The Experts Speak on the Risks of Holding Overvalued Stocks in Retirement

Ed Easterling (author of Unexpected Returns) Speaks on the Risks of Holding Overvalued Stocks in Retirement

“The implication for today’s investor is that the likelihood of financial success in retirement is considerably less than most pundits are advocating. Twenty years from now, if the response is ‘who knew’”, it won’t be much comfort for retirees in the employment line at Wal-Mart. This is especially true since a rational understanding of history and the drivers of longer-term stock market returns can help today’s retiree to avoid that ‘surprise.’ I assure you that these are not fear-driven statements, but rather insights that are based upon history and the financial principle that valuation is a major determinant of future returns.” — Article at InvestorsInsight.com, “Destitute at 80: Retiring in Secular Cycles,” February 12, 2007

Stocks in Retirement

Peter Ponzo (publisher of the Gummy-Stuff.org web site) Speaks on the Risks of Holding Overvalued Stocks in Retirement

“Forget the 4 percent rule…. Do not expect to withdrawal 4 percent after retirement [in a retirement begun at a time of high valuation] except by accident.” — Post to the RetireEarlyHomePage.com discussion board, October 2005

John Bogle (author of Common Sense on Mutual Funds) Speaks on the Risks of Holding Overvalued Stocks in Retirement

“In the long run, stock returns depend almost entirely on the reality of the investment returns earned by business. Momentary investor perception, reflected in speculative return, proves to be an illusion that counts for little. Put another way, it is economics that controls long-term equity returns; emotions, so dominant in the short-term, dissolve.” — Speech Entitled “What’s Ahead for Stocks and Bonds,” May 2006

Rob Arnott (Editor of the Financial Analysts Journal)

“The implications of a negative risk premium [for equities] are far-reaching and profound. Perhaps the most important issue is that actuarial return assumptions in pension funding today may be too aggressive.” — Article in the Journal of Portfolio Management entitled “Death of the Risk Premium,” Spring 2001

Scott Burns (personal finance columnist for the Dallas Morning News) Speaks on the Increased Risks of Holding Stocks in Retirement

“While most of the research says any retiree can safely start with a withdrawal rate of 4 percent to 5 percent a year, a newer school of thought believes the safe withdrawal rate depends on how stocks are priced at the time you start making withdrawals…. If stocks were expensive and selling at a high multiple of earnings and offering low dividend yields, history shows that a higher withdrawal rate can be fatal to your nest egg.” — Column dated December 14, 2006

“The established safe-withdrawal-rate rules of thumb are based on long periods of time in which yields were higher than they are today and stock valuations were lower. A growing school of thought believes future withdrawal rates should be reduced to reflect expected lower future returns. This would knock another 1.5 to 2 percentage points off the safe withdrawal rate. You don’t hear much about this because it is information most people don’t want to hear.” — Column dated June 6, 2005.

William Bernstein (author of The Four Pillars of Investing) Speaks on the Increased Risks of Holding Stocks in Retirement

“A particularly bad returns sequence can reduce your safe withdrawal amount by as much as 2 percent below the long-term return of stocks. Recall from Chapter Two that it’s likely that future real stock returns will be in the 3.5 percent range, which means that current retirees may not be entirely safe withdrawing more than 2 percent of the real starting values of their portfolios per year.” — The Four Pillars of Investing, Page 234

Are Stocks Too Risky for Retirement Portfolio
Asked in an e-mail whether it is prudent for aspiring retirees to place their trust in the findings of the Old School safe withdrawal rate studies in planning retirements beginning at today’s valuations, Bernstein offered a blunt, one-word, New Yorkerese response — “FuhGedDaBouDit!”

Phil DeMuth (co-author [with Ben Stein] of Yes, You Can Time the Market!) Speaks on the Risks of Holding Overvalued Stocks in Retirement

“It sounds like the new SWR people say valuations matter, and of course I completely agree, having written with Ben a book on the subject.” — Post to the Vanguard Diehards discussion board, December 16, 2006.

“Raddr” (owner of the raddr-pages.com discussion boards) Speaks on the Increased Risks of Holding Stocks in Retirement

“The whole point of this exercise was to show what would’ve happened if someone had taken the advice that was prevalent around the start of 2000 and that was that 4 percent was a “safe” percentage, even for early retirees. We know better now, of course.” — Post to the discussion board at Raddr-Pages.com, February 1, 2006

Larry Swedroe (author of What Wall Street Doesn’t Want You to Know) Speaks on the Increased Risks of Holding Stocks in Retirement

“Putting in historic returns in my opinion ensures you have garbage in and garbage out…. So if you rely on the Trinity study [an Old School SWR study] in my opinion that is garbage in and garbage out for the two reasons mentioned above–though the big problem is not the order but the overly optimistic returns.” — Post to Vanguard Diehards board, November 16, 2005

Jonathan Clements (author of the “Getting Going” Column in The Wall Street Journal) Speaks on the Increased Risks of Holding Stocks in Retirement

“You might limit your initial portfolio withdrawal rate to just 3% or 4%, equal to $3,000 or $4,000 for every $100,000 saved. This is well below the 5% and 6% withdrawal rates that used to be advocated and reflects, in part, a concern about today’s lofty stock valuations and low after-inflation bond yields.” — Column dated January 17, 2006

Retirement Planning Strategies

In response to an e-mail asking why he has included links in his columns to the findings of Old School studies even after their grave flaws had become publicly acknowledged by a good number of the best-informed investing analysts, Clements acknowledged that the old studies are “not the last word” in safe withdrawal rate analysis.

