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Today’s Investors Have Little Idea What Makes for a Safe Retirement

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Valuation-Informed Indexing #225

by Rob Bennett

One of the most fundamental purposes of investment analysis is to help investors to plan safe retirements. I believe that we are close to being able to do a very good job of this. But today we fall a good bit short of the goal. A recent analysis posted at Schwab.com (Make Sure Your Money Lasts) evidences a frightening level of confusion while also making a few good points that I believe may take us all to a better place in days to come.

The key point of the article is to point out that most financial planners have lost faith in the “4 percent rule,” the claim that retirees can safely take out an inflation-adjusted 4 percent of their stock portfolio to cover their annual living costs. This is of course a good thing. It is likely that we will be seeing millions of failed retirements because of the heavy promotion of the long-discredited studies advocating the 4 percent rule. But the Schwab article does a poor job of explaining how the 4 percent rule came to let us all down.

The article cites two reasons why following the 4 percent rule is now widely considered to be a bad practice: (1) Market conditions are different; and (2) The sequence of returns that an investor sees can have a big effect on the withdrawal rate that will work for him. I am a huge critic of the 4 percent rule. I was arguing that it was a dangerous rule back in 2002, nearly ten years before the Wall Street Journal and scores of other big-name publications jumped on the bandwagon. But I feel compelled to say that the Schwab article is not being even a little bit fair to the authors of the studies that were once thought to support the 4 percent rule.

People forget that the studies that were once thought to support the 4 percent rule represented a big advance in our understanding of how retirement planning works. Prior to the publication of these studies, people as intelligent and informed as Peter Lynch were recommending a 7 percent rule! Why? Because U.S. stocks have for 140 years provided an average annual return of 6.5 percent real. So an annual withdrawal of 7 percent real should only deplete the account very gradually. This works intuitively!

It doesn’t work at all in the real world. It doesn’t work because the sequence of returns that turns up affects the result and the retiree does not know in advance what sequence will turn up. So those who want safe retirements must build in a lot of slack to cover the possibility that they will experience unfortunate return sequences. It was the authors of the 4 percent studies who showed us why the returns sequence factor is so important. This is not something that the authors of the 4 percent studies missed. This is something that the authors of the authors of the 4 percent studies taught us!

It’s also unfair to find fault with the authors of the 4 percent studies for failing to anticipate that we might see poor market conditions. The entire purpose of a safe withdrawal rate study is to show investors how to choose withdrawal rates that will work in any market conditions. The possibility that we might be seeing the sorts of market conditions that apply today was factored in to the 4 percent studies.

Consider what it means to say that the safe withdrawal rate is 4 percent. The studies assume that the retirement will take begin at age 65 and that the retiree will not live past age 95 and that thus the account may be depleted over the course of 30 years. So if stocks earned a zero percent real return over the three decades following the retirement date, the safe withdrawal rate would be 3.3 percent. The fact that the number generated by the studies is only 0.7 percentage points higher than the number that would apply in a world where stocks offered no positive return shows how conservative is the methodology that was employed in these studies.

The problem with the 4 percent studies is not that they did not anticipate poor market conditions or that they did not factor in the effect of unfortunate return sequences. It is that they did not factor in the effect of valuations. There is now 33 years of peer-reviewed research showing that the valuation level that applies on the day the retirement begins is the biggest factor affecting the safe withdrawal rate. This factor was ignored because most academics to this day maintain confidence in Buy-and-Hold Model for understanding how stock investing works and that model posits that stock investing risk is constant rather than variable.

The safe withdrawal rate varies from a low of 1.6 percent to a high of 9.0 percent real, depending on the valuation level that applies on the day the retirement begins. The authors of the 4 percent rule ignored the valuations factor for the same reason that virtually all peer-reviewed research in this field ignores this critical factor. The Schwab analysis does not discuss this critical factor.

The Schwab analysis argues for customized retirement planning. There is merit in this argument. The 4 percent studies gave numbers that assume the retirement will need to survive for 30 years. That is not always a valid assumption. Some of us retire early and need guidance that works in cases where the retirement might extend for 40 or even 50 years. And not all retirees demand the same level of safety. The old studies offered numbers that worked in every returns sequence that exists in the historical record (at least that would have been so had the valuations factor been considered). Some aspiring retirees would like to use a withdrawal rate that is largely but not entirely safe, perhaps one that worked in only 80 percent of the return sequences on record. It makes sense to design future studies to show these numbers.

That said, it would be a mistake to suggest that customization of retirement planning advice is the answer or that it is even a good idea in every circumstance. All investors, even non-retirees, need to know the safe withdrawal rate as the concept is defined in the old studies. Knowing that the safe withdrawal rate varies from 1.6 percent real to 9 percent real tells us all something important about how stock investing works — the valuations factor is of huge importance. We should use the failure of the 4 percent studies as a learning experience. We messed up and we did serious harm to lots of people by doing so. We need to acknowledge the true cause of the massive mess-up and focus in on the factor behind it if we are finally to make true sense of the retirement planning project.

Rob Bennett recorded a RobCast titled Investing Ethics: An Oxymoron? His bio is here.

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