Wednesday, April 11, 2012

Safe Withdrawal Rates and Retirement Date Market Conditions

Classic safe withdrawal rates studies such as the works of William Bengen and the Trinity study investigate sustainable withdrawal rates from rolling periods of the historical data, giving us an idea about what would have worked in the past. For a 30-year retirement period, we can learn about the historical sustainable withdrawal rates beginning up to 30 years ago. The question remains as to whether those past outcomes provide sufficient insight about what can reasonably be expected to work in the future.
The general problem with attempting to gain insights from the historical outcomes is that future market returns and withdrawal rate outcomes are connected to the current values of the sources for market returns. Writing in his 2009 book Enough, John Bogle makes this point:
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)
These sources include income, growth, and changing valuation multiples. Future stock returns depend on dividend income, growth of the underlying earnings, and changes in the valuation multiples placed on those earnings. If the current dividend yield is below its historical average, then future stock returns will also tend to be lower. When price-earnings multiples are high, markets tend to exhibit mean reversion and relatively lower future returns should be expected. In case this point is not fully clear yet, John Bogle added in his book:
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.)
Returns on bonds, meanwhile, depend on the initial bond yield and on subsequent yield changes. Low bond yields will tend to translate into lower returns due to less income and the heightened interest rate risk associated with capital losses if interest rates rise.
Sustainable withdrawal rates are intricately related to the returns provided by the underlying investment portfolio. Current market conditions are much more relevant than historical averages. Past historical success rates are not really the type of information that current and prospective retirees need for making their withdrawal rate decisions.
An alternative way to look at the historical data is to consider not just the past withdrawal rate outcomes, but rather to consider how past withdrawal rates were related to the retirement date values of the underlying sources of returns. When looking at 30-year retirements with historical simulations, we can only consider retirements beginning up to the early 1980s. Because of sequence of returns risk in which early retirement events matter much more, recent market conditions only show up at the end of these retirements and have little bearing on their outcomes. This is a matter of much more than just academic interest, because market conditions have witnessed historical extremes in recent years.
For Robert Shiller’s cyclically-adjusted price-earnings ratio (PE10), the highest value in a January before 1980 was 27.1, which happened in 1929, the year of the stock market crash leading to the Great Depression. Since 1980, though, PE10 was above 27.1 in 8 years, including 1997-2002, 2004, and 2007. A highpoint of 43.8 occurred in January 2000.  Meanwhile, for the pre-1980 period, the dividend yield reached a historic low of 2.7 percent in January 1973. But in every January since 1996 (except 2009), the dividend yield was below this value. Finally, the nominal 10-year bond yield reached a historic low of 1.95 percent in January 1941, and though levels in recent years are not that low, they are also not particularly high and cannot help much to counteract the other factors which may tend to depress sustainable withdrawal rates. With these extreme market conditions, the past may not serve as prologue.
For at least a decade, this issue has been debated ad nauseam at personal finance discussion boards, but it was Michael Kitces’ May 2008 issue of The Kitces Report that brought the issue to wider attention. He divided the historical PE10 values into quintiles and then showed the lowest and highest sustainable withdrawal rates within each quintile. He concluded that retirees should be extra cautious when retiring at times with high PE10 ratios, but his focus was more in the other direction, i.e. that retirees who observe a low PE10 value at retirement (below 12) could safely increase their withdrawal rate to 5.5 percent.
An article I wrote for the August 2011 Journal of Financial Planning, “Can We Predict the Sustainable Withdrawal Rate for New Retirees?” picks up where Michael Kitces left off by combining his idea with a regression technique developed by John Campbell and Robert Shiller in their 1998 article, "Valuation Ratios and the Long-Run Stock Market Outlook," from the Journal of Portfolio Management. Campbell and Shiller found predictive power for market valuations to explain real stock returns over the subsequent 10 years.
I expand that to explain past sustainable withdrawal rates (for inflation-adjusted withdrawals over a 30-year period and using a 60/40 asset allocation of large-capitalization stocks and 10-year government bonds) using retirement date market valuation levels, and dividend and bond yields. I then use the fitted regression model from the past historical data to also predict the maximum sustainable withdrawal rates for retirees in more recent years. Figure 4 shows two things: first that the regression model provides estimates that fit the historical data pretty well, and second the continued predictions from the regression model for the sustainable withdrawal rates of more recent retirees. Again, though we do not know the path of the blue curve in recent years because we don’t have enough data, I can make these predictions with the red curve by including the values of market conditions for more recent retirement dates. Figure 4 tells the story:  

With this approach, the news for recent retirees is not good. The 4 percent withdrawal rate rule cannot be considered as safe for U.S. retirees in recent years when stock market valuations have been at historical highs and the dividend yield has been at historical lows. Despite the peak for PE10 in 2000, I find that sustainable withdrawal rates may continue to decline after 2000 as the continued falling dividend yields and bond yields offset falling earnings-valuation levels. The model predicts sustainable withdrawal rates falling below three percent since 1999, and even below two percent since 2003.