The Wall Street Journal Speaks on the Increased Risks of Holding Stocks in Retirement

“Some planners say 3 percent is a safer figure these days, given that market returns in coming years are expected to hover in the single digit range.” — Article published in December 2005

Robert Powell (Editor of Retirement Weekly) Speaks on the Increased Risks of Holding Stocks in Retirement

”It’s likely the stock and bond markets will return far less than the historical averages over the next few years. And that could spell trouble for retirees who spend more than 3% from their investment accounts earmarked for retirement spending.” — Article published on MarketWatch.com entitled: “The Number?: New Thinking on Nest-Egg Withdrawals in Retirement,” April 20, 2006

Andrew Smithers (co-author of Valuing Wall Street) Speaks on the Risks of Holding Overvalued Stocks in Retirement

“News of the demise of the random walk has only very slowly spread outside of the economics profession, in part because its overthrow came as a considerable shock to many economists. Nonetheless, if the random walk hypothesis were correct, then the most likely return on equity investment in the future would simply be its historic average return [the Old School SWR studies assume a random walk]. The evidence, however, is strongly against this and points to valuation indicators being mean reverting [New School SWR studies assume mean reversion], with the usual result that after a period of high returns, when reliable valuation criteria are at historic highs, investors must expect poor returns (and, of course, vice versa). — Interview entitled “The Coming Revolution,” published at welling.weedinco.com, April 30, 2004.

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A good number of big-name investing experts have pointed out the deficiencies of the “Old School” retirement calculators (our calculator is the first “New School” retirement planning tool) in recent years. William Bernstein, author of The Four Pillars of Investing has said that anyone planning to use one of the conventional safe-withdrawal-rate (SWR) studies to put together a retirement plan would be well-advised to “FuhGedDaBouDit!” Larry Swedroe, author of The Only Guide to a Winning Investment Strategy You’ll Ever Need, described the safe withdrawal rate studies that are the engines of most other calculators as “Garbage-In, Garbage-Out” research. Ed Easterling, author of Absolute Returns, said: “The likelihood of financial success in retirement is considerably less than most pundits are advocating.” Our simple retirement calculator avoids the problems that are the cause of these criticisms by the big-name experts.

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Community Comments on Using Stock Data to Diminish Retirement Risks

Using Stock Data to Diminish Retirement Risks — Community Comment #1

Retirement Risks The 4% number has worked at every valuation level and sequence of returns which have happened in the U.S. stock market (#1 in the world)…. These SWR numbers are just rates that survived in the past, we don’t know that they were safe. U.S. stocks have had a relatively lucky sequence of returns in the past, even starting from periods of high valuations, other countries were not so lucky. It has not worked with sequences of returns from the #2 stock market (Japan) and #3 (U.K.) — Adrian2, Vanguard Diehards board, October 12, 2005

Using Stock Data to Diminish Retirement Risks — Community Comment #2

Since large negative returns early in retirement are so devastating, then a more conservative, less risky asset allocation should be used. More bonds, conservative stocks and maybe even significant cash or cash equivalents. — Larmewar, Vanguard Diehards board, 9-29-05

Using Stock Data to Diminish Retirement Risks — Community Comment #3

It seems that Dr. Bernstein is saying, although not with direct sentences but with the academic verbiage that he is good at, that 2% is probably the safest withdrawal rate, and 4% is looking for serious trouble. And it seems that Larry is saying 3% in that scenario. While most would say “it’s just a one percent difference, essentially they are saying the same thing”, the truth is that it’s actually a 50% difference in lifestyle and is a huge difference. Must I scrimp by living merely on 2% of my nest egg, adjusted for inflation each year, or can I take 50% more than that and whoop it up? — Daryll40, Vanguard Diehards board, August 14, 2005

Using Stock Data to Diminish Retirement Risks — Community Comment #4

For some reason, people expect to sustain the same withdrawal rate in the current return environment as they could in the 20th century return environment. Doesn’t make much sense to me. — Snarkl, Vanguard Diehards board, 07-21-05

Using Stock Date to Diminish Retirement Risks — Community Comment #5

It is obvious that Rob, in attempting to identify new SWR strategies and thus change from the “tried and true” long term average, ~4%, is goring your ox. If Rob improves on average SWR methodology, the implication is clear: You are all, metaphorically, out of business….If SWR’s weren’t such a potentially serious question, this discussion could be considered humorous. — Sirschnitz, Vanguard Diehards board, 11-16-05

Using Stock Data to Diminish Retirement Risks — Community Comment #6

Why Retirement Plans Fail From the ashes of a decimated equity market. will rise an attractive equity risk premium. While waiting my portfolio is mostly Ibonds, TIPS, and less than 30% globally diversified equities. Hard to justify big equity risk for expected low equity returns. — Gadlfy888, Vanguard Diehards board, 07-21-05

Using Data to Cope with Retirement Risks — Community Comment #7

The objective should be to achieve the flattest possible distribution of outcomes over the historical starting points. My preference would be to do this by using a lower allocation of stocks vs fixed, rather than a lower SWR (if possible). — karnkor53, Vanguard Diehards board, May 24, 2006.

