Monday, May 16, 2011

Can We Predict the Sustainable Withdrawal Rate for New Retirees?

I have mostly re-written an earlier article, and it is now called, “Can We Predict the Sustainable Withdrawal Rate for New Retirees?” This paper can be downloaded from RePEc. It has since been published in the August 2011 issue of the Journal of Financial Planning. I hope it is more readable than its predecessor, "Predicting Sustainable Retirement Withdrawal Rates Using Valuation and Yield Measures."

This revised paper serves as a sequel to “Safe Savings Rates: A New Approach to Retirement Planning over the Lifecycle,” as it uses the basic underlying idea from that article, about how sustainable withdrawal rates relate to whether there was a bull or bear market prior to retirement, to provide some indication about how much a retiree may be able to reasonably expect to withdraw from retirement savings in a sustainable manner.

Retirees now frequently base their retirement decisions on the portfolio success rates found in research such as the Trinity study. Studies such as those are fine for what they accomplish: they show how successful different withdrawal rate strategies were in the historical data. But it must be clear that this is not the information that current and prospective retirees need for making their withdrawal rate decisions. John Bogle makes clear why in his 2009 book, Enough. Though he was speaking about stock returns, the same idea applies to sustainable withdrawal rates, since they are related to the returns of the underlying portfolio of stocks and bonds. He wrote, “My concern is that too many of us make the implicit assumption that stock market history repeats itself when we know, deep down, that the only valid prism through which to view the market’s future is the one that takes into account not history, but the sources of stock returns” (page 102, original emphasis).

Future stock returns (and, therefore, future sustainable withdrawal rates) depend on the sources of returns: dividend income, growth of the underlying earnings, and changes in the valuation multiples placed on those earnings. The historical average success rate for a withdrawal strategy is not the information retirees need to know when determining their forward-looking sustainable withdrawal rate. As Mr. Bogle also writes, “But no, the contribution of dividend yields to returns depends, not on historic norms, but on the dividend yield that actually exists at the time of the projection of future returns. With the dividend yield at 2.3 percent in July 2008, of what use are historical statistics that reflect a dividend yield that averaged 5 percent - more than twice the present yield? (Answer: None.)”

I use this idea to develop a regression model in which I attempt to predict the maximum sustainable withdrawal rates that a person can use with their retirement savings to obtain inflation-adjusted income over a 30-year period, for a 60/40 asset allocation of large-capitalization stocks and 10-year government bonds. The regression model explains and predicts the withdrawal rate including variables for the cyclically-adjusted earnings yield (100 / PE10), a 10-year moving average of the dividend yield, and the nominal bond yield at the retirement date. The regression framework includes variables to predict long-term stock returns, bond returns, and inflation (the components driving a retiree's remaining portfolio balance). It produces estimates that fit the historical data well. The past model fit and the predictions for sustainable 30-year inflation-adjusted withdrawal rates for the years since 1981 can be seen below:


This study suggests that a 4 percent withdrawal rate cannot be considered as safe for U.S. retirees in recent years when the cyclically-adjusted price-earnings ratio has experienced historical highs and the dividend yield has experienced historical lows. What must be clear, as I explain at length in the article, is that the events that have taken place since about 1990 have very little impact on the results of the updated Trinity study, even though it uses data through 2009. What we have experienced in terms of record-high PE10 levels and record-low dividend yields during the past 15 years explain why the model predicts sustainable withdrawal rates falling below 3 percent since 1999, and even below two percent in the years since 2003.

I do have hope that withdrawal rates in recent years will not actually fall this low. In the past 15 years, financial markets have really been sailing in uncharted waters. We have never experienced such high valuation multiples and such low dividend yields. This makes it difficult for the model to make predictions for withdrawal rates, as it must make predictions outside the range of historical observation. Hopefully withdrawal rates will not fall as low as shown in the above figure. But the real lesson here is that even though the Trinity study indicates that a 4% withdrawal rate had a historical 96% success rate for a 50-50 portfolio with inflation-adjustments over 30 years, this success rate does not really apply to the situation in recent years.

Readers persuaded by this analysis may wish to include TIPS and other assets as a part of their portfolios. TIPS, in particular, can be used to create a floor that the withdrawal rate shouldn’t be able to fall under. Recent retirees should closely monitor their spending and portfolio balance. Maintaining flexibility with retirement spending is important. More generally, this framework can guide new retirees at other times as well toward a reasonable range for their expected MWR so that the 4 percent rule need not be blindly followed.


Supplemental materials for this article, including a spreadsheet that lets users make their own predictions by choosing values for the explanatory variables, can be found at this blog entry.

Further discussions of the paper can be found at:

Peter Benedek's Retirement Action updates 

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