## Does the 4 percent rule work in Singapore?

In our previous blogpost * The 4 Percent Rule for Financial Independence*, we discuss the “safe” withdrawal rule popular with the FIRE (Financial Independence, Retire Early) movement. The 4 percent rule is a rule of thumb on how to create an annuity from a portfolio of assets, and has become the received wisdom on how to live on the stream of income it produces. A variant of this is, once you save 25 times your annual expenses, you will be able to retire.

However, Finke, Wade and Blanchett (and also here) argue that the fact the 4 percent rule works using historical US data was an anomaly, in a period where both stock and bond returns were higher than they are today in the US. If future stock and bond returns are lower, for example, in the low interest rate environment of the last decade, then retirees should instead be using a much lower 2.5% initial withdrawal rate to be assured of retirement sustainability. Work done by “Big Ern” here also support this conclusion.

If true, this is bad news for retirees hoping that the 4 percent rule will give them a comfortable retirement. Now, they can only look forward to a more frugal existence, or run the risk of outliving their funds.

#### Testing the 4 percent rule Singapore

Most of the research on safe withdrawal rules has focused US examples, and ignore other features about retirement. These features would be the use of annuities (like CPF Life), life expectancy (the chance that a retiree would actually survived for 30 years in retirement, from age 65 to 95). Abstracting from these features, we want to know does the 4 percent rule works in Singapore for someone retiring at the age of 65 today and expecting another 25 to 30 years in retirement. Will retirement be comfortable, or a terrifying, frugal existence, wracked by fears of outliving his/her money?

Since we do not have data for Singapore stock and bond returns since 1928, there is no way to do a similar historical exercise on the feasibility of the 4 percent rule in Singapore. However, a Monte Carlo simulation based on the projected returns on stocks and bonds over the past 20 years for which data has been available can be done.

Singapore stock returns have been quite volatile over the past 20 years. Using the Straits Times Index (STI) returns over 20 years, we assume that the average annual return on stocks is ** 5.07%**, with a standard deviation of

**. From the past 10 years of the dividend yield on the STI Exchange Traded Fund (ETF), we estimate the average dividend yield per year to be**

*26.32%***with a standard deviation of**

*2.80%***. For bonds, we assume the yield on bonds available for retail investors would be similar to the yields on the Singapore Savings Bonds, or very generously around**

*1.09%***per year, which has been the highest projected for a ten year holding period in the past few years. We assume the correlation between all these returns is zero.**

*2.80%*While we can quibble whether these assumptions are 100% accurate, basing them on the actual returns and volatility over the past 10 to 20 years assures us that they are reasonable estimates of the investment outlook in the next 30 years. Here is a summary of the initial assumptions, returns, standard deviations and fees used:

Annual Returns | Standard Deviation of Annual Returns | Annual Fees | |
---|---|---|---|

Stocks | 5.07% | 26.32% | 1.00% |

Dividends | 2.80% | 1.09% | 0.00% |

Bonds | 2.80% | 0.00% | 0.00% |

Inflation | 2.00% | 0.00% | NA |

#### Let’s run some simulations!

For our first set of simulations of annual stock returns, dividends and bond interest, we use an asset allocation of 50% in stocks and 50% in bonds, re-balanced annually after the withdrawals from the portfolio are made at the start of the year. We increase the withdrawal amount by the rate of inflation, 2%, every year. Failure in the withdrawal plan occurs when the value of the portfolio reaches zero before the end of the retirement horizon (at 20 years, 25 years, 30 years, 35 years, and 40 years) in the simulation.