Using Stock Data to Diminish Retirement Risks — Community Comment #8

Yes, I believe that one’s prospects for a safe retirement withdrawal rate are higher when equity valuations are at historical lows. — JohnYaker, Vanguard Diehards board, Vanguard Diehards board, August 31, 2006

Using Stock Data to Diminish Retirement Risks — Community Comment #9

The point is that, given any particular strategy where the resources supporting the withdrawal are affected by stock returns, the initial valuation at retirement has to have an effect on the outcome. An interesting perspective, however, is that the existence of high valuations at retirement may be what accounts for having a large nest egg in the first place vs. having a smaller nest egg and better prospects for growth in the future. It could be a wash over a total lifetime in terms of end-result standard of living. — Dbredmond, Vanguard Diehards board, December 17, 2006

Using Stock Data to Diminish Retirement Risks — Community Comment #10

What I take from this is that, since there have been only a few historical sequences starting with high PE ratios, maybe the fact that these did survive with 4% withdrawal rates doesn’t mean very much. Maybe they were lucky sequences. If this is what you are saying, I wholeheartedly concur. — MacDuff, SWR Research Group board, June 19, 2003

Using Stock Data to Diminish Retirement Risks — Community Comment #11

Remember that such studies treat any portfolio which merely “survives” as being successful. Think about what this means. It means that a portfolio (and in fact the entire safe withdrawal methodology) is successful if it declines 50%, 75%, 90% or even 99.44%, if it subsequently recovers. Question is . . . will it have a chance? It would be a rare person indeed who can can stick with a methodology that periodically exposes the savings of a lifetime (upon which he depends for his very survival) to such erosion. IMO it is unreasonable to make such as assumption. I don’t know anyone who could do this. I know I couldn’t. But when you accept the results of such studies, by definition, you are agreeing to such an assumption. It’s nonsense.” — FoolMeOnce, Motley Fool boards, November 23, 2004

Using Stock Data to Diminish Retirement Risks — Community Comment #12

How to Avoid the Worst Retirement Risks

The last 10-13 years have been a clinic in investor psychology. I just was chatting with someone offline who asked why I didn’t go for the 4% from reputable sources stuff in 2000, that hocus references above. I had a lot of answers, logical stuff, but i ended with the fact that I’m not a joiner and that I was pessimistic and that the frequent refrain of “can I take out 4% from my all-time high value since it doesn’t really matter where i start, right?” and the 15%-20% p.a. ‘birthright’ were earmarks of “regression”. I noted that all my overarching reasons appeared to be personality/psychological explanations for my behavior. Smell test, hunches approach. I guess, at some level, there was probably some experiential reason for many of my investing behaviors (auditing makes you pessimistic – you exist because people steal, you see people at their greediest). — Wanderer, SWR Research Group, August 28, 2003.

Using Data to Cope with Retirement Risks — Community Comment #13

What is the alternative? Ignore valuations, cross our collective fingers and hope? Year 2000 retirees did just this, ignored P/E over 40 and look how that turned out! Ignorance is not bliss when it comes to market values. Should retirees kid themselves about what is possible on the traditional 60/40 S&P 500/US bond index mix? Just retire anyway? Surely it is better to understand the situation ahead of time, consider saving more and work longer? Better that than suffering crushing portfolio losses from a reversion to the mean and be forced back to the workforce at reduced pay having left your job before you could really afford it.

No problems here, just tired of seeing rearview mirror people posting that 4% is safe when it ain’t. It seems people are happy to use past returns as an indicator for the future, but not past valuations that went with past returns as an indicator of anything. This is a rather selective & blinkered view, and unrealistic. — PeteyPerson, Early Retirement Forum, March 26, 2005.

Using Stock Data to Diminish Retirement Risks — Community Comment #14

Petey, your points are well taken. Future market returns may, or may not look much like the past. This view is not overly popular here because it rains on many of the people lining up to march in the early retirement parade, myself included…. My concern applies mainly to young early retirees with marginal resources. IMO It’s a disservice to encourage such individuals to “pull the plug” as soon as FIRECalc says they are 95% safe or whatever. — Roc, Early Retirement Forum, March 26, 2005.

Using Stock Data to Diminish Retirement Risks — Community Comment #15

Some SWR discussions are being held by people who are already in the belly of the whale but just don’t know it yet. — Mikey, March 26, 2005.

Using Stock Data to Diminish Retirement Risks — Community Comment #16

FIRECalc et al are historical simulations with no claims about the future. — BigMoneyJim, RetireEarlyHomePage.com board, June 24, 2006

Using Stock Data to Diminish Retirement Risks — Community Comment #17

Greaney (the reference is to an author of an Old School SWR study) did his thing based upon historical market action. Yes, he stated that it was the past, but he proceeded to put out the number as relevant to today. Much discussion and planning were done based upon that number. — Earnabuck, Vanguard Diehards board, June 24, 2006

Using Stock Data to Diminish Retirement Risks — Community Comment #18

Common Retirement Planning Mistakes We know intuitively that 6.21% runs a high risk of failure going forward. If we accept that, then we must also accept that 4.21% in 2000 runs a high risk of failure. It seems to me that anything exceeding dividend yield (plus around 1% or so) is automatically suspect. — Bob Smith, March 28, 2004

Using Stock Data to Diminish Retirement Risks — Community Comment #19

The odds of repeating that sequence (or any other specific sequence) are about 1 in a billion. If we get a different sequence, even without a catastrophic event like the Great Depression, all bets are off. All it would take is a streak of bad luck to blow the SWR assumptions out of the water. — Wabmester, March 30, 2004

Using Stock Data to Diminish Retirement Risks — Community Comment #20

The predicted annualized real return for 30 years is about 3%. This was when the S&P yield was somewhat higher than it is today. Hence today’s predicted yield would be less. How can an SWR be greater than the average annual return? Only one way — one is helped, rather than hurt, by statistical variability. Yet the whole purpose of SWR was to demonstrate the folly of Fidelity’s silver haired guru telling us that we could withdraw whatever the real market return was. Variability tends to be our enemy, not our friend. — Mikey, Early Retirement Forum, March 23, 2004

