Morningstar: The 4% Rule Doesn’t Apply Anymore!

Morningstar: The 4% Rule Doesn’t Apply Anymore!
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Morningstar researchers claimed that the 4% rule expired in a published study. Morningstar is a US-based asset management company founded in 1984, operating in 29 countries. It also offers investment advisory services. More detailed information can be found here. For those who don’t know yet, let me briefly explain what the 4% rule is. When you withdraw money from your portfolio at an annual rate of 4% (+ inflation rate), your portfolio lasts for 30 years. At least, financial advisors have reached this conclusion in studies using historical data of the US capital markets. It is also known as the safe withdrawal rate. We use it when estimating how much portfolio size is required for financial freedom. I’ve explained it in detail here. This ratio is not reasonable means that investors like me, pursuing financial independence, are reviewing plans. So the subject is essential. 🙂

Morningstar research

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Morningstar published a research paper titled “State of Retirement Income: Safe Withdrawal Rates” on November 11, 2021. Researchers; made a Monte-Carlo simulation based on the assumptions in the original study, not on past rates of return, but on expected rates of return for the upcoming period. As a result, they estimated the safe withdrawal rate for retirees at 3.3% under current market conditions. They say this was caused by meager bond yields and very high stock valuations relative to historical norms. In other words, researchers expect stock and bond yields to decline in the coming period compared to the past.

Original works

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Financial planner William Bengen was the first to develop the 4% rule. For this reason, it is also called the Bengen Rule. Bengen calculated what percentage of money could be withdrawn during a 30-year retirement without completely drying out the portfolio. In his 1994 study, he assumed that a fictitious retiree created a portfolio of 50% stocks and 50% government bonds. He predicted that the retired person would withdraw money from this portfolio at a fixed rate while maintaining real purchasing power. He then estimated the safe withdrawal rate using realized capital market returns every 30 years since 1926.

Accordingly, if our fictitious pensioner started at 4% and increased the amount of withdrawal at the inflation rate each year, the portfolio would last for 33 years. In 1998, Trinity University professors developed Bengen’s research by extending the assumptions. In other words, they differentiated the asset ratios and periods in the portfolio. They also relied on investable corporate bonds rather than government bonds. The result has not changed.

Has the 4% rule wholly gone to waste?

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Don’t get excited right away. Because Morninstar’s work is based on very conservative assumptions. First of all, a life expectancy of 30 years as a retiree is a bit high. In other words, most people couldn’t live more than 30 years. Secondly, in the simulation, the money is withdrawn from the portfolio increases in parallel with the rise in inflation. However, the consumption expenditures of most retirees decrease in real terms over time. Thirdly, the withdrawal amount does not change depending on the market volatility. In real life, people change their spending patterns in such changes. Finally, the 4% rule was 74% successful in the simulation. So if you can accept a lower probability of success, you can withdraw money higher than 3.3% from your portfolio. In fact, in some scenarios you obtain by differentiating the above assumptions, it seems possible to withdraw even 4.5% from the portfolio.

Recommendations of Morningstar

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What can we do to increase our probability of success or withdrawal rate? Researchers have given detailed answers to this question in their article. They have been grouped into two categories as portfolio and non-portfolio strategies.

Portfolio strategies

Reducing tax cost

The total tax burden of a payroll captive living in Turkey is at least half of his income. In other words, tax is the most significant expense of a salaried employee in terms of rate and amount. Therefore, I think we should ask ourselves how I can reduce my tax expense at every opportunity. As a matter of fact, tax avoidance is always in the back of my mind when investing. Anyway, Morningstar researchers recommend tax minimization first at retirement. They recommend deferring taxable sales transactions and withdrawing non-taxable gains first.

Limiting transaction costs

Most of the small investors in Turkey do not care about transaction costs. At least, that’s what I observed on social media. However, this item is one of the variables most affecting the rate of return in the long run. As a matter of fact, researchers suggest minimizing this cost item as the second thing to do after tax. You must reduce brokerage commissions, general administrative expenses if you have bought funds and financial advisory fees.

Valuation-based withdrawals

To maximize the income you will get from your retirement portfolio, you can differentiate the assets you sell according to the market conditions. For example, it might make sense to sell stock and get cash in a highly valued stock market environment. On the other hand, in an environment where the stock market is terrible, it would be wise to make do with dividend and coupon income. Of course, you can support these items by selling bonds.

Accepting a lower success rate

Every investor has a different risk appetite. If you can take more risks than the average investor, there’s no need to overthink it. According to Morningstar’s study, an 80% success rate means a safe withdrawal rate of 3.9%. In other words, while 3.9% is given, 80 out of every 100 portfolios do not run out of money before 30 years.

Not reflecting inflation fully

As I mentioned above, it is assumed in the simulation study that retirees want to earn a fixed income every year in real terms. However, in real life, consumption decreases as the retirement period increases. It is just that the need for money increases due to health expenditures at a very advanced age. Thus, in real terms, the spending power may not be kept constant and may be allowed to decrease slightly. According to the researchers, every 25% decrease in inflation adjustment means a 0.25 percentage point increase in the safe withdrawal rate.

Improving investment performance

Another way to achieve a higher safe withdrawal rate can be to improve the portfolio’s rate of return. Of course, easier said than done. 🙂 However, you can take a little more systematic risk and increase the expected rate of return. However, more risk means a higher standard deviation. Researchers emphasize that if volatility gets too high, it will lead to the opposite result.

Non-portfolio strategies

Postponing retirement

Another non-portfolio way to increase spending power during retirement is to delay retirement. This preference provides advantages in two ways: (1) It leads to a decrease in the expected life expectancy (in retirement) every year worked. (2) It can transfer additional savings to the pension portfolio and further leverage the strength of the current portfolio composite return. According to Morningstar, if retirement is delayed by 5 years as part of this study, a 4% safe withdrawal rate becomes applicable.

Reducing spending

When calculating portfolio size within the scope of the study, it is generally assumed that 80% of working life income will be spent on retirement. However, this is a general acceptance. If you are a person with a high income and high savings, it is possible to live with an income far below this rate.

Social security pensions

Morningstar was mainly targeting US citizens when commissioning this study. Therefore, some suggestions are suitable for the conditions of the place. In Turkey, working in a job with good Social Security and Private Pension conditions can provide a great advantage.

Annuity income

By paying premiums to the insurance company, you can provide a regular cash flow (annuity) for a certain period in the future. It is not very common in Turkey. It may not be familiar in other developing countries as well. However, such insurance can secure cash flow later in retirement.

In conclusion

The return rates of capital markets may not be as they were in the past decades in the coming decades. Besides, Morningstar researchers also predicted that global inflation would remain at a reasonable level (2.2%). Currently, we see that inflation in the US economy is much higher. Suppose the realization of inflation, in the long run, differs from the expectations. In that case, this research will be completely trashed. Because the researchers who conducted this study emphasized that the expected inflation variable has the highest effect on the result. Inflation is currently at the highest level in the last 30 years in most developed country economies. However, the 4% rule should not be considered the law of gravity. By being flexible about investing and spending, we can minimize the possibility of running out of money in retirement.

Good luck, and see you in the following article.


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