Fine-Tuning Needed on the 4% Rule

No clear consensus exists among advisers about how to create a retirement spending plan, according to the Financial Professional Outlook (FPO), a quarterly survey of U.S. financial advisers from Russell Investments.

Advisers say their top challenges in serving clients near or in retirement are “setting reasonable spending expectations” (52%), “maintaining sustainable plans” (44%), and “determining sustainable spending policy” (33%), the survey finds. 

Although more than 60% of survey participants said that more than half of their clients are in or near retirement, there is still no clear consensus about how to create a sustainable retirement spending plan that accounts for market volatility and other unpredictable financial shocks.

“While generating sustainable retirement income for their clients is already a challenge for advisers, the eventual rise in interest rates could certainly further impact the financial security of those in or near retirement,” says Rod Greenshields, consulting director for Russell’s adviser-sold business. “With the Fed’s quantitative easing measures drawing to a close and the American economy back on line, there could be momentous implications for retirees once interest rates rise.”

In the face of challenging marketing conditions, advisers continue to struggle to find strategies that are simple for their clients to understand and yet sophisticated enough to meet an investor’s individual needs. In designing a retirement spending plan, 16% of advisers consider a client’s funded ratio, or the actuarial net present value of assets divided by expected lifetime liabilities. Most take a less scientific approach.

Among survey respondents, 25% said that they based the retirement spending plan on pre-retirement spending patterns, followed by 22% who chose a rule of thumb like the “4% rule,” and 19% who used some type of time-segmented bucket strategy.

“Common approaches like the ‘4% rule’ are easy to understand, but do not account for a client’s individual circumstances and can lead to unintended mistakes,” Greenshields says. He feels advisers would do well to follow the lead taken by defined benefit plans and calculate a funded ratio.

“By determining the cost of a client’s liabilities compared to the value of their assets, the funded ratio offers a superior method of evaluating retirement readiness,” Greenshields contends. “The math behind the ratio is sophisticated, but the outcome is a simple yet powerful percentage that most clients understand immediately. This individualized approach gives advisers the opportunity to engage with clients in a meaningful conversation about their progress toward retirement goals and the amount of risk they may need to take in order to meet them.”

In determining their approach to asset allocation for clients near or in retirement, 38% of advisers said that they rely on a risk profile questionnaire to determine the asset allocation of portfolios. These questionnaires tend to define how much risk clients think they can tolerate. This is very useful during the accumulation phase, but as clients approach retirement it becomes critically important to understand how much risk their assets can handle while also funding retirement expenses—in other words, their true risk capacity.

The investor’s funded ratio incorporates risk capacity, Russell Investments maintains. The ratio represents the surplus or deficit of assets necessary to fund lifetime retirement liabilities. This yardstick helps measure the feasibility of a spending plan and it can be used to monitor and adapt a portfolio’s allocation through time. The funded ratio, and any asset allocation based on it, relies on the capacity for risk as determined by the client’s real assets rather than the client’s self-reported tolerance for investment risk.

Despite the current low yields, a majority of advisers (66%) believe yield-focused strategies are a good option because they protect the client’s initial investment, are sustainable, and are simple for investors to understand. But not all advisers see it this way. Thirty percent don’t like yield-focused strategies because they feel current yields are not attractive enough to meet clients’ retirement income needs. This group also suggests that, because yields change over time, a yield-focused strategy presents too many challenges to support consistent income; and the risk/return trade-off is too great.

“We understand why clients ask for yield-seeking strategies—they are simple and clients like the idea of preserving principal while living off dividends and interest. It seems like a safe plan to eat the eggs but spare the chicken,” Greenshields says. “However, in this low-yield environment, what seems simple may end up increasing risk. If income isn’t sufficient, clients have to cut back expense or chase yield.”

The survey was fielded between September 24 and October 8, 2014. Russell Investments reached 234 financial advisers working for nearly 145 investment firms nationwide to explore how they deal with volatility and low interest rates, and what kinds of risks they are taking on for their clients, among other challenges.

The Financial Professional Outlook (FPO) survey from Russell Investments can be downloaded here.