Using Stock Data to Diminish Retirement Risks — Community Comment #21

All of these calculators are tools and we should be cautious enough to use them and interpret their results into our own situation. It is essential to know how they work and what they are based on. A discussion of possible limitations or other interpretations does not seem in any way out of line to me. Thanks to those who created FIRECALC and and to those who wish to provide an alternative viewpoint or calculator. — Bruce1, Early Retirement Forum, August 14, 2004

Using Stock Data to Diminish Retirement Risks — Community Comment #22

There is an overwhelming tendency to reify the SWR concept. — Bill Sholar (author of the FIRECalc calculator, an Old School SWR calculator), March 29, 2004

Using Stock Data to Diminish Retirement Risks — Community Comment #23

Remember that Templeton made that statement (“The most dangerous words in the investment business are, ‘this time it’s different'”) to express that valuation does matter. He was agreeing with hocus and the pessimists here. — Bongo, Early Retirement Forum, May 27, 2004

Using Stock Data to Diminish Retirement Risks — Community Comment #24

I’ve finally gotten around to calculating the 2004 year-end balance of the portfolio of a hypothetical investor who retired at the end of 1999 with a 75:25 mix of S&P500 stocks and 6 mo. commercial paper. This was the type of portfolio that was being touted as “100% safe” on some investment boards based on historical backtesting at the time. The following numbers assume a 0.2%/yr. expense ratio, 4%/yr. withdrawal, and are stated in constant (real) dollar amounts….

It’s clear that this person would be in real trouble, particularly if he is an early retiree with possibly 30-50 years of life remaining. He would be taking withdrawals of about 6.4% at the start of 2005 because of the severe hit that the portfolio has taken. Using Monte Carlo analysis this portfolio would have a greater than 50:50 chance of failure during the next 40 years if you assume that returns will be as good as in the past. Using Gordon equation predictions, the chance of failure is about 80%.– Raddr, Raddr-Pages.com board, May 22, 2005

Using Stock Data to Diminish Retirement Risks — Community Comment #25

Is Your Retirement Plan Safe? Very interesting and scary analysis. I imagine if one did something like the Trinity study in 1965, the 100% safe withdrawal rate would be higher than 4%. (I guess we can calculate the SWR to 1965, I haven’t). Then, a 1965 or 1973 retiree using that maximum SWR would have run out of money. I think the same might be true for 1999/2000, only more so. Year-end 1999 might turn out to have been worse than any point in history to retire on an S&P500/shortbond portfolio. I agree that the hypothetical retiree is in trouble, and may easily run out of money in the years or decades ahead. — LazyDay, Raddr-Pages.com board, March 22, 2005

Using Stock Data to Diminish Retirement Risks — Community Comment #26

I’ve tended to be skeptical of the view that, in a bear market, one could cut down to a barebones budget, say 2% or 2.5% SWR, for a couple of years and then go back to, say, the 4% SWR – the difference between 4% and 2.5% of 1.5% is small relative to 25% or so falls in portfolio value and an extended period of several years of low portfolio values would probably result in years and years of uncomfortable barebones living. — KenM, Raddr-Pages.com, February 6, 2006

Using Stock Data to Diminish Retirement Risks — Community Comment #27

Some time ago I posted a poll over at the Motley Fool board that was designed to gauge how many people started retirement during the record valuations of the 2000 bubble…. A surprisingly high percentage of respondents retired during that time. I suspect that the record valuations contributed directly to this phenomenon. That is, people with high stock allocations through the 90s benefitted from the bubble and found themselves with enough net worth to retire. — BenSolar, FIRE board, June 19, 2003

Using Stock Data to Diminish Retirement Risks — Community Comment #28

I assume you’re unlikely to get very much feedback from them – in that position I wouldn’t want to talk about it – too painful. — KenM, FIRE board, June 22, 2003

Using Stock Data to Diminish Retirement Risks — Community Comment #29

There is a strong foundation of logic and statistics that valuation directly affects long-term stock market returns, and thus directly affects the long-term withdrawal rate achievable from a stock-heavy portfolio. — BenSolar, FIRE board, June 4, 2003

Using Stock Data to Diminish Retirement Risks — Community Comment #30

I think fundamentally he [the reference here is to William Bernstein] believes the return on equity will be 3% in the future. This does indeed have an impact on SWR, if he is correct. If he is correct, the ~2.2% yield on TIPS start to look good again. That is a 0.8% equity premium before expenses. — Oliver, FIRE board, May 31, 2003.

Using Stock Data to Diminish Retirement Risks — Community Comment #31

I submit that a 75% stock allocation that is optimal for one year, cannot possibly be optimal for other years unless the market dynamics are the same for every year, which they patently are not…. It’s only because I was reasonably well-heeled, and backed away from that allocation that I’m still retired. — MHTyler, FIRE board, January 20, 2003

Using Stock Data to Diminish Retirement Risks — Community Comment #32

The 100% safe SWR going forward is one where there is no possibility of going broke within the time-frame selected. One way to create such a portfolio would be to use nothing but bonds, specifically TIPS. For a 30 year portfolio, constructed of only TIPS, there is no inflation risk, no deflation risk, no reinvestment risk, etc…..

