Beyond The 4% Rule

My review of Beyond The 4% Rule by Abraham Okusanya. This retirement expert makes a good case for portfolio drawdown strategies, but underplays the value of annuities.

Abraham Okusanya is the founder and CEO of Timeline. His firm provides administration and modelling software for financial advisers, with a particular expertise around sophisticated analysis of income drawdown strategies.

Since the advent of pension freedoms in 2015, the retirement planning market has been blown wide open. Sales of annuities have collapsed as punters have been seduced by the flexibility and promise of higher incomes by keeping their pension funds invested and ‘drawing down’ income from their pot as they need it. This is a dramatic difference from the days when a pension fund had to be used to buy an annuity on retirement.

The changes are something of a bonanza for financial advisers. With clients keeping their money invested for longer in drawdown, there’s an opportunity to keep charging that 1% investment management fee. The complexity of the issues in play creates demand for ongoing advice. Timeline is trying to bring data and insightful analytics to this most difficult of problems.

In principle, the few years up to retirement are a time when it’s well worth taking independent financial advice. Unfortunately many (most?) financial advisers are all at sea when it comes to the complexity of retirement income planning. Who can blame them? Even William F. Sharpe, the Nobel Prize winning financial economist has called it ‘the nastiest, hardest problem in finance’.

In this context, Abraham Okausanya’s book, Beyond The 4% Rule, is a good read for someone wanting to educate themselves on some of the issues. And he is personally committed to improving expertise in this specialist branch of financial planning.

Probability-based vs safety first

The book starts by exploring the contrast between two schools of thought on retirement income planning.

‘Safety first’ is what might be considered traditional planning. You establish a minimum level of income that you need and secure that using an annuity. Any surplus you can invest in financial markets (e.g. a mixture of stocks and bonds) to create surplus income. Because this income is nice to have rather than must have it doesn’t matter if returns are volatile.

The probability-based approach claims that safety first leaves too much return on the table. Using historic modelling based on diversified portfolios of stocks and bonds, the approach allows an individual to target a given level of retirement income with a ‘probability of success’. By accepting some risk, higher income can be achieved.

Unsurprisingly, Okusanya is in the latter camp and claims Modern Portfolio Theory and optimal asset allocation for his side of the argument. This would perhaps come as a surprise to Nobel Laureates William F. Sharpe and Robert C. Merton who are, if anything, in the safety first camp. Or at least in the ‘no free lunch’ camp.

Safe withdrawal rates

For anyone with teenage children, talk of a safe withdrawal strategy is enough to bring you out in a cold sweat. But in the context of this book Okusanya is talking about the level of income you can withdraw from a retirement pot without running out of money in a specified timeframe.

The name of the book comes from the original US analysis of retirement drawdown by William F. Bengen. He showed that, based on history in US stock markets, a retiree investing 60% in equities and 40% in bonds could draw an inflation-linked income of 4% of their initial fund without the fund being exhausted for at least 30 years. So as an example, for a $1m initial fund, a $40,000 income could be taken, and increased in line with inflation each year, regardless of what is happening to fund performance.

Beyond the 4% rule

Okusanya goes ‘beyond’ the 4% rule in three important respects.

First, he applies the analysis beyond US borders, to assess safe withdrawal rates for the UK market, for global markets and for various investment styles (in particular small-cap and value) and asset mixes. He also looks at different risk levels, such as a 10% probability of failure based on history as opposed to zero failure. Overall the figures on these bases don’t quite justify the 4% rule. After allowing for adviser fees of 1% a year, most of his results fall in the 2.8% to 3.5% range, so around a quarter less favourable than the US data. This is unsurprising given the US stock market has been the strongest performer amongst major markets over the last 100 years or more.

Second, the book provides important data on retirement expenditure patterns. The data consistently shows that retirement expenditure falls by 1% to 1.5% pa in real terms from the point of retirement. This means that real income is around a quarter to a third lower when you hit 80 compared with your mid fifties. Factoring in likely reductions in expenditure is an important antidote to excessive conservatism when answering the question ‘Have I got enough?’

Third, Okusanya also recognises the importance of flexible expenditure rules as one way of eking a little bit more out of safe withdrawal rates — perhaps adding 10% to the income that can be taken. These include rules that forgo income increases if investments fall.

Good, as far as it goes

Beyond The 4% Rule covers useful and educational ground for people approaching income drawdown. But in my view the book suffers from three key weaknesses.

First, annuities are not really given a fair hearing. But they have significant benefits even for the relatively well off. These include:

  • Protection against tail risk — just because something hasn’t happened in the past doesn’t mean it won’t happen in future.
  • Protection against living far beyond your life expectancy.
  • Protection against declining financial competence in old age.
  • Protection against financial stress in difficult markets (when your drawdown portfolio is being devastated in a 1970s style bear market, will you be confident that a 1980s style bull market will appear in time to save you?).

Second, the problem of underspending is insufficiently acknowledged. Safe withdrawal rates by definition protect you in what has been a historic worst-case scenario. However, this leaves far too much money on the table (or rather in your pension fund) in the vast majority of cases. Not spending enough is as much of a problem as spending too much.

Third, much is made of the problem of sequence of returns risk. But as Sharpe and co-authors point out, this is a self-inflicted risk arising from the attempt to meet fixed expenditure from unmatched volatile investments. The various expenditure rules introduced in the book are a way of closing that gap, but perhaps it would be better to approach the problem from an expenditure matching perspective in the first place.

Beyond The 4% Rule is a good read with useful data. It provides a good articulation of the arguments on the probability-based side of the debate. It’s therefore worth a read for anyone wanting to educate themselves in this difficult area.

But although it’s a good book, I side with the Nobel Laureates in this debate.