Using a Variable Withdrawal Rate Is No Advance Over Using a Fixed One


Valuation-Informed Indexing #143

by Rob Bennett

Just about everyone has given up on the Old School withdrawal rate studies. These studies claimed to identify for aspiring retirees an amount that they could take out of their portfolios each year to cover living expenses.The studies failed to consider valuations and thus generated insanely risky “safe withdrawal rates.” An analytically valid methodology shows that retirements that were initiated at the top of the bubble and that employed the famous 4 Percent Rule stand only a 30 percent chance of surviving 30 years.

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Unfortunately, we are not yet in a place where the “experts” who have long advocated Buy-and-Hold strategies feel comfortable acknowledging their mistake (the Buy-and-Hold concept was developed prior to the publication of Robert Shiller’s research showing that valuations affect long-term returns). Acknowledging the mistake means rewriting all the textbooks in this field and revisiting all the conventional wisdom about how stock investing works. So we live today in a Twilight Zone where everyone who is paying attention knows that the old ideas don’t work but in which few dare to talk openly about what the research really says.

People putting together retirement plans today need advice today. They cannot wait for us to work up the courage to move to the next stage (which I believe will be a national debate on Valuation-Informed Indexing). To fill the void, a number of financial planners have put forward suggestions that perhaps aspiring retirees could identify safe withdrawal rates in a new way that doesn’t require making the mistakes that have doomed retirements in the past but also doesn’t require moving to the more sensible but radically new approach of taking valuations into consideration when making investing decisions.

The approach that gets mentioned most often is one in which retirees are encouraged to make variable withdrawals rather than fixed withdrawals from their portfolios. The idea has surface appeal. My view is that the variable withdrawal concept is no advance over the fixed-withdrawal-without-considering-valuations approach that is likely on its way to causing millions of failed retirements.

The Old School fixed-withdrawal approach was to take 4 percent out of a portfolio every year for 30 years of retirement. This means that a retiree who began his retirement with a $1 million portfolio would live on $40,000 (inflation-adjusted) from age 65 to age 95. The 4 Percent Rule has indeed worked for the first 140 years of U.S. stock market history. The mistake in thinking that it will work for today’s retirees is that the 4 Percent Rule barely worked on the earlier occasions when valuations reached insanely high levels and valuations went to far higher levels in the past bull market than they did at any earlier time in U.S. history. Retirements employing the 4 Percent Rule might squeak by one more time. But it is unlikely. It is certainly not anything close to a safe bet.

The appeal of the variable-withdrawal-rate approach is that it permits investors to be responsive to poor return periods. Say that stock prices decline sharply during the first ten years of your retirement, falling enough so that at the end of the 10-year period the inflation-adjusted value of your portfolio is $500,000 rather than $1,000,000. If you take out $40,000 in each of those 10 years, for are left with a portfolio value at the beginning of Year 11 of $100,000. Not good.

Now —

Say that instead of taking out a fixed 4 percent, you take out a variable 4 percent, insuring that your withdrawal will be less in times of poor returns than at times of good returns. In this scenario, you will be taking out only $20,000 in Year 11. Since you are taking out only half of the money that you would be taking out under the fixed-withdrawal approach, the odds of the retirement surviving are obviously far better. That’s the appeal of the variable-withdrawal approach. It makes the numbers look better.

People who think this solves the problem are kidding themselves, in my assessment.

Yes, your retirement will obviously stand a better chance of surviving if you withdraw smaller amounts from your portfolio. The problem is that safety is not the only goal that must be taken into consideration when planning a retirement. If safety were the only concern, you could live only on gains and never touch principal. That’s a very safe way to retire. The trouble with the idea is that going with that approach would cause long and unnecessary delays in retirement for most of us.

You want to be safe. But you also want to enjoy a pleasant lifestyle in retirement. The fixed-withdrawal approach permits the retiree to picture his retirement lifestyle. You either like the idea of living on $40,000 per year or you don’t. If you don’t, you wait until you have more assets. If you do, you pull the trigger.

The variable-withdrawal approach does not tell the retiree in advance what sort of living standard he will enjoy in retirement. That’s not a step forwards. It’s a step backwards. Retirees seeking to plan successful retirements need to know in advance how much they are going to be able to spend in the remaining years of their lives.

If there were no way to achieve this goal, it might be that we really would need to give serious consideration to the variable-withdrawal approach. But this is not the case. It is not at all difficult to structure a retirement plan that is both safe and that lets the retiree know in advance how much he will be able to spend each year.

The answer is to take valuations into considerations when setting the fixed-withdrawal percentage. People are freaking out today because they are coming to see that we have encouraged millions of people to structure retirements that are likely going to go bust in coming days. The side of the story that people are missing is that the failures should not come as a surprise. Retirement using the 4 Percent Rule at times of high valuations have always fared poorly.

Take valuations into consideration when planning your retirement, and the fixed-withdrawal approach works. It’s that simple and that complicated. We shouldn’t be looking for ways to tell retirees less about how their retirements will play out, we should be looking for ways to tell them more. Retirees need the certainty that comes with the fixed-withdrawal approach but they also need the accuracy that comes only with a fixed-withdrawal approach that calls for adjustments to the withdrawal percentage depending on the valuation level that applies on the starting date of the retirements.

Rob Bennett has recorded a podcast titled “It’s Not a Conspiracy, It’s Cognitive Dissonance.” His bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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