Adding other investments increases the potential rewards as well as the potential risks, IMHO. For the risk averse, perhaps one approach to retirement planning could be to have one portfolio which is 100% safe, the all TIPS portfolio, which pays for the bare-bones budget, and a second portfolio might be 100% equities, for growth. — nnn12345, Motley Fool board, December 31, 2002

Using Stock Data to Diminish Retirement Risks — Community Comment #33

Dangerous and Misleading Retirement Studies I examined the effects of a stock switching strategy similar to the one described by hocus. My conclusion: history backs hocus up, his valuation based switching strategy…worked in the past, and in fact beat the static ‘optimal allocation’. Hocus is the only person I know (if only via message boards) who has completely opted out of participation in the stock market bubble. And you know what? He has benefited immensely from doing so. — BenSolar, Motley Fool board, May 1, 2003

Using Stock Data to Diminish Retirement Risks — Community Comment #34

What counts is not where the hyper-emtional Mr. Market happens to value your portfolio on a given date, but the underlying long-term earning power of your shares in the companies represented in that portfolio…. To me, a useful way to think about this problem is to focus on the sustainable cash generated by the portfolio. Imagine that one is going to live on a private business….Would the amount of cash you could take out have anything to do with what valuation was put on the business? — Mikey, Early Retirement Forum, October 8, 2003

Using Stock Data to Diminish Retirement Risks — Community Comment #35

Another significant variable in the SWR equation has to do with the makeup of the portfolio. The individual with 70% in TIPS and 30% in stocks can be far more certain about his/her SWR than the person with 30% TIPS and 70% stocks, for example. — Bob Smith, Early Retirement Forum, October 8, 2003

Using Stock Data to Diminish Retirement Risks — Community Comment #36

You have to understand that there is always a chance that your portfolio will be depleted, and once it has fallen in value by 30-50%, then that chance is going to be much greater than it was when you started. In the 130 years of history the stock market has always rallied strongly off of 30%+ drops — are you going to count on a rally like that this time? — Bongo2, Early Retirement Forum, October 8, 2003

Using Stock Data to Diminish Retirement Risks — Community Comment #37

The system of using the worst-case historical SWR to set your future SWR would have failed about 20% of the time in actual history. For example, if you retired in 1929, 1930, or 1931, the worst-case historical SWR known in these years would have been 5.3% (using my inputs of 70/30 equity/comm. paper, etc.) which occurred in the period starting in 1893.

The 5.3% “Historically Safe SWR” would have actually proved unsafe for these three periods. You would not have known about the worst-case SWR that started in ’29 since that period didn’t end until 1959. A 1959 retiree would have picked 4.4%, which was a new minimum and would have been “safe” for his/her 30 year payout period. However, the HSWR would have, again, proven itself unsafe for anyone retiring in years starting 1964, ’65 and ’66, who would have also picked 4.4%. — Biggalloot, Motley Fool boards, February 12, 2003

Using Stock Data to Diminish Retirement Risks — Community Comment #38

My plan was to follow the basic approach as discussed on the Retire Early board here on Motley Fool; ie, to set aside three (to five) years of expenses in cash and bonds and put the rest in equities (S&P 500). This plan would have worked well except for the severity of the bear market. I had not counted on three years of decline which consumed all my cash and left me with less than a third of the portfolio I started with.

I have developed a deep understanding of why my father (who lived through the Great Depression) was so timid about investing in stocks. He would only buy blue chips that paid dividends. I really understand that thinking now.

Do I Have Enough to Retire? I also now truly understand the reason that volatility is equated with risk. Until you are withdrawing from a portfolio for your daily needs, volatility seems a non-issue….In fact, I am working at a part time job to minimize the impact as much as possible.

I have a much stronger respect for dividends. Dividends greatly reduce the volatility of the portfolio, and they are a repeating indication that the company is financially sound. As a retiree, dividends are psychologically soothing…

Needless to say, this bear market has had a profound affect on me, and I will never again view things with the statistical trust that I once did. — RKMcDonald, Motley Fool boards, December 6, 2002

Using Stock Data to Diminish Retirement Risks — Community Comment #39

I retired in August of 2000, and a few months before, based on advice from the Motley Fool board, I dumped directly into a market at DOW 10,500. I lost about 20%, and the reason I didn’t lose another 10% was because I broke all the rules and got the hell out…. Benjamin Graham recommends a mix of roughly 50% securities to fixed in retirement, but possibly as little as 25% in hard times. His perspective seems to be that although greater than 50% might have a higher return, its volatility is counter productive to the entire point of retirement, which is safely and security. — MHTyler, FIRE board, December 25, 2002

Using Stock Data to Diminish Retirement Risks — Community Comment #40

There are limitations to what those studies [the reference here is to the Old School SWR studies] can do for us, I think we need to recognize that and try to accomplish something beyond if it possible.

This is of more than mere academic interest to me as I am one of those who retired in 2000 not too far off from the market peak. If there’s a strong possibility that a 4 percent withdrawal rate isn’t going to cut it for me, due to record-high stock valuations when I retired, then I need to deal with that as early as possible by studying everything I can on the matter and coming up with a “Plan B” for my own life while I still have substantial assets (Should I take on part-time work? Should I move to a cheaper country, maybe one that offers low- or no-cost health care?, etc., etc.). My fear is just sitting back, putting blind faith in the SWR studies, only to find myself broke 15-20 years from now (or whenever). — Andrew61, Motley Fool board, December 11, 2002

Using Historical Data to Diminish Retirement Risks — Community Comment #41

Retirement Panic The Great SWR Debate is over. Hocus has won. The technical evidence supporting this assertion is rock solid. There is plenty of credit to spread around. –John Walter Russell, Safe Withdrawal Rate Research Group board, August 3, 2003

Using Historical Data to Diminish Retirement Risks — Community Comment #42

I am afraid that Emperor SWR has no clothes. — Mikey, Early Retirement Forum, October 8, 2003

Retirement Planning Tools Don’t Work

Most retirement planning tools don’t do the job that retirees are counting on them to do. There, I said it. I’ve been debating the flaws in safe withdrawal rate calculators for over three years now, and I have become increasingly alarmed over the grave flaws in the advice that is being given to aspiring retirees in books, magazines, and websites. The bottom-line finding of The Great Safe Withdrawal Rate Debate needs to be stated in clear and direct terms–most existing retirement planning tools simply do not do the job. They employ dangerous assumptions about the long-term returns that retirees are likely to obtain from their stock portfolios.

