Updated: Jul 12
I remember it like it was yesterday. It was a rainy, Saturday evening as I sat patiently in the back seat of my Mom's car eagerly awaiting to arrive at Toys R Us. It was fall and my pockets were deep. I just had my 7th birthday party and was anxious to spend some money. "How many Ninja Turtles could I buy with thirty bucks," I wondered?
As we drove, I started to envision how big the toy store was. How thousands upon thousands of action figures, board games and stuffed animals aligned the walls. I began to wonder how hard it must be for Santa Clause to deliver all of these toys to girls and boys around the world in one night. How did he get the toys? Did he make them at his shop or strike a deal with the big retailers to buy in bulk? Then it dawned on me...Santa isn't real!
After confronting my Mom about this newfound epiphany, she sadly admitted that Santa was in fact a myth. I remember being angry for only a minute or two, then feeling a sense of ease wash over me, almost like I unearthed something top-secret only few people knew about. In reality, I simply came to terms with the facts as I understood them and realized some things just don't make sense anymore.
There have been many tried and true retirement strategies introduced over the years, some of which probably made sense at the time.
But with the ever-changing economic landscape, new investment products and the recent pandemic, it's important to realize that the times have changed. The fact is, some of these strategies, or rules of thumb are no more real than Kris Kringle himself.
MYTH #1 - THE 4% RULE
One of these rules of thumb is the 4% rule, or the idea that withdrawing 4% from your retirement accounts each year is a sustainable withdrawal rate for living comfortably in retirement and not running out of money.
Sounds pretty simple and straight-forward, doesn't it? The idea that you can safely take $40,000 from a $1,000,000 IRA each year without outliving your money sounds almost too good to be true. That's because it is.
One of the underlying issues with the 4% rule is it doesn't consider variability. It doesn't account for emergencies, changes in spending habits, vacations, rising healthcare costs or anything specific to your personal financial situation. Using the example above, is $40,000 per year adjusted for inflation enough to live an enjoyable retirement if you still have a mortgage and other monthly obligations? What if you saved $3,000,000 in an IRA...should you blindly take $120,000 out of your account each year and incur over $18,000 in taxes if you only spend around $60,000? You get my point.
The other problems with the 4% rule are the investment assumptions used. For example, the rule uses historical market returns to project future returns. With almost every major financial institution's long-term market projections being adjusted down due to COVID-19, low interest rates and high stock valuations, it's foolish to assume future returns will mirror the past.
On top of that, the 4% rule is based off of a portfolio invested 50% in stocks, 50% in bonds and one that has a high confidence level. In other words, it assumes retirees invest in a moderately conservative portfolio of stocks and bonds and always have money left over at the end of their lifetime regardless of fluctuations in the market.
This can be a challenging assumption to use for people who require a higher rate of return to cover living expenses in retirement than that of a 50/50 portfolio. And it also neglects to consider the true impact of major downturns in the market like we've seen in 1987, 2001, 2008 and 2020.
In reality, there shouldn't be any definitive rule of thumb dictating what percentage of money investors should withdraw for their retirement. There are simply too many personal, financial, and economic variables to consider, all of which may change at a moments notice.
The only rule applicable in this case is the fiduciary rule which states that advisors must always act in the best interests of their clients. If that means recommending a 2.5% withdrawal rate, so be it. At the end of the day, it's all about the investor and what's in her best interests, not an arbitrary rule.
MYTH #2 - DEATH OF THE 60/40 PORTFOLIO
The next retirement myth floating around is what some prognosticators coin as "the death of the 60/40." What they're referring to is the traditional balanced portfolio of 60% in stocks, 40% in bonds, once thought of as the ideal investment mix for a broad mass of retirees.
With interest rates at all time lows, the emergence of alternative investments and reduced optimism regarding the long-term outlook for stocks, some believe the 60/40 portfolio is no longer relevant.
First, I think it's important to consider the individuals and institutions making this claim. Often you'll read articles that recommend investing in alternatives such has hedge funds or structured products rather than a traditional 60/40 portfolio, only to realize the person or institution writing the article either endorses, or works for an institution selling said alternative products. This isn't always the case, but something to be aware of.
Those who aren't self-serving and site lower expected returns and rock-bottom interest rates as reasons why not to invest in a traditional 60/40 portfolio do make valid points, but I guess I'd simply counter with, "What's best for the client?"
