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The Retirement Risk Evaluator Is the First Safe-Withdrawal-Rate Calculator That Contains a Valuations Adjustment

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Valuation-Informed Indexing #297

By Rob Bennett

Michael Kitces wrote in a recent blog entry that: “Today’s financial planning software packages are incapable of modeling regime-based retirement projections — not because it’s impossible or even difficult to program but simply because they aren’t programmed to do so.” He’s right. A regime-based projection is one that takes into consideration the reality discovered by Robert Shiller in 1981 that stock prices do not fall in the pattern of a random walk but play out in predictable long-term patterns in which valuations rise for about 20 years and then fall for about 15 years. Most of today’s calculators (this is true not just for retirement calculators but for all investment calcultors) are rooted in the Buy-and-Hold model for understanding how stock investing works, based on Eugene Fama’s 1965 finding that the market is efficient and thus should play out in the pattern of a random walk.

Another way of saying it is — Today’s investment calculators get the numbers wildly wrong (presuming that the model based on Shiller’s finding is the legitimate one and that the model based on Fama’s finding has been discredited as a result). This is a big deal. Investing is a numbers game. People use calculators to set their stock allocations and to determine how much to save and to plan their retirements. If today’s calculators are giving bad information, millions of us are going to be suffering serious financial shortfalls in days to come. This is not just an investing problem, it is a public policy problem.

I learned about the problem 14 years ago when I put up a post to a Motley Fool discussion board asking my fellow community members who were using a retirement calculator to plan their retirements whether the calculator should contain an adjustment for the valuation level that applied on the day the retirement was to begin. A large segment of the community believed that it should and showed great interest in determining what the calculator would say were it constructed properly. An even larger segment of the community felt strongly that no adjustment should be included and that no further discussion of whether an adjustment were needed should be permitted. The calculator in question remains uncorrected to this day.

As a result of my amazement at things I heard during that debate, I developed five calculators that take Shiller’s findings into consideration and that thus offer a very different take on the issues examined than do conventional investment calculators examining similar questions. I will use the next few columns to introduce you to those calculators. I’ll start this week with the calculator that Kitces suggested is needed, one that takes valuations into consideration when determining the safe withdrawal rate (the percentage of the retiree’s portfolio that he may withdraw each year to cover living expenses with virtual certainty that the portfolio will last 30 years assuming that stocks continue to perform in the future at least somewhat aa they have always performed in the past).

I call the calculator The Retirement Risk Evaluator. The headline at the page of my web site that houses the calculator is: “Retirement Planning Calculator Smashes Safe Withdrawal Rate Myths.” That says it. I believe that the primary reason why the Shiller-based model for understanding how stock investing works (Valuation-Informed Indexing) has not become dominant in the 35 years since publication of his research is that the the huge effect of the valuations factor is a highly counter-intuitive reality. We all accept that valuations matter. But until we see with numbers how big the effect is, most of us (this included me at one time) fail to recognize how much harm we do to ourselves by our failure to take this one factor into consideration. The purpose of the Risk Evaluator is to confront our cognitive dissonance head on and smash it into bits.

Today’s retirement calculators say that the safe withdrawal rate is always 4 percent because, if the market really were efficient, risk would be a constant. The Risk Evaluator shows that this number can drop to as low as 2.0 percent at times of high valuations and rise to as high as 9.0 percent at times of low valuations. For a retiree who has accumulated $1 million in assets, that’s the difference between living on $20,000 for the remaining years of her life or living on $90,000 for the remaining years of her life. Valuations matter!

When I was designing the calculator with its co-developer (John Walter Russell), we came to the conclusion that it would be good to show aspiring retirees how they can in some circumstances retire sooner by lowering their stock allocations (under the Buy-and-Hold Model, stocks are always the best investment choice because return expectations are always the same in a world of random-walk prices). I was amazed to learn when we worked the numbers that the safe withdrawal rate for Treasury Inflation-Protected Securities purchased at the time when the SWR for stocks was 2.0 percent was 5.85 percent. That’s amazing, isn’t it? At the time when stocks offered the worst value proposition that they have ever offered in the history of the U.S. market, a risk-free asset class was available that offered a SWR nearly three times larger. Valuations matter a lot!

Another feature of the new calculator is that it permits retirees to examine the difference it makes if they want to be sure to retain a portion of their portfolios at the expiration of 30 years. The standard assumption is that the retiree wants to know what withdrawal rate will allow the retiree to live for 30 years after the retirement begins, taking an age-65 retiree to age 95. That’s not an unreasonable assumption. But I thought it would be illuminating to examine other possibilities. Early retirees might want to insure that their starting-point portfolio amount remains in effect at the end of 30 years. Even standard-age retirees might want to insure that half of the portfolio remains in place so that something can be left to heirs or that at least 20 percent remains in place as slack in the plan. The more options offered to the retiree, the more strategic questions he can examine before putting his plan into place.

Rob Bennett’s bio is here.


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