Will the Money Last?

Retirement Planning Tools

Will the money last? That’s the question that retirees most need an answer to when planning their retirements, is it not? Most middle-class investors of today have a good portion of their savings invested in stocks. Stocks are not likely to provide the sorts of returns assumed in most retirement planning tools, presuming that stocks perform in the future much as the historical stock-return data shows they have always performed in the past. Many of the planning tools you come across today were constructed during the amazing bull market we enjoyed in recent decades, and employ flat-out dangerous assumptions on the question of how stocks are likely to perform starting from the valuations levels that apply today.

This is not just my personal opinion. The question has been examined from hundreds of angles during The Great Safe Withdrawal Rate Debate and the answer has always come out the same–valuations matter. Today’s safe withdrawal rate studies do not do the job, today’s retirement planning tools are leading aspiring retirees astray by causing them to feel a level of comfort in their stock allocations that the historical return data does not support. We need to get about the business of getting the word out to the people who put safe withdrawal rate analysis to practical use–the retirees who go to web sites looking for retirement planning tools to determine whether or not they have enough saved to hand in a resignation, whether the money is likely to last or not.

Here’s the problem with the existing tools in a nutshell–most retirement planning tools do not factor in the effect of changes in valuation levels when reporting whether stocks are likely to provide a return strong enough to support a retirement over the long term. The usual scenario is that the planning tool uses some form of the conventional methodology approach to safe withdrawal rate analysis. That doesn’t work.

Valuations Matter

Internet Retirement Planning Tools

The conventional methodology makes no adjustment for changes in valuation levels–it tells a retiree that he can take out the same inflation-adjusted percentage of his stock portfolio to cover living costs (often 4 percent) regardless of the valuation level that applies on the day the retirement begins. That is of course not the case; retirees handing in their resignations at times of low valuations can safely withdrawal far larger percentages than can retirees handing in their resignations at times of high valuations.

Tools employing Monte Carlo analyses do make adjustments for valuation levels. But these tools often have problems of their own because they do not rely on the actual historical data to determine what sorts of take-out percentages are reasonable. We need to be using realistic and accurate safe withdrawal rate studies as the foundation of our retirement planning tools, analyses of the type described by William Bernstein in his book “The Four Pillars of Investing” and of the type set forth by John Walter Russell at his Early-Retirement-Planning-Insights.com web site.

The key point is that it is not a good idea for an aspiring retiree to use any of the existing tools unless he or she studies the methodology carefully enough to understand what assumptions are being employed. If you don’t fully grasp where the numbers generated by a retirement calculator are coming from, do not trust the calculator to tell you what you need to know in putting together an effective retirement plan.

Free Retirement Planning Tools

It is not just fly-by-night organizations that have put forward faulty safe withdrawal rate analyses. I have seen conventional methodology studies cited in The Wall Street Journal, in Newsweek, and in Money magazine. The most dangerous aspect of the conventional safe withdrawal rate studies is that they possess a good deal of surface plausibility. These studies have fooled some of the smartest people in the field of personal finance.

You Can’t Fool the Historical Data

They are not going to “fool” the historical data, however. In all likelihood, stocks are going to perform in the future much as they have in the past. If that possibility indeed comes to pass, many people who relied on today’s retirement planning tools to put together their investment strategies are going to be facing busted retirements. Investment strategies identified in conventional methodology studies as safe are in the real world often not safe at all, according to an informed assessment of the historical stock-return data.

Anyone using a retirement calculator to plan his or her retirement needs to ask this question before proceeding: “How does this tool adjust for the effects of changes in valuation levels?” If the tool in question appears to identify the same take-out percentage as safe for retirements beginning at both high and low valuation levels, the aspiring retiree needs to be wary of the results reported. Changes in valuation have in the past always affected long-term stock returns. In all likelihood, they always will. As William Bernstein has observed, the connection between valuation levels and long-term returns is one of “mathematical certainty.”

Using the Risk Evaluator to Develop Retirement Planning Strategies

This article examines eight retirement planning strategies developed through use of the Retirement Risk Evaluator, the first calculator developed by followers of the New School of safe withdrawal rate analysis. It will help you follow the discussion if you open a new window on your web browser and click on the tab at the left marked “Risk Evaluator” to bring up the calculator. As each new strategy is discussed, construct the scenarios described on the window containing the calculator:

The Retirement Risk Evaluator

To make use of the strategies discussed in this article, you need to understand the safe-withdrawal-rate concept. The safe withdrawal rate is the inflation-adjusted percentage withdrawal that you can take from your portfolio each year to cover living expenses without any significant risk of having your retirement plan fail, presuming that stocks perform in the future at least somewhat as they always have in the past. The safe withdrawal rate for a 30-year retirement is a number a good bit less than the annualized 30-year real return for that portfolio. The reason is that losses suffered in the early years of a retirement can require retirees to sell stocks to cover living expenses. Those who are forced to sell miss out on the price recovery that the historical stock-return data indicates is likely to come along in later years.

