Self-Directed IRAs – The Problem With ‘Safe’ Retirement Withdrawal Rates

Self-Directed IRA owners know that, for many years, financial planners have bandied about the number ‘4 percent’ as the default ‘safe withdrawal rate’ for a retirement portfolio. That is, the amount that a retiree in decent health leaving the work force at age 65 could withdraw each year from his or her retirement balance, while still maintaining a reasonable assurance that they would not totally run out of income while still alive.

This 4 percent number puts them above the required minimum distribution levels for IRAs, 401(k)s and similar vehicles, so it certainly keeps the retiree out of trouble with the IRS, as far as RMD rules are concerned. But when it comes to portfolio strategies, there are some problems with the 4 percent rule of thumb, which we’ll discuss below.

Where Does The ‘4 Percent Rule’ Come From?

While not exactly brand new, the financial planning industry’s adoption of 4 percent as a reasonable withdrawal rate for retirees comes to us from a 1998 article by Philip L. Coole, Carl M. Hubbard and Daniel Waltz of Trinity University, in The AAII Journal.

The article made use of stochastic analysis, or Monte Carlo simulation, which analyzed the results of a 4 percent withdrawal rate over the previous 50 years of stock market returns. The article also dealt with the challenge of dealing with inflation over time – a 3 percent inflation rate, for example, would result in a 50 percent loss of purchasing power over 25 years.

The problem with this kind of analysis, however, is that it is backward looking. The stock market assumptions that get plugged in to these kinds of models are all in the past, and may well not reflect market realities today.

Superficially, of course, today’s snapshot of the S&P 500 compares favorably to 1998. For example, when the article was published in 1998 the dividend yield on the S&P 500 was 1.36 percent – and the price-to-earnings ratio at the end of 1998 was 32.92. Today it’s about 21 times earnings.

We know, with the benefit of hindsight, the market in 1998 was doomed to fall when the Internet bubble burst. We don’t know what will happen going forward from here, with the Dow above 20 times earnings. But the Trinity Study’s conclusions were based not just on the market of 1998 but also on the markets during the five decades before that. For example, using year-end data:

In 1949 the p/e ratio was 6.62. In 1958 investors were buying at 12.5 times earnings. In 1968 the S&P 500 p/e ratio was 17.70 but only half that a decade later in 1978, when the S&P 500 was trading at 8.28 times earnings. And in 1988, the S&P was trading at 14.03 times earnings.

Investors who were buying in the 5 decades prior to 1998 had the advantage of buying in at much more favorable multiples than those who are buying now – and even those whose investment windows included the sky-high valuations of the late 1990s.

The dividend yields also paint a similar picture: From 1948 to 1990, the S&P 500 dividend yield bounced around between 3 percent and 7 percent, before plunging to below 1.4 percent in the late 90s. The dividend is better today, but still well below the range it was in for most of the Trinity study.

Meanwhile, investors in their retirement years need income now.

When multiples are relatively high, and dividends are relatively low, the potential for a 4 percent withdrawal rate to begin eating into principal is very high. Yes, with a 20x earnings multiple, the earnings yield on a stock portfolio should cover the withdrawal in theory, it does so at considerable risk to principal. Older investors will have only a fraction of their portfolio in equities, anyway.

One of the advantages of the Self-Directed IRA strategy is the flexibility. Where yields may be limited in conventional bond and equity portfolios, a self-directed retirement account allows the investor to move into more areas that may sport higher yields or better potential for income. For example, leveraged rental real estate, untraded REITs, business development companies, private placements, and independently owned C-corporations or partnerships may generate superior spendable income compared to options commonly marketed by mutual fund companies, for skilled investors.

If you’re one of them, we want to work with you. American IRA, LLC is a leading administrator of Self-Directed IRA and other retirement accounts. To arrange a no-obligation consultation, call us today at 866-7500-IRA(472). Alternatively, please visit our website at and peruse our vast library of information and insight. We look forward to hearing from you.