Thursday, June 27, 2013

Asset Valuations and Safe Portfolio Withdrawal Rates

In the current issue of the Journal of Financial Planning, I co-authored an article called, "The 4 Percent Rule Is Not Safe in a Low-Yield World " with Michael Finke of Texas Tech University and David Blanchett of Morningstar.

The three of us have now followed up with a new article which we have just posted online called, "Asset Valuations and Safe Portfolio Withdrawal Rates."

This new article is on the same general theme about how current market conditions can impact sustainable withdrawal rates, but it uses a different methodology and also incorporates stock market valuation levels.

The issue is that bond yields today are well below and stock market valuations are well above their historical average. Importantly, there are no historical periods in the United States where comparable low bond yields and high equity valuations have occurred simultaneously. It is only in the last few years that we've simultaneously seen 10-year government bond yields fall below 2.5% while the cyclically-adjusted price earnings ratio is also above 20.

Both current bond yields and stock values have been shown to have predictive power for near-term returns. As well, portfolio returns in the first decade of retirement have an outsized impact on the final outcomes for retirement income strategies, which diminishes the importance of any notions that the markets may normalize toward their historical averages at a later date. Retirements today are occurring in a historically unprecedented environment in the United States and concepts like the 4% rule may not be reliable.

Traditional Monte Carlo simulation approaches generally do not incorporate valuations for either stocks or bonds into their analysis. This is because they assume that stock and bond returns are independent over time, fluctuating around some unvarying average return. In this article, we move away from those assumptions so that market returns are connected to what happens in the past. We simulate evolving bond yields and stock market valuation levels (specifically the cyclically adjusted price-earnings ratio sometimes called CAPE, PE10, or Shiller's PE), and then link those to bond and stock returns.

Our simulations indicate that the safety of a given withdrawal strategy is significantly affected by the initial bond yield and CAPE value at retirement, and that the relative impact varies based
on the portfolio equity allocation. Using valuation measures current as of April 15, 2013, which is a bond yield of 2.0% and a CAPE of 22, we find the probability of success for a 40% equity allocation with a 4% initial withdrawal rate over a 30 year period is approximately 48%. The sustainable withdrawal rate for a 30-year retirement, 40% stock allocation, and a 10% accepted failure rate is 2.8%.

To close out this post, here is a 12-minute interview on these topics conducted with Michael Finke and myself in late April for the American College's Wealth Channel: