Valuation-Informed Indexing #134
by Rob Bennett
I have a calculator at my web site called “The Retirement Risk Evaluator.” I promote it as “the first New School safe-withdrawal-rate (SWR) calculator. That means that it identifies for aspiring retirees how much they can take out of their investment portfolios each year with near certainty that they will never run out of money, presuming that stocks perform in the future at least somewhat as they always have in the past. What makes the calculator a product of “New School” thinking is that it contains a valuation adjustment; that is, the SWR is different for retirements beginning at different valuation levels. The Old School calculators report the same withdrawal rate (4 percent) as “safe” at all times.
I have doubts about one of the numbers generated by the calculator. I was not the sole developer of the Risk Evaluator. I worked with John Walter Russell, who died in October of 2009. John and I had a number of differences of opinion during the time the Risk Evaluator was being developed. On a number of issues, he ended up going along with my take. On this issue, I went along with his take. I think his take is perfectly reasonable. Still, I always feel a little funny when the particular number that he favored pops out of the calculator. So I thought it might be a good idea to explain the circumstances here. Going through the background might help people see that there are often not right or wrong answers to the questions addressed by investment studies and calculators.
The Old School SWR studies and calculators report that a 4 percent withdrawal is always safe. The reason why they report this is that there has never been a case in U.S. history in which a retiree using a withdrawal rate lower than 4 percent saw his retirement fail. There’s a case in which a withdrawal rate of 4.1 percent failed. But 4.0 percent has always worked. So the Old School calculators call that withdrawal rate “safe” (one study goes so far as to call it “100 percent safe”).
I argue that that way of looking at things is analytically invalid.
It’s accurate to say that all retirement plans calling for a 4 percent withdrawal rate have survived. It doesn’t follow to say that a retirement plan calling for a 4 percent withdrawal rate is safe any more than it would follow to say that because you have driven drunk four times in your lifetime and are still alive today that driving drunk is “100 percent safe.” There have been three earlier times in U.S. history when stock prices reached the insanely dangerous levels that have applied since 1996. On those occasions, retirement plans calling for a 4 percent withdrawal barely survived. What this shows is that, for retirements that begin at times of high valuations, a 4 percent withdrawal is a high-risk withdrawal. There is a chance that such a withdrawal rate will work out a fourth time. But the record shows that you are taking a big chance by counting on such an outcome.
The Risk Evaluator shows that the safe withdrawal rate varies with changes in the P/E10 level that applies on the day the retirement begins. When valuations are at rock bottom levels (as they were in the early 1980s), the SWR rises to 9 percent. When valuations rise to the insanely dangerous levels that applied at the top of the bubble, the SWR drops to 1.6 percent.
The Risk Evaluator reports that the SWR is 2 percent when the P/E10 value is 44, the value that applied in 2000. John’s research showed that the number was 1.6 percent. Why doesn’t the calculator result match the research result?
I think it would be better if the numbers matched. Just about everybody finds the 1.6 number shocking. A not small number of people become angry when they hear it. My response to the skepticism and anger is to say “Well, that’s what the numbers say — I don’t create the historical return data, I just report what it tells us!”
John was swayed by language in Robert Shiller’s book Irrational Exuberance. Regarding the extreme valuation levels we saw at the top of the bubble, Shiller wrote: “The recent values of the price-earnings ratio, well over 40, are far outside the historical range of price-earnings ratios. If one were to locate such a price-earnings ratio on the horizontal axis, it would be off the chart altogether. It is a matter of judgment to say, from the the data shown in Figure 1.3, what predicted return the relationship suggests over the succeeding ten years; the answer depends on whether one fits a straight line or a curve to the scatter, and since the 2000 price-earnings ratio is outside the historical range, the shape of the curve can matter a lot.”
John felt that the 1.6 number was extreme and not entirely reliable because the P/E10 value of 44 that applied in 2000 was an outlier. So he applied a filter to pull the number up just a bit. Thus, the RIsk Evaluator identifies a slightly higher SWR as the lowest in history than does the research in which the other calculations performed by the Risk Evaluator was rooted.