May 2004 Overview

Research on Safe Withdrawal Rates

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May 2004 Overview

Post by JWR1945 »

We have made a tremendous amount of progress in our research. There are many factors that affect the safety of withdrawals during retirement. Prices are one of them and prices are special. You control the prices that you pay for your investments.

Our first major milestone was met on June 24, 2003, when I submitted my post Safe Withdrawal Rate versus P/E10 Data. From a technical standpoint that post ended the Great Debate. It is meaningful to talk about Price-Adjusted Safe Withdrawal Rates and to estimate them using objective, mathematical techniques. [P/E10 is the price or index value of the S&P500 divided by the average of the last ten years of earnings.]

We have cleaned up the method of presenting the concept of Safe Withdrawal Rates. To do so, we have had to draw some precise distinctions between what has happened (i.e., Historical Database Rates and other historical survival rates) and what is likely to happen (e.g., Safe Withdrawal Rates and Zero Balance Rates).

Historical Database Rates are based on an actual historical sequence of investment returns. A hypothetical portfolio would have survived for a specified number of years at the Historical Database Rate. Its balance would have fallen to zero or become negative at a slightly higher (0.1%) withdrawal rate. Unless we identify the first year of a historical sequence, the Historical Database Rate is the lowest among those that we investigate (typically, 1921-1980). Withdrawals are adjusted to match inflation (and deflation).

The Zero Balance Rate is our best estimate of what the Historical Database Rate will turn out to be when we look back sometime in the future. It is a mathematical prediction and, preferably, it includes confidence limits. The Safe Withdrawal Rate is its lower confidence limit. [I anticipate changing the name of the Zero Balance Rate to the Calculated Rate.]

Early researchers estimated the Safe Withdrawal Rate to be the same as the (smallest) Historical Database Rates. They did not provide confidence limits. We now know that today's stock market is outside of the range of the historical database. We have made suitable adjustments to allow us to use the historical data. We have placed Safe Withdrawal Rates in a proper statistical setting and we have added confidence limits.

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. Retirement portfolios fail when large quantities of stock are sold below normal prices. Volatility is the culprit.

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 in the past. Today's dividend yields are between 1% and 2%. In terms of the historical cause and effect analysis, this suggests a Safe Withdrawal Rate below 3%.

It turns out that there is quite a bit that we can do. There is now an attractive alternative to stocks. TIPS (Treasury Inflation Protected Securities) match inflation and have higher yields than stocks. 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. This kind of information had not been reported prior to this board's existence because of a calculator error that we have corrected. We refer to this kind of response as the design of a retirement strategy. It is founded firmly on what we have discovered in our Safe Withdrawal Rate investigations.

For general guidance in today's market, read Retirement Investment Summary from Thu Sep 25, 2003.

We are now enter in era of designing retirement strategies based upon what we have learned from our Safe Withdrawal Rate investigations.
See Interim Withdrawal Rates from Tue Feb 24, 2004.

We have found that switching portfolio allocations according to P/E10 would have improved past results considerably. The 30-year Historical Database Rate with switching is 5% as opposed to 4% without switching, but that was when dividends and valuations were inside of the historical range. The historical range for dividends extended down to 3% as opposed to less than 2% today. The historical range for valuations as measured by P/E10 extended up to 24 or 27 before the bubble. To bring today's numbers into the historical range, you might adjust the 30-year withdrawal rate to be 5% times the ratio of 24 (or 27) and today's P/E10. Without switching, you would use 4% times the same ratio.

Recently, we have found that earnings yield (using the average of the past decade's earnings) does an excellent job of predicting Safe Withdrawal Rates. It is even better than using dividend yield (plus about 1%) as a lower bound. The earnings yield overcomes the problem of surprise cuts in dividend amounts. It automatically corrects for any unsustainable payouts.

We already have a spin-off from our research, which I call A New Tool. It allows you to translate an assumed rate of return (perhaps for the next decade) into a Safe Withdrawal Rate (complete with confidence limits). It has an interesting side benefit. We can calculate how much a Safe Withdrawal Rate depends upon the exact sequence of returns as opposed to their overall total.

A New Tool: Overview from Wed Apr 28, 2004
A New Tool from Wed Apr 28, 2004

We have made several modifications to the Retire Early Safe Withdrawal Calculator, Version 1.61, November 7, 2002 to allow us to extract data more easily and to extend its capabilities. We are always receptive to those who wish to see an added capability and to find out what it has to offer.

Have fun.

John R.
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