I do 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. I think the real lesson from this exercise is that using a 4% withdrawal rate from a portfolio of risky assets is not as safe as the historical outcomes would lead us to believe.

More generally, can retirees have any inclination for whether they are retiring at a time which will allow for a relatively high or low withdrawal rate? I think so. Retirement date market return sources provide a tool to help predict how much retirees can sustainably withdraw from their portfolios. The relationship between these variables and withdrawal rates is stronger than what had first caught Campbell and Shiller’s attention regarding 10-year stock returns. The predictive power is far from perfect, and readers must ultimately judge this matter for themselves, but in my view the model fit is explained by a theoretically sound relationship that is likely to remain relevant in the future.


  1. I'm confused (which probably is normal). In this article you suggest that safe withdrawal rates traditionally viewed at 4% for 30 years (approximately) are too liberal. Then for the Burns piece you suggest that even 5% may be too little.

    Regarding the Burns piece, if you suggested to my wife that she can live better now because there is "only" going to have a 7.5% chance of running out of money IF we both are AVERAGE in terms of longevity -- well you'd find a very rude reaction. Her Grandmother, who made it to 102 would have been living on dog food because that "lucky" husband, who died younger, too a chance to live better. A very rude word indeed.

    Regarding this piece, I don't see any indication that "this time is unique in history" enough to abandon the Trinity study and others. I agree that there is different evidence in other countries, but now you seem TOO conservative.

    Just saying ...

    1. Bob,

      Thanks for the comment and your confusion is understandable.

      This is the situation.

      In this blog post I am describing why I think you are more likely to run out of money using the 4% rule than is widely believed.

      But in relation to the Burns piece, what my co-authors and I are describing is that in some cases it can be okay to run of out money after all. That is, if you have a sufficient income floor from other sources such as Social Security or other pensions, etc. It's not that 5% or 7% is safe, it is just that these withdrawal rates balance the desires to spend more now with the understanding you may have to spend less later. Running out of money doesn't mean zero income, it just means having to rely on a floor of basic income you have available from other sources. Then could also include a SPIA.

      Also, here is something I wrote before about this issue:

      "The findings we describe are starting to get discussed at internet discussion boards and personal finance blog sites. This is primarily because Glenn Ruffenach wrote a column at SmartMoney juxtaposing the findings of this approach with the 1.8% withdrawal rate I described last August in the Journal of Financial Planning. The comments are along the lines of: these moronic researchers can't figure out if the safe withdrawal rate is 1.8% or 7%. A think a lot of confusion stems from this throwaway line in the introduction of Mr. Ruffenach's column: "a safe withdrawal rate for some individuals could be as much as 7%."

      That 7% appears in Figure 3 of our article. But it is not correctly described as a safe withdrawal rate. As we add in this article, this 7% withdrawal rate has a 57% chance of failure over a 30-year retirement. It's not safe. But what is does is maximize the overall expected lifetime satisfaction for a fairly flexible retired couple who has a secured income base of $20,000 from Social Security. This is how the couple best balances spending more early in retirement with the tradeoff that they may have to spend less later in retirement."

      And finally, Doug Nordman made a good effort at explaining these competing viewpoints here:

    2. Thank you Wade. Your work with Doug Short and the time you took with Robert Brokamp at Rule Your Retirement indeed gets your work discussed. My favorite statistic (I think from AARP)these days is that on 1/1/2011 10,000 boomers turned 65 and that will continue every day for the next 19 years. Not that all those have planned for retirement, but for those of us who have, that SWR or the MWR is very important. Good blog.
      Bob (Hockeypop on the TMF boards ... husband to that wonderful woman who WILL live actively until 102)

  2. This is interesting research but it has to be considered in the context of an experiment. That is, it is life in a test tube. What would be better is if this analysis were coupled with your recent analysis on the Scott Burns' piece.

    As it exists, it doesn't seem to be useful to the average reader.

