I wrote last week about a recent article in Financial Advisor magazine titled Bill Bengen Revisits the 4 Percent Rule Using Shiller’s CAPE Ratio, Michael Kitce’s Research. I like the article because it says things that could not be said in May 2002, when I first pointed out the error in the studies claiming that the safe withdrawal rate is always 4 percent.
Q3 2020 hedge fund letters, conferences and more
Bengen writes: “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 sort of talk was forbidden as anxiety provoking to Buy-and-Holders not that long ago. I am of course happy to see that we are as a society making progress in the direction of offering more realistic retirement planning advice.
But not nearly as much progress as I would like to see!
The Issue Of Safe Withdrawal Rates
There’s a frankness about the issue of safe withdrawal rates that I believe is vital that is missing from this article. Why is it only now that we are seeing articles dismissing the 4 percent rule, given that Shiller published his Nobel-prize-winning research showing that valuations affect long-term returns (and that, thus, the safe withdrawal rate is a number that varies with changes in valuation levels) 39 years ago? It is because it is widely viewed as economically incorrect to point out the error at the core of the Buy-and-Hold Model -- the idea that there is no need for investors to engage in market timing. If, as Bengen correctly observes, retirement is easier at times when stock prices are low, it’s because stocks offer a stronger value proposition when prices are low. So of course buying more stocks at such times (market timing!) always works. Why not tell people that?
Bengen makes the point about the benefits of market timing, which is certainly a plus. But he does not highlight the point. My view is that it should be in the headline. But Bengen crafts his article to downplay the point. One thing that he does is to examine a portfolio comprised of only 50 percent stocks. Back in the day when the 4 percent rule became popular, researchers were examining portfolios comprised of 80 percent stocks. By lowering the stock allocation, Bengen is able to show a high safe withdrawal rate at times of high stock valuations.
I don’t have a problem with showing the numbers that apply for a 50 percent stock allocation. I always felt that the convention of showing results for an 80 percent stock allocation was a product of the pro-stock insanity that prevailed in the 1990s and that it would be a better practice to show investors how they could put together retirement plans featuring more moderate stock allocations. But I know from personal experience that many investors would be shocked to learn that they could increase the safe withdrawal rate dramatically by lowering their stock allocation. People were always hearing the opposite story in the 1990s, that it is only by taking on the risk of stocks that they could retire at a reasonable age. The fact that the reality is quite the opposite at times of super high stock prices is news. And it is news that is rarely broadcast even today, 18 years down the road from that fateful day in 2002 when I pointed out the error in the old retirement studies.
'Safe' Does Not Imply A Guarantee Of Future Applicability
There is language at the end of the Bengen article that makes me uncomfortable. He states: “I should also state the usual cheerful disclaimer that this research is based on the analysis of historical data and its application to future situations involves risk, as the future may differ significantly from the past. The term ‘safe’ is meaningful only in its historical context, and does not imply a guarantee of future applicability.”
It is obvious that no study can offer a guarantee of what will work in the future. Nothing could be more clear.
But it appears to me that more if being suggested by these words. The old studies not only failed to offer a guarantee (which is of course right and proper), they failed even to employ a methodology that stood a reasonable chance of revealing what would work presuming that stocks do continue to perform in the future much as they always have in the past. The 4 percent rule showed what happened in the worst-case valuation starting point that we have seen in the past. But it did not show what would have happened had we seen a worst-case returns sequence starting from a worse-case valuation starting point, which of course is something we could indeed see in the future. So the old studies do not look at a true worst case scenario, even though they claim to do so.
In short, the Buy-and-Hold studies show what would work if we lived in a world in which the market was efficient instead of a world in which valuations affect long-term returns, which is the world we actually live in. Those are two very different worlds and in the past 18 years all investment advisors should have made it their business to come to a clear understanding of the differences between those two worlds. The safe withdrawal rate is NOT always 4 percent in the event that stocks continue to perform in the future somewhat as they always have in the past. The true safe withdrawal rate (the one obtained in an analysis that takes valuations into consideration) is often a very different number.
The 4 Percent Rule Simply Does Not Work
I believe that we are making very slow progress. We know much more about safe withdrawal rates than we did in 2002 and we even are beginning to see some brave investment advisors acknowledge that the 4 percent rule simply does not work, which is something that almost no one dared to do in 2002. But we need to push harder. There is still a reluctance to just state simply that market timing is essential. The investment analysis of the future, I believe, is an investment analysis in which investors are warned that there are times when stocks offer so poor a long-term value proposition that aspiring retirees can retire much sooner by lowering their stock allocations.
Investors need to learn how to identify those times and how to understand the trade-offs that need to be considered in setting a rational stock allocation in a post-Shiller world. To get there, we all need to be more frank in pointing out the dangers of following a Buy-and-Hold approach. Stocks do not offer the same value proposition at all times. So it makes no sense for investors to maintain the same stock allocation at all times. Market timing is a critical piece of the stock investing puzzle, both in the retirement planning realm and in all other realms. The more blunt we all are in saying that, the less surprise investors will come to experience when hearing the message.
Rob’s bio is here.
