How not to outlive your cash

Obeying the 4% rule is not always enough to ensure your savings last through retirement

It may be decades from now or just a year or two, but we all eventually receive our last pay cheque. Once you’ve packed up your desk, it’s time to get very serious about what to do with that lump sum you’ve painstakingly saved towards retirement.

One important question to consider is: How much money should I draw from my savings every year?

The 4% rule is a popular rule of thumb in the retirement industry. The rule states, in short, that if you want to sustain your income in the long years after you stop full-time employment, you should never use more than 4% of your savings in any given year.

That would mean a downward adjustment for most of us: the latest figures by the Association for Savings and Investment South Africa (Asisa) show that South Africans are drawing down their living annuities at an average rate of 6.62% a year. “This means that capital will run down sooner or later, with unhappy consequences for the individual concerned,” said David Crawford, a certified financial planner who specialises in retirement planning.

But before we cancel our holiday plans, how reliable is the 4% rule and how realistic is it to implement?

Let’s start by understanding its origins. “The rule comes from a study done in the United States, which looked at data spanning from 1925 to 1995, and determined what is the most that someone could withdraw from a portfolio made up of bonds and shares in the first year, and then adjust that amount for inflation each year for a period of 30 years, such that they would never run out of money,” explained “Ben Collins”, who writes the personal finance blog stealthywealth.co.za and uses a pseudonym when speaking to the media.

“This starting percentage became known as the safe maximum withdrawal rate and was found to be 4%. Since the period that the study covered had its fair share of ups and downs (including the Great Depression and a world war), it is viewed as an excellent rule of thumb,” he said.

Collins cites three extra considerations that indicate the 4% rule is fairly conservative and therefore safe to rely on.

First, “if your retirement portfolio experiences a significant drawdown, it is unlikely you will continue spending and drawing down at the same rate. It is more likely that you will curb some of your spending to compensate,” said Collins.

Second, “there is also the assumption that there will be zero additional income — which may not be the case, especially for early retirees,” he said.

Furthermore, studies show that people naturally spend less as they age. Several separate studies drawing data from the US Census Bureau and the University of Michigan have found a solid trend: spending decreases by at least 12% each decade starting from age 55.

But the data underpinning the 4% rule comes from the US and only covers a 30-year period. How applicable is it to the South African market and would the theory still hold if tested over a longer period of time?

American retirement researcher Professor Wade Pfau did just that. “He extended the 4% rule study to cover 109 years’ worth of data across 17 countries to get a better idea of how the rule might play out, Collins explained.

Pfau’s findings suggested that the 4% rule shouldn’t be seen as failproof. He found that in all 17 countries surveyed, the rule would have failed at some point over the period.

He then created a hypothetical best-case scenario for each country and tested whether the 4% drawdown would suffice in each place. South Africa was one of the countries tested and the news isn’t great: Pfau’s calculations indicated that a 4% drawdown is actually too generous.

The “safe maximum” amount to draw down in South Africa, according to his research, is 3.84%. Out of the 17 countries studied, in only four could retirees draw their savings at a rate of 4% without risking running out of money.

Pfau’s research perhaps underscores an observation from Christine Benz, Morningstar’s director of personal finance: “The 4% rule … has its share of detractors, who have reasonably pointed out that it’s an overly simplified take on an exceptionally complex problem.”

South Africa’s unique tax regulations add a layer of complexity. Tracy Jensen, product architect at 10X Investments, said in a statement published by Discovery Health: “South Africa[n] regulations restrict the income drawn each year from 2.5% to 17.5% of your investment balance. As a result, you could have enough money to draw the income you desire, but you are restricted once you reach the 17.5% cap. So, an adaptation of the rule is required in our context.”

Crawford highlights another consideration. The “drawdown” rule assumes a retiree is making use of a living annuity — one that allows them to determine where their cash is invested and how much they draw from it each year. But this autonomy comes with risk: their savings could lose value if invested in the wrong place, and retirees could run out of money before they die.

Most retirees don’t want to take that risk. The 2015 Sanlam Benchmark Survey found that 87% of South Africans between the ages of 55 and 85 preferred guaranteed income for life in retirement. But there’s a disconnect between their preferences and their actions: Asisa statistics from the same year showed that 90% of retirement annuity sales in South Africa were living annuity products — ones that do not guarantee an income for life.

In contrast, “conventional guaranteed annuities offer retirees pensions that are guaranteed to continue being paid until the death of the longest-living of a couple”, said Crawford.

“They are also guaranteed never to reduce, something that a living annuity can and does do on occasion. There are several ways in which annual increases can be conferred to these pensions and, in each case, whenever an increase is conferred it forms the new minimum guaranteed pension.”

Of course, this approach has catches too: if there is money left over after you or your partner die, it can’t be inherited by another loved one. But there are ways to mitigate this, said Crawford. “Where the fear of dying too soon is a problem, it is possible to ensure that the pension pays for a fixed term regardless of when the pensioner dies.”

Ultimately, each retiree must weigh up the autonomy of directing their own investments and passing on any remaining money with the guarantee of an income that will never run out. But for those who opt for a living annuity, aiming to draw down 3.84% of your income a year seems a reasonable way of ensuring you don’t outlive your cash.

So, maybe rethink those holiday plans after all?