How not to out­live your cash

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

Mail & Guardian - - Business - Thalia Holmes

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?

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