Bill Bengen has written an important article on safe withdrawal rates for Financial Advisor. It is titled Bill Bengen Revisits the 4 Percent Rule Using Shiller’s CAPE Ratio, Michael Kitce’s Research.
The 4 Percent Rule
The 4 percent rule has been around since the mid-1990s. The idea in creating it was to provide aspiring retirees a rule-of-thumb that they could use to determine whether they had saved enough to hand in a resignation. Stocks were king in the mid-1990s. So the researchers calculating the number would assume an 80 percent stock allocation. They would look to the worst time-period in U.S. history for beginning a retirement. This was the time-period immediately following the Great Depression of 1929. A retirement beginning at that time and calling for a 4 percent annual withdrawal to cover living expenses would survive 30 years (although the capital would have been depleted to near zero by the end of that time). Analysts claimed that a 4 percent withdrawal is “safe” on grounds that, even in a worst-case scenario, retirement plans calling for that withdrawal at least barely survived for 30 years (covering someone who retired at age 65 up to age 95).
I pointed out the error in these studies in a post that I put to a Motley Fool discussion board on the morning of May 13, 2002. If the market were efficient, as was believed to be the case when the Buy-and-Hold investment strategy was developed, the safe withdrawal rate would indeed always be the same number and that number would be 4 percent. So the studies that gave rise to the 4 percent rule advanced our understanding. Prior to the popularization of the 4 percent rule, Peter Lynch had been saying that a retirement plan calling for a 7 percent withdrawal was safe on grounds that U.S. stocks offer an average annual return of close to 7 percent.
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The error in the studies that gave rise to the 4 percent rule is that they do not take valuations into consideration. Robert Shiller’s Nobel-prize-winning research shows that the market is NOT efficient, that investors are in fact highly emotional and often set stock prices far above or far below their true value. So risk is not constant but variable and the safe withdrawal rate is not always 4 percent but a number that ranges from 1.6 percent when stock prices are insanely high to 9.0 percent when stock prices are insanely low.
Lower Safe Withdrawal Rates Make Stocks More Appealing
This finding makes Buy-and-Holders anxious. It is a challenge to their often repeated claim that market timing does not work or is not required. Stocks are obviously a much more appealing asset class when the safe withdrawal rate is 9.0 percent than they are when the safe withdrawal rate is 1.6 percent. If the value proposition offered by stocks changes that much because of valuation shifts, then market timing is imperative. The investor who fails to engage in market timing is taking on more risk than he intended while setting himself up to earn less in the way of a long-term return than expected.
Bengen acknowledges this in his new article. Not directly. There is no statement in the article to the effect that the 4 percent rule is in error and that we need to be warning investors who followed it when setting up retirement plans that their plans are in danger of failing in the days following the next price crash. But in an indirect way, Bengen makes the point that needs to be made, a point that I can testify was very, very, very difficult to make back in May 2002, when I first began making it.
Bengen states: “Examining the chart, one is immediately struck by the countervailing behavior of the two data series. High initial withdrawal rates are consistently associated with ‘cheap” stock markets and low initial withdrawal rates are associated with ‘expensive’ stock markets. The correlation between the two data series is negative 0.75, which is quite strong. Obviously, it paid to retire when stocks were cheap!”
That’s Valuation-Informed Indexing, not Buy-and-Hold. That’s market timing. Bengen wouldn’t have dared to write something like that in 2002 and Financial Advisors wouldn’t have dared to publish it at that time. We’ve come a long way in 18 years!
The safe withdrawal rate is not always the same number. Stocks offer a better value proposition at times of low or moderate prices than they do at times of high prices. So the safe withdrawal rate is naturally higher at such times. Market timing works! Coming to understand that is perhaps the biggest advance in the history of personal finance. Spread the word.
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