Retirement Planning Strategies

The withdrawal rate you choose determines how much you can spend in retirement. For example, a withdrawal rate of 4 percent from a portfolio of $1,000,000 permits annual spending of $40,000 (inflation-adjusted).

#1 of 8 Retirement Planning Strategies — Lower Your Stock Allocation to Increase Your Safe Withdrawal Rate

Enter “27” as the P/E10 value for each of the four scenarios (this article was posted in April 2007, when the P/E10 value was 27). Enter “2.0” as the TIPS return. Enter “0” as the Year 30 Percentage Balance. Enter stock allocations of 80 percent (Scenario One), 60 percent (Scenario Two), 40 percent (Scenario Three) and 20 Percent (Scenario Four).

The highest stock allocation yields a safe withdrawal rate of 3.02. Lower your stock allocation by 20 percent and the safe withdrawal rate increases to 3.43. Another 20 percent drop brings the safe withdrawal rate to 3.72. The lowest stock allocation yields a safe withdrawal rate of 3.90.

#2 of 8 Retirement Planning Strategies — Increase Your Stock Allocation to Increase Your Safe Withdrawal Rate

Change the P/E10 value used in all four scenarios to “14,” a moderate valuation level. Leave all other entries the same.

Now we see a very different story. At moderate valuation levels, it is increases in your stock allocation that yield higher safe withdrawal rates. As the stock allocation moves from 20 percent to 80 percent, the safe withdrawal rate increases from 4.45 to 5.41.

#3 of 8 Retirement Planning Strategies — Trade Off Safety for Return

Planning A Retirement In our discussion of Strategy #1, we saw that, at times of high valuations, higher stock allocations translate into lower safe withdrawal rates. Does it follow that all of today’s retirees should be going with stock allocations of 20 percent? It does not.

Stocks are certainly not the safest of asset classes. The appeal of stocks is the strong long-term returns they offer. There are circumstances in which it is worth accepting a lower safe withdrawal rate in exchange for the possibility of having a higher portfolio value at the end of your 30-year retirement (either to cover the possibility that you might live longer than 30 years or to have more money to pass along to heirs).

Say that a P/E10 value of 27 applies at the beginning of your retirement, and that a withdrawal rate of less than 3.50 is unacceptable to you because it does not provide for enough annual spending. That rules out stock allocations of 80 percent and 60 percent. It doesn’t rule out a stock allocation of 40 percent. Depending on your personal circumstances and preferences, you might decide on a stock allocation of 20 percent (higher safe withdrawal rate) or a stock allocation of 40 percent (good chance of a higher end-point portfolio value).

The Retirement Risk Evaluator doesn’t reveal to you what stock allocation is best. There is no one correct answer to that question because we do not know precisely how stocks are going to perform in the future and because retirees in different circumstances and with different preferences need to make different choices. The purpose of the calculator is to better inform your choices. Looking at the historical data in an analytically valid way permits us to explore the nature of the trade-offs involved in a realistic way. The calculator gives you some idea of the extent to which you have to give up safety to obtain better returns.

#4 of 8 Retirement Planning Strategies — Trade Off Return for Safety

In our discussion of Strategy #2, we saw that, at times of moderate valuations, higher stock allocations translate into higher safe withdrawal rates. Does it follow that all retirees retiring at times of moderate valuations should be going with stock allocations of 80 percent? It does not.

Even when purchased at reasonable prices, stocks have their ups and downs. There are more uncertainties in a retirement portfolio comprised of 80 percent stocks than there are in a retirement portfolio comprised of 60 percent stocks. If you are particularly concerned about safety, and if you are in circumstances in which the safe withdrawal rate available by choosing a lower stock allocation is acceptable, you might quite reasonably elect the stock allocation yielding the lower safe withdrawal rate.

How to Plan a Retirement

Again, the Retirement Risk Evaluator is not making your choices for you, but informing your decision-making process. If you require a safe withdrawal rate of 5 percent for a retirement in which the numbers cited in Strategy #2 apply, you would need to rule out stock allocations of 20 percent and 40 percent. But you might prefer the 5.18 safe withdrawal rate that applies for a 60 percent stock allocation over the 5.41 safe withdrawal rate that applies for an 80 percent stock allocation. You might like the 5.03 safe withdrawal rate that applies for a 50 percent stock allocation better yet.

When looking at safe withdrawal rates, higher numbers are always better than lower numbers. But when planning a retirement, safe withdrawal rates are never the only factor to be taken into consideration. It often makes sense to trade off the greater return possible by investing in stocks with the greater stability of portfolio value available through other investment classes. Knowing the numbers leaves you better able to make good trade-offs.

#5 of 8 Retirement Planning Strategies — Deliberately Take On Risk

Few of us will be able to save enough money to be able to retire without risk. Our goal should be not to avoid risk altogether, but to learn enough about the risks involved to take on only acceptable risks.

Enter a P/E10 value of “18” for all four scenarios, a TIPS rate of 2.0 for all four scenarios, and a Year-30 Percentage Balance of “0” for all four scenarios. Enter stock allocations of 20 percent, 40 percent, 60 percent, and 80 percent. At this valuation level, increasing your stock allocation increases the safe withdrawal rate. But not by much. Going from a stock allocation of 20 percent to one of 80 percent brings the safe withdrawal rate up from 4.19 to 4.30. It hardly seems worth taking on the uncertainties associated with going with a high stock allocation to receive that little of an increase in the safe withdrawal rate.

Say that you require a safe withdrawal rate of 4.50. What should you do? Move your eye from the column in the Results Table reporting the safe withdrawal rate to the one reporting the “Reasonably Safe” rate; that’s the withdrawal rate that stands an 80 percent chance of working out, presuming that stocks perform in the future at least somewhat as they always have in the past. The number for portfolios with a 20 percent stock allocation is 4.44. The number for portfolios with a 40 percent stock allocation is 4.68.

