July 29, 2022 – Generally speaking, rules of thumb exist to simplify life. There’s no sense in trying to reinvent the wheel after someone already went through the process of trial and error that spawned the rule in the first place.

When it comes to wealth planning, many of the profession’s rules of thumb — such as  the 4% safe withdrawal rate and keeping 3-6 months of liquidity— were born out of necessity. As clients and prospects sought quick answers on how to make important planning decisions, advisors found themselves innovating on the spot and evaluating clients’ respective situations with limited data and tools at their disposal. Before the advancements of the digital age, wealth planners of the ‘70s, ‘80s, and ‘90s likely had more difficulty collecting data from clients in a timely manner and comprehensively projecting their individual circumstances accurately over prolonged periods of time.

The 4% Rule is Outdated

One piece of conventional wisdom that emerged from this period is the 4% rule. Conceived by retired financial planner Bill Bengen in 1994, the maxim holds that retirees should be able to comfortably withdraw 4% of their assets during each year of retirement. Using that percentage as a starting point, spending in subsequent years may be adjusted to keep up with inflation.

As Bengen originally conceived it, the 4% rule was thought of as a reliable and responsible method of managing retirement funds without depleting assets. The media popularized Bengen’s findings and the rule soon became widely used by financial advisors.

However, neither the 4% rule nor many of the truisms touted by financial advisors are customized for a specific family’s circumstances or the current and forecasted economic, market and regulatory environment. Likewise, the array of data and resources wealth managers have at their disposal today has made it easier than ever to tailor client plans through a lens of specialization, rather than generalization. With these tools and the current economic outlook in mind, clients and wealth managers should feel comfortable abandoning most rules of thumb, especially if it means improving outcomes.

Customized Advice for Investors

The state of the market has left many in a perpetual mode of fear about the fluctuating value of their assets. Speaking to The Wall Street Journal, Bengen even remarked “The problem is that there’s no precedent for today’s conditions.”

Although Bengen used the piece as an opportunity to suggest cutting back on spending, a more effective solution may be applying more personalized solutions and leveraging sophisticated planning tools. Many of us are looking for certainty amid uncertain circumstances, and while nothing is guaranteed, a comprehensive assessment of one’s retirement plan and tailored withdrawal rate are significantly better than relying on a generic rule.

Given what’s at stake, individualized wealth plans should be designed around clients’ specific circumstances to ensure that they can maintain financial security for the duration of their retirement. Although a 4% withdrawal rate may still work for some, investors should refrain from assuming a one-size-fits-all approach to wealth management.

Calculating an Appropriate Withdrawal Rate

If a client is thinking about a safe amount to withdraw, now or in the future, odds are that there are concerns about depleting the assets. This is why we test a family’s financial circumstances against a range of variables, including higher-than-average inflation and lower returns, as well as longevity and investment return sequence risk.  Considering the recent drift into bear market territory, the latter concern may be the most salient.

Even with an array of market scenarios evaluated through Monte Carlo simulations, it likely behooves us to review the full range of possibilities, even if they’re unsettling. When conducting simulations, assigning handicaps down as much as 30% at the start of decumulation could be invaluable in helping fortify the resilience of a client’s plan. We can improve a plan’s odds of success by adjusting variables such as investment allocation, event timelines, retirement location and any other important factors that apply. The definition of success is maintaining a client’s lifestyle throughout their lifetime,  funding elderly care, and fulfilling any philanthropic and legacy goals.

Although Monte Carlo results are useful, they are not the only metric worth taking into consideration. Timeline is important – Clients in their 30s and 40s with a likelihood of success in the 50-60% range still have ample time to adjust; those further down the road don’t enjoy the same luxury. Anyone entering the later stages of life where income has ceased or been reduced significantly should ideally have a 70-80% chance of success. For those whose probability of success is less than 60%, we suggest a frequent plan review, at least 2-3 times a year.

If one has been abiding by the 4% rule,  they may want to go through the wealth planning process.  The exercise is even more important given the current market and economic conditions. There may be precious little time to correct course if these issues persist, and while assets can eventually yield a return, withdrawals taken out in weak standing can’t be restored.

Looking at Liquidity Differently

Even though retirement plays an outsized part in wealth planning, it’s not the only area where certain rules of thumb may need to be reconsidered.

Liquidity – the amount of cash and equivalents held separately from a portfolio – affords clients a degree of control over their lives. For those in the early stages of building wealth and accumulating assets, liquidity provides a cash cushion against the undesirable events that inevitably occur in life. Whether it’s a health emergency or an unexpected pause in income, having liquidity means having safety against the unknown. For those who have accumulated significant assets, investment professionals often agree that withdrawing from your portfolio during a downturn will likely lead to a less than optimal long-term returns.  Selling securities to fund expense compounds the devaluation of assets and may trigger undesirable tax consequences. These challenges will likely reduce the strength of your long-term wealth plan.

The liquidity rule of thumb suggests that a clients ought to have between three to six months’ worth of cash on hand as an emergency fund. Clients bringing in dual income are often advised to have three months’ liquidity, while single investors or anyone with multiple dependents ought to have six months.  However, a sufficient liquidity amount is unique to the household, economic environment, and how much risk a client is willing to take. Risk in this context is the probability of needing to withdraw from the portfolio.

Biding Time in a Bear Market

Since 1928, the average bear market has lasted around 10 months, excluding the one that we are currently experiencing. It is important to evaluate how much liquidity to set aside in the interest of minimizing portfolio withdrawal risk. Determining an appropriate liquidity amount assumes the worst over the next 12 months: lower income, higher expenses, and increased private equity capital calls. Add your costs together: living expenses, education, estimated taxes, annual exclusion gifts, and loan payments. Set aside this amount in a money market or liquid interest-bearing account separate from your investments and revisit the calculations 1-2 times a year.

Clients living on a dual income in an expansionary economic environment in a bull market may not need as much liquidity. The rule of 3 to 6 months of liquidity may be sufficient. However, we are in a bear market and the economy is contracting according to the latest GDP numbers. There are risks to income, portfolio values as well as  unknown risks. An evaluation of the circumstances and environment may lead to the conclusion that 12 months of liquidity is a better amount.   

If a client mostly relies on their portfolio to fund their lifestyle, retired or otherwise, they may want to consider putting away as much as 18 to 24 months’ worth of liquidity. The market in 2022 thus far has been eventful and unpredictable, and it’s impossible to definitively say where it will go next. In the event of a down market with no clear bottom or end point, it’s critical that investors retain their existing portfolios and make as few withdrawals as possible. Ultimately, different portfolios necessitate unique approaches.

Reigning in Rules of Thumb

Rules of thumb had a place in wealth planning when it was challenging to calculate a personalized recommendation. This is no longer the case: personal financial data is readily available, and planning software, enhanced with market analysis, can produce reasonably accurate probabilities. Each family or client can benefit from a personalized set of recommendations that is driven by their circumstances.  Working closely with a wealth manager to synthesize your income, expenses, assets, and goals into a comprehensive wealth plan is a far more effective means of planning and producing results than, well, twiddling your thumbs.

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