PensionsSep 23 2019

Does the 4% rule work?

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I would call them room-splitters. 

Innocuous questions like: "Active or Passive?" or "Network or not?" will have the tribes forming faster than you can say "Brexit", but in among these financial shibboleths is undoubtedly the good old "4 per cent rule".

In the days when annuities ruled, there was little need to spark up a chat with clients on longevity risk. 

That problem sat with the life companies. 

Understanding longevity and making sense of the calculations is not easy

For their part, such was the complexity of insuring and ensuring that customers had an income for the rest of their lives, they recruited armies of actuaries to help them untangle the knot. 

Understanding longevity and making sense of the calculations is not easy.

But in a world of pension freedoms and more customers entering into drawdown, understand it we must.  And not just us. 

We also have to be able to convey the risk to clients. 

Given the number of variables involved: expected life, withdrawal rates, inflation, spending patterns, investment returns (and the order in which they are witnessed) the chances of having a proper discussion about this with a client are pretty slim. 

That is where the 4 per cent rule can come in handy.

It is not a silver bullet. 

Far from it. 

I am yet to meet an adviser who uses it in isolation without pointing out the pros and cons, but it is a useful jumping off point, especially when backed up with the use of cash flow forecasting software such as CashCalc, Voyant or our friend Abraham’s Timeline App.

If Abe was penning this piece, he would no doubt (in ways more eloquent than I could ever) demonstrate that the best strategy to follow for drawdown clients is to take as much equity risk as you can bear, set a flexible, but structured withdrawal policy and tough out the years when investment returns are inevitably tough. 

And he would be right. At least statistically.

But designing investment products and services requires more than just statistics and theory. 

Despite advances in artificial intelligence, financial services are bought by humans, not robots and so it is important to build a human element into their design.

To this end, the FCA commissioned the Financial Advice Working Group to develop useful rules of thumb and ‘nudges’ for UK consumers. 

Similarly so, the regulator encourages product designers to consider behavioural aspects when developing new services.

It was with these aspects in mind that we launched our Retirement Portfolio Service with reference to the 4 per cent rule. 

Sure, we know it is not perfect. 

We know the world is more nuanced and every customer is different, but it is a useful rule of thumb to have in the toolkit and one that we know is used extensively by advisers up and down the land. 

We know this, because they helped us design it.

Behavioural Assists

Statistically, the best way to maximise portfolio longevity in drawdown is to take as much equity risk as you can handle and ride out the rollercoaster that follows.

Equally statistically, the best way to cause stress and anxiety for your clients and have them abandon an investment strategy is also to take as much equity risk as you can handle and ride out the rollercoaster that follows. 

Human nature being what it is, some clients will just want to get off.

It is with this in mind that the concept of ‘bucketing’ and ‘natural income’ provide some behavioural assists.

‘Bucketing’ is a pretty simple concept that acknowledges the humans prefer immediate gratification and can be distracted. 

By holding a client’s immediate income needs in a cash pot, the comfort that comes from knowing that the immediate future is taken care of, and subject to no risk, keeps the stress levels low and helps draw attention away from whatever may be going on with the investments in more risky assets.

Reinforcing this, is the idea of ‘natural income’, where if the risky assets can also be relied upon to produce a regular and growing level of income, then these flows can help keep the cash pot topped up for years into the future. 

Stress levels?  What stress levels?

Flexibility

Since we know the 4 per cent rule is far from perfect, any withdrawal strategy based upon it has to also incorporate some flexibility. 

That’s where Smart Rebalancing comes into play.

The Smart Rebalancing rules are easy to understand, and simple to explain.

  1. If, after one year, and periodically thereafter, gains have been made on investments, these gains will be banked in order to replenish the cash reserve bucket
  2. If market conditions are such that the cash reserve bucket falls to a level lower than the 4 per cent of the initial monies invested, the portfolio will be reset to its initial allocation

Smart rebalancing revolves around the idea of periodically banking profits, when they arise, along the way. 

Since later life can last a long time, it is inevitable that over the retirement journey, there will be periods of strong gains as well as times in which investment values fall sharply.

With Smart Rebalancing, the need to sell after a fall is reduced by replenishing the cash reserve with profits from the more risky parts of the portfolio over time.

As a result of the Smart Rebalancing process, each client will have their own unique journey according to their own unique circumstances – including the ability to handle more flexible withdrawal rates throughout the retirement journey. 

4 per cent?  Sure, it’s handy, but at the end of the day, we are human.  Not robots.

Kevin Doran is chief investment officer at AJ Bell