Saving for retirement is hard enough. It turns out, though, that spending intelligently during retirement is difficult as well. The soon-to-be-retired person has to make a range of decisions about spending that will have real consequences for as long as he or she lives.
Sadly, though, "the 4% rule," which is the most commonly offered spending advice proffered by investment professionals and the popular press, can ultimately be harmful to the interests of people who heed it, according to recent research by Nobel Laureate William Sharpe, STANCO 25 Professor of Finance, Emeritus, at Stanford GSB.
Simply put, the rule suggests that the retiree spend an inflation-adjusted 4% of his or her retirement assets each year, while keeping the balance of those assets in a portfolio that typically includes both stocks and bonds. That might be a reasonable strategy in a world where stocks aren't risky. But they are, of course. Moreover, there's more wrong with the rule than simply that it discounts the downside of investing in instruments that have an element of risk.
"If a retiree adopts a 4% rule, he will waste money by purchasing surpluses, will overpay for his spending distribution, and may be saddled with an inferior spending plan," wrote Sharpe and colleagues Jason Scott, managing director of the Retiree Research Center at Financial Engines, and John Watson, a fellow at Financial Engines, Inc., of Palo Alto, Calif.
What's really wrong with the 4% plan is its insistence on fixed spending coupled with investing in a portfolio with variable returns, says Sharpe. In the most obvious case, when a retiree's portfolio underperforms, stubbornly pulling money out at the same rate means he'll run out of money at some point. Clearly, most advisors would see that coming, and caution the retiree to spend less.
Less obvious, though, is the consequence of better-than-expected returns. First of all, remember that investments have a price. Then, remember that the rule assumes a constant rate of spending and posits a retirement lasting 30 years. Ruling out what economists call "the bequest motive," we can assume that the retiree wants to spend it all within the retirement period.
But generating a surplus means that there's money left over at the end, which is a waste. Not only is the surplus wasted, but also there's additional waste on the front end because the retiree paid for investment surpluses he didn't need.
Planners who believe in the 4% rule often modify it, changing the amount to withdraw, the length of the plan, the portfolio mix, the rebalancing frequency, or the level of confidence that the money will last. "However, all these variations have a common theme — they attempt to finance a constant, nonvolatile spending plan using a risky, volatile investment strategy," say the researchers.
Consider a client with a portfolio of $1 million. Rather than adopt a 4% plan with risky securities, the investor could instead invest in TIPS (treasury inflation protected securities), suggests Sharpe. The yield will be lower than that of equities in good stock market years, but TIPS deliver the most purchasing power without risk one can obtain. So an investor might be guaranteed approximately 3%, which would allow him to withdraw $30,000 a year.
Maybe that's enough. If not, the client might choose to accept some level of risk as a tradeoff for higher earnings. But how much risk is he willing to tolerate? Traditionally, financial advisors give clients a list of questions that are supposed to paint a portrait of risk tolerance or aversion. However, there's no evidence that these quizzes yield much useful information. That's according to a 2008 research paper by Sharpe and colleagues Daniel G. Goldstein, of the London Business School, and Eric J. Johnson, of Columbia University. It's titled: "Choosing Outcomes Versus Choosing Products: Consumer-Focused Retirement Investment Advice."
Sharpe says investment professionals need to find ways to help clients make a realistic assessment of their own risk tolerance. And that means discarding the traditional quiz and finding a better approach. "The way in which you frame a decision affects how someone will make it," he says. Sharpe and other researchers are working to develop methods that will help identify real risk tolerances.
Sharpe, Goldstein, and Hal Ersner-Hershfield, of the Kellogg School of Management, are currently testing an experiment that will use computer software to change the appearance of photos of test subjects as they make choices about retirement. Here's a rough description of how the experiment will work. As the subject moves a slider to the left, which indicates earning more now and saving less, a photo of the subject as a young person gets happier, while a computer-aged photo of the subject as an older person, gets less happy. The reverse is true as well; saving more for retirement makes the older photo happier and the younger photo less happy. The hypothesis to be tested, says Sharpe, is that a visual representation of outcomes will be more meaningful than a column of numbers.
In the future, this experiment may get a lot more elaborate, showing other visual representations of outcomes, such as comparing the homes of a retiree who saved successfully and one who didn't.
These new experiments are on the frontier of what is now being called behavioral economics. "The hot thing in finance is to understand more about how people make choices," says Sharpe. "The more we know about the decision process, the better able we will be to help people make more informed choices." If people are going to invest in risky assets after they retire, they will need to choose a strategy that adjusts their spending as the value of their savings changes. And that's quite a leap from the inflexible 4% rule.