Financial advisers and the pensions sector must stop talking about the 3% and 4% drawdown rules, FinalytiQ founder Abraham Okusanya told delegates at the Personal Finance Society’s annual conference.
Okusanya (pictured) said that, although the popular default drawdown rates were rooted in empirical data, there was still room for improvement.
He explained the arbitrary rules of thumb come from US adviser William Bengen, who pioneered the idea of ‘safe withdrawal rates’ – drawdown rates that withstand longevity risk by assessing the worst-case scenarios of historical markets.
Although he applauded Bengen for his pioneering work, he called on advisers to stop talking about these 3% or 4% rules that come from his research because “there are so many variables in this equation”. He added that, empirically, around 80% of the time the client would end up with more money than they started with by drawing down 3% rates.
Okusanya admitted market conditions could be worse than the empirical data available in market history but argued recognising the wide range of outcomes and investment returns from historical markets was also important.
He pointed out the single best year for equities in the UK market was around 145% – in 1974. The very worst, he added, however, was a drop of more than 40%.
“Should we really be basing client plans on the idea we are going to get market conditions that are worse than World War I and World War II type scenarios?” he asked. “This is why I think we need to understand Bengen’s framework – but there is a room for improvement.
“When you compare the very worst-case scenario with the 2000 tech bubble and 2008 financial crisis, what you see is that the framework continues to hold up very well.”
He added: “Market conditions have to be extremely bad for the safe withdrawal rates framework to fail. We shouldn’t necessarily plan for the very worst-case scenario but we should definitely stress-test the client withdrawal and get a perspective of the wide range of outcomes.”
Okusanya also addressed what he called the “default” mindset of diluting equity allocations in client portfolios when they enter drawdown. He said that, when stress-tested through good times and bad, having equities in the investment portfolio tends to produce a higher sustainable withdrawal rate.
“Should we put everyone in 100% equities [in drawdown]?” he continued. “Of course not. But this idea we need, by default, to reduce the allocation to equities in retirement needs to be seriously, seriously challenged.
“If psychologically, from an emotional point of view, the client can withstand the portfolio declines a higher-equity portfolio will experience, then by all means they should be in the highest equity allocation they can stomach emotionally and that their financial requirements demand.
“This idea that, by default, we should reduce the equity content doesn’t hold up on an empirical basis.”