Is the 4% safe withdrawal rate still valid for UK retirees - part 3?
- Noel Watson
- Jun 2
- 5 min read
Updated: Jun 11
Introduction
In parts one and two of this withdrawal strategy series, we discussed data and real-world challenges for those relying on the '4% rule'. In part three, we will look at investor challenges.
Challenge Fourteen: Assumes perfect investor behaviour
We talked about the impact of costs on portfolio sustainability. Now, we need to discuss the effects of investor (mis)behaviour on retirement outcomes and investigate investor vs. investment returns. Investment returns are the returns that a given portfolio generates, while investor returns are those that the investor actually receives. The difference between investor and investment returns is sometimes known as the 'Behaviour Gap', and as you will see below, measuring this 'gap' can be tricky, and there is no agreement on what it might be.
The Behaviour Gap is caused by investor 'misbehaviour', with common misbehaviours including:
Performance chasing by investing with 'star' fund managers who have enjoyed strong recent returns.
Many stories demonstrate the impact of investor misbehaviour. The problem is that often, it's hard to determine whether they are true! One such story is the infamous Fidelity investment survey, where Fidelity conducted an internal review of customer performance from 2003 to 2013 and determined that those with the best returns were "either dead or inactive." The problem is that no one has been able to verify that story!
Another story features legendary fund manager Peter Lynch and the supposed returns for those invested in his Magellan fund. From 1977 to 1990, Lynch returned a compound annual return of 29%, whereas the average investor in the fund made only 7%. Again, it seems hard to determine where this story came from!
That said, there is evidence to suggest that investors do underperform their investments.
A study of UK investors from 1992 to 2009 finds the behaviour gap to be 1.2% per annum.
A study of US investors from 1991 to 2004 reveals a gap of 1.62% per annum.
Research from Morningstar suggests that the behaviour gap tends to grow as diversification reduces, with multi-asset investors ('Allocation' in the screenshot below) having a gap of 0.4% per annum versus holders of more concentrated sector equity funds, who have a gap of 2.6% per annum. However, recent research questions the Morningstar methodology, finding the behaviour gap to be almost zero.
A study by Ilia Dichev found that investors in the NASDAQ index trailed the benchmark by 5.3% a year from 1973 to 2002.
Elderly investors often face a decline in financial literacy. A report titled "Do Older Investors Make Better Investment Decisions?" determined the following.
"Examining the economic costs of aging, we find that, on average, investors with stronger aging effects earn about 3% lower risk-adjusted annual returns, and the performance differential is over 5% among older investors with large portfolios."
Recall from Challenge Five in part 2 of this '4% rule series' that for every 1% increase in total fees, the SWR reduces by around 0.4%, and you see that a misbehaving investor may be surprised at how unsustainable their retirement spending is!
Challenge Fifteen: Being able to cope with drawdowns
Bengen’s logic assumes investors continue withdrawing money even as their portfolio balance drops in challenging markets. A nervous retiree is unlikely to allow this to happen. But what happens if your pot is depleted in the early years of retirement, yet things would have worked out fine in hindsight? For example, our 1920 retiree would see their portfolio balance reduce by almost 25% two years into retirement. Would they be confident to continue their retirement spending, even though history shows they would not have run out?
Positives
So far, we have only examined the potential challenges a retiree may encounter when using Bengen's logic. However, this approach has many positives.
It's easy to implement
This can only be a good thing, especially since our financial literacy tends to decline with age as mentioned above.
Bengen's approach doesn't require expensive and sophisticated modelling tools that can have a steep learning curve and might not always be intuitive to use, with many nuances that can catch the infrequent user.
Future income is known
Assuming a retiree's planning assumptions around longevity, market returns, and inflation are prudent, and they are fortunate enough not to experience investment and inflation in retirement (especially in the early years) that are worse than in historical datasets, they can be reasonably confident that they can withdraw an inflation-adjusted amount from their portfolio each year without worrying about running out of money. They don't need to adjust spending depending on how well the market has performed.
Does not require complicated ongoing monitoring
Other than checking the prevailing inflation rate on an annual basis, we do not need to worry about issues such as:
Adjusting our withdrawals based on estimated longevity.
Monitoring our withdrawal rates against various 'guardrails' (necessary for both withdrawal-rate guardrails and risk-based guardrails).
Conclusion
In these three articles, we have reviewed Bill Bengen's seminal work, which evaluated taking inflation-adjusted withdrawals from a portfolio over fixed timeframes. Bengen's work was instrumental in putting a framework around retirement withdrawal planning. Examples of common thinking at the time included:
The average annual portfolio return is approximately 7%. Therefore, I can withdraw 6-7% a year without fear of running out of money.
In retirement, you cannot afford to take the risk of being invested in the stock market and should instead be invested 100% in bonds.
While Bengen's work was considered groundbreaking at the time, given that retirement research has evolved since his initial publication, there is an argument that it should now be viewed more as an academic exercise rather than a practical tool for real-world retirement planning, one that looks good in theory but less so in practice.
In our next blog, we will examine Guyton-Klinger withdrawal rate guardrails, which aim to address the numerous challenges associated with Bengen's approach. The question is, does this method succeed, or does it introduce new problems......
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