The percentage of successes across 10,000 simulations is tallied below:

Withdrawal Rate | 20 years | 25 years | 30 years | 35 years | 40 years |
---|---|---|---|---|---|

5.0% | 65% | 45% | 31% | 23% | 17% |

4.5% | 76% | 67% | 42% | 31% | 25% |

4.0% | 86% | 69% | 54% | 43% | 35% |

3.5% | 92% | 80% | 68% | 57% | 47% |

3.0% | 97% | 89% | 80% | 71% | 62% |

2.5% | 99% | 96% | 91% | 82% | 76% |

2.0% | 100% | 99% | 96% | 96% | 87% |

Oh dear! If we define safety as a success rate of 95% or more, only withdrawal rates of 2.5% are safe for a 25 year retirement horizon, and a 2.0% withdrawal rate is safe for a 30 year retirement horizon. Even over a 20-year retirement horizon (which is short since life expectancy is 85 years, meaning that half of the retirees would still be alive at age 85), only a 3.0% withdrawal rate, or a little higher, is safe. For those hoping to retire early in Singapore, the safe withdrawal rate is around 1%! This is definitely bad news for those who believe that the 4 percent rule will work in Singapore.

For a portfolio half in stocks and half in bonds, only a 2% withdrawal rate is safe for a 30 year retirement horizon

#### More in stocks? Or less?

Can we save the 4 percent rule by allocating more of the portfolio to stocks? After all, stocks have higher returns to help grow the portfolio over time. Simulation results with a 60% allocation to equity are below:

Withdrawal Rate | 20 years | 25 years | 30 years | 35 years | 40 years |
---|---|---|---|---|---|

5.0% | 63% | 45% | 34% | 26% | 21% |

4.5% | 72% | 55% | 43% | 34% | 28% |

4.0% | 81% | 66% | 53% | 44% | 37% |

3.5% | 88% | 76% | 65% | 55% | 47% |

3.0% | 94% | 84% | 75% | 67% | 59% |

2.5% | 97% | 92% | 85% | 78% | 72% |

2.0% | 99% | 97% | 93 | 88% | 83% |

These outcomes are even worse than before! While stocks have higher returns, the higher volatility in the past 20 years e.g. Asian Crisis in 1997/8, SARS in 2003, Global Financial Crisis in 2008, mean that more stocks is less safe in retirement.

What about lowering the asset allocation to stocks? The results of the simulations with a 40% allocation to stocks are below:

Withdrawal Rate | 20 years | 25 years | 30 years | 35 years | 40 years |
---|---|---|---|---|---|

5.0% | 68% | 43% | 26% | 17% | 11% |

4.5% | 81% | 57% | 39% | 27% | 19% |

4.0% | 91% | 73% | 55% | 40% | 31% |

3.5% | 96% | 85% | 71% | 67% | 46% |

3.0% | 99% | 95% | 84% | 74% | 64% |

2.5% | 100% | 99% | 94% | 87% | 80% |

2.0% | 100% | 100% | 99% | 96% | 92% |

Now, contrary to the 4 percent rule findings in the US which require an allocation of at least 50% to stocks, an initial 3.0% withdrawal rate may just be borderline feasible in Singapore over a 25-year retirement horizon. For a 30-year retirement horizon, a 2.5% withdrawal rate is required.

So far, everything looks pretty bleak for retirees. But perhaps we have estimated the fees for investing in stocks too high at 1%. Maybe 0.25% in fees for a buy and hold investor would be sufficient. Maybe, we don’t need to index the withdrawals for inflation, since retirees tend to spend less as they get older. Can we save the 4% withdrawal rule? Simulation results assuming 0% inflation adjustment and 0.25% stock investment fees are below. The results are still not promising. The 4% rule can only apply for a 20-year retirement, which is too short for our longevity.

Withdrawal Rate | 20 years | 25 years | 30 years | 35 years | 40 years |
---|---|---|---|---|---|

4.0% | 96% | 90% | 82% | 76% | 71% |

#### Taking a closer look at what is happening

At this point, let’s try to understand why the 4 percent rule is working poorly in simulations for Singapore. The chart below shows the value of the portfolio over time for different simulations, based on the withdrawals made and the returns on the portfolio, split by percentiles.

- At the top, we see that the luckiest 30% of the simulation runs (the blue and orange zones) have an increase in portfolio value over time. They essentially have no issues with funding retirement. In fact, they can increase their spending above the 4%-of-portfolio-value initial amount.

- In the middle, the next 30% of the simulation runs (the grey, yellow and blue zones) also have no problems in making the money last for 35 years or more. The portfolio values increase initially, then dip later when withdrawals are larger. However, there is little risk of outliving the funds.

