Is the 4% Rule Useful for South African Retirees?

Drawing an income in retirement from a market-linked investment portfolio, such as a living annuity or discretionary unit trust portfolio, is a question investment experts constantly grapple with, devising various strategies for retirees to optimise their income while preserving capital.

In 1994, US financial planner William Bengen came up with the “4% rule”, where he showed, using historical market data, that withdrawing 4% in the first year and increasing the amount thereafter to keep pace with inflation was the most one could draw from a retirement portfolio invested half in bonds and half in equities without the risk of running out of money within 30 years, given any market conditions. (See “What is the ‘4% rule’ for retirement income?” )

Analysts have since questioned this 4% rule of thumb, some suggesting it is too high and others saying it is possible to stretch it upwards, as one doesn’t need 100% certainty and that 80% to 90% certainty is sufficient.

Bengen himself subsequently revised his theory, suggesting, together with financial planner Michael Kitces, that market valuations at the time of retirement (whether stocks are generally trading below or above their fair value) should be taken into account. The lower the valuations, the higher the drawdown you can afford.

Note that in his original paper Bengen didn’t take into account investment fees or taxes, meaning that the net amount you receive may be considerably less than 4%.

Another point to consider is that Bengen used US data. The capital markets of other countries, particularly emerging economies such as ours, may show different characteristics over long periods.

Should the 4% rule apply to SA retirees?

Some years ago, asset manager Allan Gray replicated Bengen’s study using South African equity and bond data, and similar assumptions to Bengen. The Allan Gray team created 84 30-year periods beginning on 1 January 1900.

The team concluded that, if you had 55% equity exposure, and started with a 4% drawdown, increasing that rand amount by inflation each year, your income would have lasted for at least 30 years 93% of the time.

Allan Gray noted in its findings that an increase from 4% to 5% “may seem like a small increase, but it is in fact a 25% increase in income”. A 5% initial drawdown would have run out before 30 years one-third of the time and in 7% of starting years the portfolio would have lasted less than 20 years. An initial drawdown of 6% would have run out before 30 years nearly two-thirds of the time.

The reality is that many people reaching retirement age have not saved enough to live comfortably off an initial income of only 4% of their savings.

The Association for Savings and Investment South Africa (Asisa), provides regular updates on drawdown rates from living annuities. The average rate hovers around 6.7%, but this includes older pensioners who have increased their drawdowns as they have aged. (Don’t forget, the 4% rule applies only to the first drawdown you make.)

Jaco van Tonder, deputy chair of the Asisa Marketing and Distribution Board Committee, says annual drawdown rates of 4% to 5% in the first decade of retirement and below 8% in the later retirement years are generally considered prudent, “providing annuitants with a high probability of preserving their purchasing power for their lifetime”.

Drawdown management strategies

For retirees who cannot live off as little as 4% of their savings, there are ways of managing drawdowns from a living annuity or discretionary portfolio that can partially offset the volatility that comes with a market-based investment.

These include:

• Not taking inflation-linked increases or even lowering one’s drawdown in years in which the underlying securities have fared badly.

• Having different investment “buckets” for short-. medium- and long-term savings. Drawdowns are from the short-term, low-risk bucket, while the medium- and long-term buckets provide exposure to the more volatile but necessary growth assets.

Ultimately, a market-linked retirement portfolio, such as a living annuity, needs to be managed with the assistance of a trusted financial planner.