    1. Could you elaborate about coupling with the Burns' piece?

      I do recognize that the article Burns discussed should be re-done using lower return assumptions that more closely match current conditions. That will reduce the suggested withdrawal rates a little bit, but it won't overturn the general point of that article. It is important to do though.

      Is this what you had in mind? If you have something different in mind then please do elaborate.

    2. Wade,
      Yes, that is exactly what I had in mind.

      Connecting the two pieces of research will help a reader who is trying to understand the implications of a withdrawal rate with the concept of utility (spending while you can for a pleasant retirement) and leaving/not leaving a remainder.

      The connection can help one to set a withdrawal rate that provides some piece of mind.

  3. Wade –

    This is another extremely valuable report from you, on extremely valuable research you’ve done, on a most important topic. Thanks!

    And terribly depressing, just looking at that red curve at right – BOTTOM right – after reading the reasoning behind it.

    Even more depressing when we also consider that most folks do not have or are not on track to have anything close to enough for decent sunset years even at the old 4% withdrawal rate.

    Looking for a tiny ray of hope, I have a question about the low dividends component of the depressing outlook. Isn’t it generally true, not for every company but generally, that when dividends are lower compared to profits, company reinvestment is higher compared to profits, and therefore higher profit growth can be anticipated?

    To the extent this is true, the “negative outlook” effect of low dividends would be damped.

    Do you have information on whether or not this is true, and if so the extent to which this effect dampens the negative outlook effect of low dividends relative to profits?

    Dick Purcell

    1. Thanks Dick. what you are saying about the low dividends could be true, and also there is the issue of companies replacing dividends with stock buybacks.

    2. Wade –

      In university management education, there’s been a basis for dividend payment based on “do best for the stockholders.” It goes like this:

      “If the company can invest its profit gains better for the stockholders than they would be likely to do if we paid the money out to them as dividends, then we the company should keep the money and invest it for company profit growth. Money we can’t invest that well we should pay out to them as dividends.”

      Of course not every management follows this rule, and not all who do will estimate future results well. But if in general dividend payment is guided by this kind of thinking, explicit or not, then maybe on average “lower dividends” is likely to mean better-than-dividends future profit growth outlook.

      Lower dividends = BETTER outlook ???

      Dick Purcell

    3. Dick,

      That could be a reason that dividend yields by themselves don't predict future stock returns very well. Campbell and Shiller had also looked at that.

  4. It seems really strange that the red curve in Figure 4 bottoms out in 2009, at the bottom of the market. I would think anyone retiring then has seen great gains since then and would be able to sustain a higher than 4% rate.

    1. You are right. It does seem strange!

      I need to investigate that some more. These are out of sample predictions and something may be going on with the low dividend yields to pull down the estimates perhaps too far. Thank you for pointing this out. January 2009 shouldn't have been such a bad time to retire.

  5. It appears to me that the range of the 96% confidence level has widened recently (and in some past periods). Is that an optical illusion? If not, do you know what is driving that?

    1. Dan,

      Thank you for stopping by! That is a question I can answer. Indeed, the 96% confidence interval has widened recently. It widens whenever historical data values move further away from the normal experience, which reduces the reliability of the estimates and increases the size of the confidence interval. In particular, you can see widening around 1921 when market valuations were extremely low, and widening in the 1960s and around 2000 when market valuations were high. It is harder to tell because of the fluctuations at that time, but I think it should be wider around 1929 as well.

  6. Wade,

    Nice, if a bit scary, article. The difference between 2% and 4% is HUGE. I bet many people are still withdrawing 4% when they shouldn't be.

    For the sake of recent retirees and soon to be retired, I hope you're wrong! Furthermore, I doubt (hope) that this downward trend can continue ad nausea. What comes down...must go up...err


    1. Thanks I hope I'm wrong too. I've revised this a bit after some of the comments here.

      Please see

  7. Self-funded retirement is a farce. It ended with the 401K, professional retirement planners and managers and defined benefit plans.

    We have been thrown to the wolves with "financial planners", brokers who make money no matter that the investor loses. We have lost leverage in investments and it is every man for himself and he loses.

    2% withdrawal rate? It might as well be nothing. With an average wage of $54k the fellow has to have saved $2,500,000.00 FAT CHANCE. That the man would save half that much for a 4% withdrawal rate is big enough joke itself.

    The 401K is a cost cut for employers, a wage cut to employees and an outrageous windfall for Wall Street. It has created a lucrative industry for people who can't do anything else that have been allowed to call themselves "financial planners and analysts". This discussion is a joke and a waste of time.