- The bottom few zones are simulation runs that have trouble making the money last for 25 to 30 years. In particular, the worst case, which is the very bottom of the dark grey zone, says it all. In the first year of retirement, the portfolio suffers a loss of 40% of its value. This loss, together with withdrawals from the portfolio, leaves a hole so large that no amount of future returns can make up for, and the portfolio runs out of money in the 10
^{th}year. Look at the top of the dark grey zone, which is the bottom 10% of the simulation runs. If we can avoid making a loss of more than 15% in the first few of years of retirement, there is a good chance of making it past year 20 of retirement at a 4% withdrawal rate adjusted for inflation, which is the absolute minimum requirement.

This interplay of:

- withdrawals from the portfolio
- losses in the first couple of years of retirement, and
- no other sources of income

results in a disastrous retirement. This is known as Sequence of Returns Risk. Finding a solution to this risk is the key to designing a worry-free retirement. There are no perfect solutions to sequence of returns risk, as retirement is defined as the point when the person has no other sources of income, hence needs to live off not just the gains and interest, but also the capital or principal of the asset portfolio. A person usually retires when the asset portfolio is at its peak, and hence most vulnerable to a market downturn.

#### What can retirees in Singapore do?

So retirees in Singapore are in a difficult bind. Stocks are too volatile to ensure a safe retirement, while the interest rates on Singapore Savings Bonds are too low. But what about the CPF? If we did not withdraw our CPF, but left it earning 4% interest in the Retirement Account (RA) and Special Account (SA) like a “bond”, can this make a difference? Does the 4 percent rule now work in Singapore using CPF?

The answer is yes! The table below shows the results of the simulations with different allocations to CPF RA and SA. When the majority of assets are left in the CPF, the 4% rule works! Keeping the funds in the CPF RA or SA helps the retiree to avoid the sequence of returns risk. This is because there is no downside to the RA and SA monies, preserving their value regardless of market conditions. Also, the CPF RA/SA accounts pay enough interest to sustain the retiree without dipping too much into the capital.

Withdrawal Rate | 20 years | 25 years | 30 years | 35 years | 40 years |
---|---|---|---|---|---|

4.0%50% in CPF | 91% | 79% | 68% | 58% | 50% |

4.0%70% in CPF | 99% | 91% | 76% | 61% | 47% |

4.0%100% in CPF | 100% | 100% | 100% | 0% | 0% |

3.5%100% in CPF | 100% | 100% | 100% | 100% | 100% |

In fact, when 100% of the assets are left in the CPF RA/SA, there is no chance of failure for the 4% withdrawal rule over 30 years. If we lower the initial withdrawal rate to 3.5%, we effectively would not run of money over 40 years! However, this only happens when we can get the 4% rate of interest in the SA or RA. There are, unfortunately, limits to how much we can top up these accounts now. The Ordinary Account, which pays 2.5%, would not help, as it is too low.

When 100% of assets are put in the CPF SA, the 4% rule works for a 30-year retirement

Note, however, with 100% of the funds in the CPF, the portfolio runs out between the year 30 and 35. There also is little or no bequest left to the retiree’s heirs.

#### What other ways do we have to retire securely?

Does this mean that the future for retirees in Singapore is bleak? Trapped between high costs of living, low interest rates and volatile stock returns? We have not gone further into other approaches like:

- Withdrawing from an asset portfolio in combination with other financial products, such as annuities (e.g. CPF Life)
- The likelihood of survival until the age of 95, and
- The need to adjust the withdrawal amounts to inflation

These methods help make the withdrawing from an asset portfolio more sustainable, and will be covered in later posts. For example: 4 ways the 4 percent rule can work in Singapore.

Do not rely solely on your savings

or asset portfolio for retirement!

However, the clear message here is: **Do not rely solely on your savings for retirement!** Unless you are a multimillionaire and a 2% withdrawal rate is more than sufficient for your lifestyle.

#### Reference

Finke, Michael, Wade D. Pfau, and David M. Blanchett. 2013. “The 4 Percent Rule Is Not Safe in a Low-Yield World.”* Journal of Financial Planning* 26 (6): 46–55

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