Is the 4% safe withdrawal rate still valid for UK retirees - part 3?
Updated: 14 hours ago
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 talk about 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:
Panicking during market falls and selling investments.
Chasing fads such as 'hot' tech stocks.
Performance chasing by investing with fund managers that have enjoyed strong recent returns.
There are many stories that 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, no one has been able to verify that story!
Another story relates to 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 returned 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.
This 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 put the gap at 1.62% per annum.
Research from Morningstar suggests that the behaviour gap tends to grow as diversification reduces, with multi-asset investors having a gap of 0.69% per annum vs holders of more concentrated sector equity funds of around 4% per annum.
Recall from Challenge Five in part 2 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 1973 retiree would see their portfolio balance reduce by over 20% two years into retirement. Would they be confident to continue their retirement spending, even though history shows they would not have run out?
Over the longer term, would a retiree be happy to watch their portfolio drift down towards zero without making an adjustment at some point?
Positives
So far, we have only looked at the challenges for a retiree looking to use Bengen's logic. However, there are many positives to using this approach.
It's easy to implement
This can only be a good thing, especially as our financial literacy declines with age.
Bengen's approach doesn't require any 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 out.
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 make adjustments depending on whether the market has performed well or not.
Does not require complicated ongoing monitoring
Other than checking what inflation has done 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' (we will look at Guardrails in part four).
Conclusion
In these three articles, we have reviewed Bill Bengen's seminal work and evaluated taking inflation-adjusted withdrawals from a portfolio over fixed timeframes. In part four, we look at variable withdrawal strategies.
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