The fact is, some clients don't need to take any additional risk in the market to sustain their lifestyle in retirement. They've either saved enough or live within their means, leading to a high probability their 60/40 portfolio will never run out in their lifetime.
And what about the 60/40 portfolio itself? What types of stocks and bonds are the prognosticators referring to?
Most assume the 60% is invested in an S&P 500 index and the other 40% in a high-quality bond index. And with market valuations nearing all-time highs and interest rates at all-time lows, how much can you really expect to earn in this type of portfolio going forward? See the chart below:
Data provided by JPM Insights as of August 3, 2020
Disclaimer: Past performance is no guarantee of future results
While bonds do pay investors income based off of their stated interest rates, they also serve as a safe haven when stocks are falling. Accordingly, they can appreciate in value as demand increases and money flows from stocks to bonds. From the chart above, you'll see the U.S. Aggregate Bond Index has returned 7.72% in 2020 even though the 10-year Treasury currently sits at .55%. So even though interest rates are low, bonds still have a purpose, even at 40% of a portfolio.
Stocks on the other hand can fluctuate drastically depending on where you're invested. That's why it's good to diversify beyond the S&P 500. Not only does this reduce risk, but provides opportunities to gain exposure to other parts of the stock market like the Nasdaq or Russell 1000 which may return more over time than the S&P 500. And as most investors who use a financial advisor employ some level of diversification, it's foolish to assume the 60% of a 60/40 portfolio is all in the S&P 500.
Make no mistake, the 60/40 portfolio is alive and well.
MYTH #3 - THE BUCKET STRATEGY
Last but certainly not least is the "bucket strategy," a retirement distribution process that involves layering your money among multiple accounts.
Here's how it works:
First, you set aside two years' worth of living expenses in liquid investments like cash in a savings account. Next, you invest three to five years' worth of expenses in bonds, typically within an investment account like a brokerage or IRA. Finally, you invest the rest of your money in stocks which have proven to return more over time than cash or bonds.
This strategy purports to protect investors from major downturns in the market by setting aside large amounts of cash and fixed income, thereby not having to draw from their riskier stock investments when the market is falling.
On the surface, this appears to be a viable strategy but after careful examination, I began to notice a few holes in these buckets.
A recent Forbes article pointed out several key shortcomings of this strategy, one of them being the process by which the buckets are refilled.
If the bucket with cash is depleted down from two years' of expenses to one, it needs refilled. This means you'd have to pull from the bucket with bonds or the bucket of stocks. If you pull from bonds (Which is ideal in this case), you'll then have to refill that bucket from the stock bucket, thereby requiring you to draw from the same investments you intended to protect from the beginning. So in a way, the strategy contradicts itself.
Another problem with this strategy is it ignores risk tolerance and asset allocation. This means instead of structuring an investment portfolio based off an in-depth understanding of one's tolerance for risk and their long-term financial goals, it focuses on living expenses as its main driver of determining asset allocation. So for investors who are comfortable with assuming more risk and need a higher rate of return to achieve their retirement objectives, the bucket strategy could suggest a much more conservative allocation resulting in a potentially lower expected return.
Instead of setting up multiple accounts and disregarding risk tolerance and retirement goals, investors may be better suited with one portfolio and a comprehensive strategy encompassing their entire financial situation rather than just living expenses. This would not only simplify the process of funding retirement by reducing the number of accounts from three to one, but provide a portfolio more aligned and in-tune with what's most important to their retirement.
IT CALL COMES BACK TO YOU
John F. Kennedy once said, "The great enemy of truth is very often not the lie--deliberate, contrived and dishonest--but the myth--persistent, persuasive and unrealistic. Too often we hold fast to the cliches of our forebears. We subject all facts to a prefabricated set of interpretations. We enjoy the comfort of opinion without the discomfort of thought."
Don't get me wrong...certain rules of thumb are great. They provide the masses with a general guide for doing certain things they may not have known before.
But when it comes to your investments and retirement, I think we'd all be best suited in following the guidance of JFK by favoring the "discomfort of thought" over the "comfort of opinion."
So before accepting the investment community's rules of thumb as gospel, take some time to think about if what they're saying is right for you. What assumptions are being used and are they still relevant in today's age? Are there other points of view that should be considered? Who are the ones making these rules and what's in it for them?
Often you'll find that good questions complemented with careful thought and consideration will lead to better decisions both in life, and in finance.