Low bond yields and high stock valuations leave many retirees at risk of running out of money

According to a recent poll conducted by AARP, the majority of Americans are more fearful of running out of money than dying – a whopping 61% fear going broke versus 39% who view dying as more frightening. More than half don’t think their savings will cover their living expenses throughout retirement and many have no idea if their nest egg is sufficient to retire. Retirees are right to be fearful and the risks of running out of money are actually much higher than most imagine.

Appropriate withdrawal rates in retirement are rarely discussed, particularly during bull markets when most investors are spending as they wish with little concern about depleting their assets. The reason is simple – investors withdraw money from their portfolios to cover expenses, perhaps at unreasonable rates of 6% or more annually, yet their portfolios still continue to grow each year during a bull market, which allows them to ignore what will become a serious issue when the next bear market hits if they are unwilling or unable to reduce their spending.

In my upcoming book due out this fall, Dividend Investing for Income and Growth, I devote a lengthy chapter to the topic of appropriate withdrawal rates in retirement given our current investment environment. Quite frankly, many retirees are withdrawing far too much from their portfolios and risk dying broke. Many have grown comfortable with a certain lifestyle and are unable to cut back and reduce expenses – so they prefer to ignore this serious issue. Furthermore, in the low-yield and high stock valuation period we live in, and given the fact that we are living longer than previous generations, the risks of running out of money are higher than at any time in the past half century. The topic of appropriate withdrawal rates should be first and foremost in the minds of all pre-retirees and retirees.

Obviously the goal for most investors is to grow a portfolio to a certain level prior to retirement so that they can live off the portfolio throughout retirement. Ideally, one would live off some of the income and not touch principal. The objective is to not outlive your money and perhaps also have plenty of assets to pass on to the next generation. However, with interest rates far below “normal” levels and stock dividend yields also below average, many retirees are being forced to tap principal in addition to income. And, the situation is likely to worsen as this bull market ages and positive returns become more difficult to attain.

Portfolio withdrawals in a low-yield and high stock valuation environment

Most financial advisors and planners suggest a safe annual portfolio withdrawal rate of 4%. The 4% Rule was popularized in the 1990s and the studies at the time showed most portfolio mixes of stocks and bonds, regardless of the percentage invested in each asset class, and assuming a retirement of up to 30 years, would be successful. While I have long been a proponent of the 4% Rule, I no longer believe it is a safe withdrawal rate given current low bond yields and high stock valuations.

The research department at Morningstar has produced some excellent work on withdrawal rates that are currently far more appropriate than past studies. In April 2013, the Morningstar research trio of David Blanchett, Michael Finke and Wade Pfau put forth an exhaustive study that looked at safe withdrawal rates when factoring in low yielding bonds and stock market valuations. The paper titled Asset Valuations and Safe Portfolio Withdrawal Rates should be required reading for all investors and their advisors.

As you are no doubt aware, bond yields are at historically low levels and stock market valuations are very lofty. As of July 2015, with a 10-year Treasury yield of 2.2% and a CAPE ratio (cyclically-adjusted price-to-earnings) of 27, we pretty much don’t have any comparable period in history to predict portfolio survival rates – we are in unchartered territory. The studies conducted in the 1990s on portfolio survivability did not factor in low interest rates or stock valuations so Morningstar’s study was long overdue. What Messrs. Blanchett, Finke and Pfau discovered was that withdrawal rates in a low-yield environment and a highly valued stock market need to be much lower than previously thought to succeed.

The findings of the Morningstar study suggest that regardless of your stock allocation (20% to 80% equities), if you withdraw more than 4% annually and you are trying to make your portfolio last 25 or 30 years, you will probably fail. Morningstar found that a 25-year retirement with an initial 4% withdrawal rate, a 2% bond yield and a 25 CAPE ratio has only a 50% chance of success (80% equities). The results are eye-opening and depressing. As a matter of fact, unless you reduce your withdrawal rate to perhaps half of what you are accustomed to, your portfolio is at high risk of being depleted much earlier than anticipated. Again, the reasons are clear – the portion of your portfolio that is in bonds is no longer earning you anywhere close to “normal” historical returns AND the stock portion of your portfolio is at risk of providing negative returns or very low single-digit returns going forward, given lofty current valuations. So, without much growth from your portfolio over the coming years and ongoing withdrawals, your portfolio is likely to decline at a steady pace.

Here are some suggestions to put the odds more highly in your favor for a financially comfortable retirement:

• Don’t increase your withdrawal rate each year to keep pace with inflation. For example, if you start your withdrawal rate at 3% at age 70, stick with the 3% rate and don’t increase your withdrawal rate each year to keep up with inflation.
• Reduce your withdrawal rate during corrections or bear markets. If your portfolio has declined during a bear market, cut your expenses and reduce the amount you withdraw so you have the best chance to recover losses when the market eventually turns bullish again.
• Reduce your withdrawal rate to below 4% if your life expectancy is beyond 15 years. In our current low-yield environment, you risk greatly depleting your portfolio over the coming years, even at a 4% withdrawal rate – particularly for those investors who need their assets to last a couple decades or longer.

In summary, if one studies the correlation of returns and success rates between bond yields, stock market valuations and portfolio withdrawal rates, one can manage expectations and expenses accordingly. Historically low bond yields and high stock valuations suggest that in order to achieve success investing in retirement, one must reduce withdrawals dramatically to improve the odds. For investors with a retirement time horizon of 15 years or more, my suggestion is to reduce withdrawal rates by perhaps half of what you have grown accustomed to (perhaps to 2.5% or less annually), and to also manage risk as well as possible to hopefully minimize loss of principal and protect capital during down years. It is critical to pay attention to and adjust your asset allocation and your withdrawal rate depending on the current market environment.