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Change in Investment Return Expectations, may Impact Your Future Decisions. Why 3% is the New 4%

February 22, 2022

Change in investment return expectations, may impact your future decisions.  Why 3% is the new 4%.

…reduce your expectation of how much in distributions may be withdrawn from investment accounts and still sustain your purchasing power

 

By Jeff Secord, CFP® CAP®

 

Thanks to uncertain global economic growth, higher interest rates and excessive market valuations, we have lowered expected investment returns. Therefore, we must reduce what we withdrawal from retirement accounts from 4% to 3%.

 

Why has 4% been considered a reasonable withdrawal rate?

In 1994, The Journal of Finance (1) published an article by engineer-turned financial planner, William Bengen, that laid out the history of the financial markets and supported a 4% distribution rate while maintaining purchasing power. The financial planning and investment community was looking for some guidance and began to adopt the 4% number as the accepted rate of distribution. My premise below is that the 4% rate may be too risky given our current economic and investment outlook.

 

What is behind the reduced expectations?

An excellent article in The Wall Street Journal (2) laid out reasoning why after World War II Americans have unrealistic expectations regarding how political, economic, and business leaders may be able to stimulate economic growth. Thanks to Covid…they certainly did! As we rebuilt the world during the Golden Age after World War II, we saw economic growth fall from 4.9% from 1951 to 1973 to 3.1% through the rest of the century. “What some economists now call secular stagnation might better be termed ordinary growth. Most of the time in most economies, incomes increase slowly and living standards rise bit-by-bit.” This is a function of higher interest rates.

 

As an avid reader of business literature and economic forecasts, I have been seeing economic growth forecasts all over the map. While earnings are good, they may recede from Covid recovery rates. Volatility has increased due to higher interest rate and global geopolitical uncertainty. Given this scenario, it may not be possible for portfolios to tolerate a 4% distribution rate as they could do when returns were higher. Therefore, we must reduce our distribution rates below 4% to maintain purchasing power. Distribution rates should be in the 3.0% to 3.5% range. It may then be important to you to adjust anticipated spending needs to accommodate your lifestyle within the reduced distribution rates.

 

How do I know if this directly impacts me?

The only real way to know…run the numbers, given your age, various distribution rates and investment return assumptions. Meet with your financial advisor to plug-in reduced distribution capacity with your spending needs so you can anticipate the impact and plan accordingly.

 

P.S. Reduced growth and investment return expectations may also demand higher savings rates to create and sustain financial independence for younger investors (i.e., your children and grandchildren if you are currently in or approaching the asset distribution phase). Run the numbers!

 

(1) William Bengen, “Determining Withdrawal Rates using Historical Data,” The Journal of Finance, October 1994, pp. 171-180

(2) Marc Levinson, “Why the Economy Doesn’t Roar Anymore,The Wall Street Journal; October 201620