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 for more
recent retirees.
It does not follow that we can extrapolate
the historical success rates from the Trinity study forward and apply them to
future retirees. But this was known well even before the Trinity study was ever
written in the first place. Understanding about this comes from the theory of
life-cycle finance, which had gotten moving with independent works by Nobel
laureates Paul Samuelson and Robert Merton, both published in the same August
1969 journal issue of Review of Economics
and Statistics. Before getting into more detail about that, just who was
the first to link withdrawal rates to valuations?
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. The methodology for doing
this was provided in a 1998 article by John Campbell and Robert Shiller, "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. Sustainable withdrawal rates
from a diversified portfolio including stocks can also be expected to also share
this relationship with market valuations. The real credit for establishing this
link belongs to Campbell and Shiller.
But getting back to life-cycle finance, Campbell
and Shiller may not feel much pride in receiving credit for this ’discovery.’
They are both financial economists who are trained in life-cycle finance
theory, which views hedging (such as with a bond ladder) and insuring (such as
with fixed income annuities) as important risk management tools beyond precautionary
savings (saving enough to use a ‘safe’ withdrawal rate) and portfolio
diversification. They might even find it rather perplexing that people talk
about ‘safe withdrawal rates’ from a portfolio of volatile assets. After all,
look at what can happen to stock markets.
Life-cycle finance tells us that current
market conditions are much more relevant than historical averages. Rather than
using historical averages to define our capital market expectations, we can get
better information about this by looking at the term structure of interest
rates and the implications for expected returns and volatilities provided by
the prices of various financial derivatives. Financial economists have been
saying this since the 1970s. Campbell and Shiller’s work follows along those
lines.
And when viewed in this context, valuations
are an interesting issue for retirement income, but they may not really be of
central importance when building an overall retirement income strategy. That is
because just as historical withdrawal rate outcomes don’t guarantee future
safety, the relationship between valuations and withdrawal rates can change as
well. We are still prone to black swans. Past is not necessarily prologue.
Don’t treat the predictions coming from a model incorporating valuations as a
guaranteed annuitization rate from your portfolio, especially when trying to
extrapolate outcomes when valuations reach previously unseen levels. And don’t
forget to account for fees, taxes, and whether your investment returns actually
match the underlying indices used in research studies.
After all, markets may not behave as
planned, and retirees only get one whack at the cat. As Mike Zwecher indicated
in that link, retirement income strategies should work by construction and it
is not enough that they would have worked historically. Modern Retirement Theory also informs us that basic expenses should be covered by income sources
that are “secure, stable, and sustainable.” Systematic withdrawals from a
volatile portfolio do not fit that bill, no matter what you think the safe
withdrawal rate might be. With the exception of Moshe Milevsky, no major
financial economist has spent time discussing traditional safe withdrawal
rates, except for brief asides such as when Laurence Kotlikoff refers to the
“4% rule of dumb.”
William Bengen made an incredibly important
contribution when he demonstrated that sequence-of-returns risk means that you
cannot withdraw at the same rate as the average investment return, and he
naturally did this by looking at a simple spending pattern: spend a constant
inflation-adjusted withdrawal amount each year for as long as possible until
wealth runs out. The truth is that this is not an optimal spending strategy.
More generally, optimal retirement income
strategies will involve building a “secure, stable, and sustainable” floor with
Social Security, bond ladders, and perhaps some annuitization. With the leftover
funds to be used for more discretionary expenses, the optimal strategy will be
to then spend something along the lines of 1 / remaining life expectancy (using
the life expectancies provided by the IRS for the Required Minimum Withdrawals
from IRAs is fine) for each year of retirement. That can be made more
conservative if leaving a bequest or greater consumption smoothing is desired,
or it can be made more aggressive for retirees who wish to spend more now while
they know they can and are willing to spend less later should they live longer
than expected or should financial markets not cooperate.
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