average.

“Even if rates go back up in 5 years, retirees are still facing an 18% failure rate,” or three times the rate Bengen thought acceptable. “If they go back up after 10 years, the failure rate rises to 32%. The bottom line is that the current low-yield environment is a retirement income game changer. And hoping that things will get better eventually is a risky strategy.

“By relying on 20th century market returns which we may never see again,” Finke continues, “we’re giving people a false sense of security.”

While knocking the fixed-withdrawal rate retirement income strategy, Finke did not offer any more enthusiasm for the so-called bucket approach often seen by advisors as an alternative to systematic withdrawals.

“Buckets is an investment-based strategy, so it is in line with that failure rate methodology, which I think we need to rethink,” he says.

“It’s perhaps overly simplistic and perhaps doesn’t take advantage of all the products an advisor has available to maximize spending and minimize the risk of failure.

“The problem with the traditional investment-based approach,” Finke continues, “is you have a pot of money and you want to withdraw a chunk of money from that pot of money and you’re afraid of that pot of money disappearing.

“It’s relatively easy to get rid of that risk, but in many cases advisors haven’t been attracted to instruments that would allow them to get rid of that risk because the yields are very low.”

Giving Annuities Another Look

Those instruments are deferred and immediate annuities, but advisors stuck in the past on historical returns may be reluctant to recommend them to their clients. Compared with historical yields, even the best annuities don’t seem competitive, Finke says.

“You can either create a retirement income using investments, or you can annuitize, which may seem relatively unattractive if you expect investment returns to be in the future what they have been in the past,” he says.

“Our purpose isn’t to depress people. It’s to help them understand the risk of overestimating the returns within a retirement portfolio.”

So what’s an advisor to do?

“You need to start with having a more conservative approach to estimating retirement income,” Finke counsels. “That means if people want the same level of retirement income they will need to work a little bit longer and perhaps readjust their expectations about lifestyle during retirement. There’s nothing you can do to change the market—you have to accept the market as it is.

“I think an advisor has to think more carefully about constructing a retirement income portfolio that includes safeguards to prevent disaster if a client runs out of money.”

While deferred and immediate annuity products provide longevity protection and higher yield (compared to bonds), Finke acknowledges that that they reduce liquidity, which raises the problem of a potential future health shock.

“You either need to maintain more access to cash in the form of a lump sum you can always withdraw from if you need it or, if you annuitize, you make sure you can protect yourself by buying long-term care coverage,” he says.

“The best approach,” he concludes, “takes all of these potential risks and consumption aspects into account.”

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Check out Michael Finke’s stories on AdvisorOne and these other stories on Annuities:

Check out Rethinking Annuities, a Special Report landing page at AdvisorOne.