Where we are now.
Posted: Mon Oct 13, 2003 7:33 pm
Retirement portfolios fail when large quantities of stock are sold at below normal prices. Volatility is the culprit. Cause and effect analysis has shown that the Historical Database Rates are only slightly above dividend yields under worst case conditions. In effect, dividends have shielded retirement portfolios from price fluctuations. Careful examination has shown that the alternative investments available in studies yielded less than stocks. Stock prices had to fall sharply for any alternative to look attractive. The worst case time period for starting a retirement was 1959-1973, not during the Great Depression. Stock dividends were very low by historical standards. Yet, their yields were very close to 3% throughout those years (and their amounts were reasonably stable after adjusting for inflation). The Historical Database Rates were about 1% higher.
Today's stock market is still at historically high valuations. Dividend yields are even lower than they had been in the past. Today's dividend yields are between 1% and 2%. In terms of the historical cause and effect analysis, this would suggest a Safe Withdrawal Rate below 3%.
There is a third factor, however, that was not part of the historical record. It is long-term TIPS (Treasury Inflation Protected Securities). Long-term TIPS are still available on the secondary market. The longest expire in 2032. Their yields to maturity have ranged between 2.2% and 2.8% in the past few months. Recently, they yielded just above 2.6%.
We now have an attractive alternative to stocks. It matches inflation and has higher yields. It now makes sense to shift allocations based on market valuations. We can sit on the sidelines for a very long time and still have enough principal remaining to buy stocks at bargain prices. We can coast along for ten or fifteen years and still come out ahead.
My own preference has been to shift the stock allocations between 20% and 80% according to valuations as reflected in P/E10. To the extent that there is a magic number, it is a P/E10 of 12. When the P/E10 is below 12, it is time to load up on stocks. We can reduce our dependency on the magic number itself if we allow ourselves to use an intermediate allocation of 50% when prices are reasonable, but still above bargain levels. This kind of switching restores the safety traditionally associated with a 4% withdrawal rate.
Looking at today's valuations (near record highs) and dividend yields (near record lows), a prudent investor is likely to lower his withdrawal rate to a very low level, possibly as low as 2.0% or 2.5%. The good news is that does not have to. He can withdraw 3.0% with complete safety. If he purchases 2.5% long-term TIPS, he can hold them to maturity (which would be very close to 30 years) and have enough left over to last another 26 years, provided only that he is able to match inflation (i.e., zero percent real interest) throughout the time remaining. That is 56 years with total safety. There is a small amount of price fluctuation because he has to sell a small amount of TIPS each year. Interest covers 2.5%. Sales must cover the remaining 0.5%.
It is very reasonable to plan on withdrawing 4% during retirement. There is plenty of time for stocks to become attractive once again. But even under the most dire of circumstances, it is not necessary to reduce withdrawals below 3%.
(Note: In this discussion, percentages are in terms of a portfolio's initial balance. All amounts withdrawn are adjusted to match inflation. In addition, this analysis does not include the effects of taxes. The principal of TIPS changes with inflation and any increase is taxable when it occurs. That can be important. Such changes may be equal to or larger than your withdrawals.)
Have fun.
John R.
Today's stock market is still at historically high valuations. Dividend yields are even lower than they had been in the past. Today's dividend yields are between 1% and 2%. In terms of the historical cause and effect analysis, this would suggest a Safe Withdrawal Rate below 3%.
There is a third factor, however, that was not part of the historical record. It is long-term TIPS (Treasury Inflation Protected Securities). Long-term TIPS are still available on the secondary market. The longest expire in 2032. Their yields to maturity have ranged between 2.2% and 2.8% in the past few months. Recently, they yielded just above 2.6%.
We now have an attractive alternative to stocks. It matches inflation and has higher yields. It now makes sense to shift allocations based on market valuations. We can sit on the sidelines for a very long time and still have enough principal remaining to buy stocks at bargain prices. We can coast along for ten or fifteen years and still come out ahead.
My own preference has been to shift the stock allocations between 20% and 80% according to valuations as reflected in P/E10. To the extent that there is a magic number, it is a P/E10 of 12. When the P/E10 is below 12, it is time to load up on stocks. We can reduce our dependency on the magic number itself if we allow ourselves to use an intermediate allocation of 50% when prices are reasonable, but still above bargain levels. This kind of switching restores the safety traditionally associated with a 4% withdrawal rate.
Looking at today's valuations (near record highs) and dividend yields (near record lows), a prudent investor is likely to lower his withdrawal rate to a very low level, possibly as low as 2.0% or 2.5%. The good news is that does not have to. He can withdraw 3.0% with complete safety. If he purchases 2.5% long-term TIPS, he can hold them to maturity (which would be very close to 30 years) and have enough left over to last another 26 years, provided only that he is able to match inflation (i.e., zero percent real interest) throughout the time remaining. That is 56 years with total safety. There is a small amount of price fluctuation because he has to sell a small amount of TIPS each year. Interest covers 2.5%. Sales must cover the remaining 0.5%.
It is very reasonable to plan on withdrawing 4% during retirement. There is plenty of time for stocks to become attractive once again. But even under the most dire of circumstances, it is not necessary to reduce withdrawals below 3%.
(Note: In this discussion, percentages are in terms of a portfolio's initial balance. All amounts withdrawn are adjusted to match inflation. In addition, this analysis does not include the effects of taxes. The principal of TIPS changes with inflation and any increase is taxable when it occurs. That can be important. Such changes may be equal to or larger than your withdrawals.)
Have fun.
John R.