Retirement Planning As If Valuations Mattered

I see an argument in these circumstances for going with a low stock allocation and accepting a 20 percent chance that the plan will fail rather than taking on the uncertainties of stocks for a high percentage of the portfolio. The reasonably safe rate will fail only if a particularly bad returns sequence happens to turn up in the early years of your retirement. In that event, there will be things that you can do to repair the retirement plan. You could take on part-time work. Your could reduce annual spending. You could increase your stock allocation (stocks will be offering a better long-term value proposition after the price drop than they did at the beginning of the retirement).

Risk is not really a four-letter word. There are circumstances in which it makes strategic sense to take on risk deliberately.

#6 of 8 Retirement Planning Strategies — Time the Market

There’s great confusion among investors today on the merits or lack thereof of “timing the market.” Many believe that the word “time” really is a four-letter word. The reality is that the word “time” is no more a four-letter word than is the word “risk.”

Short-term timing doesn’t work (or, if it sometimes does, it is extremely hard to pull off and not to be recommended for the typical investor). Long-term timing (timing with no expectation of seeing the strategy pay off within one or two or five years) does work; at least the historical stock-return data shows that it has always worked in the past and it is hard to imagine a reason why it would not continue to work in the future.

The Retirement Risk Evaluator provides you with a means to assess the strategic value of adopting a long-term timing approach as your means of setting your stock allocation. Create a scenario using the choices examined in the discussion of Strategy #5 except for the stock allocation choice. Select “Switch Option B” as your stock allocation choice. “Switch Option B” means that you will be changing your stock allocation in response to changes in valuations.

Employ Switching Option B, and the safe withdrawal rate for the circumstances examined in the discussion of Strategy #5 moves up to 4.98 percent. With Switching Option B, the retiree uses a 0 percent stock allocation when P/E10 is above 24, moves to 20 percent stocks at a P/E10 below 24, moves to 30 percent stocks at a P/E10 below 21, moves to 50 percent stocks at a P/E10 below 12, and moves to 100 percent stocks at a P/E10 below 9.

#7 of 8 Retirement Planning Strategies — Watch for Good TIPS Returns

Enter “18” as the P/E10 value for all four scenarios. Enter “40 Percent” as the stock allocation. Enter “0” as the 30-Year Percentage Balance. Enter TIPS returns of 1.0, 2.0, 2.5, and 3.0.

Putting Together a Retirement Plan The calculator shows that the safe withdrawal rate increases from 4.08 to 4.85 as the TIPS rate increases.

If your retirement is not far off, and TIPS become available at good rates, it makes sense to buy them before the rates change. Having TIPS at good rates in your portfolio makes all of your stock-choice options more attractive.

#8 of 8 Retirement Planning Strategies — Don’t Plan to “Die Broke”

I am not a fan of the “Die Broke” approach to retirement planning. Many retirement calculators assume that you are willing to have your portfolio depleted to zero over the course of 30 years and aim to identify the withdrawal rate that is likely to succeed under that assumption. It’s a dangerous assumption because it leaves you no slack in your plan. If stocks do not perform as expected (and no one knows the future, of course), the retiree is faced with a risk of seeing his retirement go bust. Plan to have 30 percent or 50 percent of your portfolio remaining at the end of 30 years, and you are covered in the event that the unexpected happens.

Enter “14” as the P/E10 value for all four scenarios. Enter “2.0” as the TIPS return. Enter “40 Percent” as the stock allocation. Enter 30-Year Percentage Balances of “0,” “30 Percent,” “50 Percent,” and 100 Percent.”

The safe withdrawal rate drops from 5.18 to 4.83 with the change from a “Die Broke” plan to a plan to have at least 30 percent of the initial portfolio balance (in inflation-adjusted terms) remaining in the portfolio at the end of 30 years. I don’t think that’s such a terrible price to pay for the added security. My preference would be to go with the lower safe withdrawal rate and the added security of having some slack in my plan.

About Our Unique Retirement Planning Calculator

Question #1 on the New Retirement Planning Calculator — What Does the Retirement Risk Evaluator Do?

The Retirement Risk Evaluator

 

It reports the safe withdrawal rate for a specified retirement plan. The safe withdrawal rate is the inflation-adjusted amount that can be withdrawn from a portfolio each year with 95 percent confidence that the portfolio will survive 30 years, presuming that U.S. stocks perform in the future at least somewhat as they always have in the past.

Question #2 on the New Retirement Planning Calculator — Aren’t There Other Safe Withdrawal Rate Calculators Already Available on the Internet?

This is the first calculator developed by members of the “New School” of safe withdrawal rate analysis. The New School maintains that the valuation level that applies at the beginning of a retirement must be taken into account in any analytically valid identification of the safe withdrawal rate. The historical data shows that valuations are a key factor in determining what withdrawal rate is safe. Thus, there is no excuse for researchers failing to consider this factor in their analyses.

Question #3 on the New Retirement Planning Calculator — Who Belongs to the New School of Safe Withdrawal Rate Analysis?

The New School arose out of The Great Safe Withdrawal Rate Debate, a series of discussions about the effect of valuations on long-term stock returns held at a number of internet discussion boards examining early retirement and general investing topics. The Great Safe Withdrawal Rate Debate was launched by a post put forward by Rob Bennett (co-developer of the new retirement planning calculator) to a Motley Fool discussion board on the morning of May 13, 2002. John Walter Russell (the other co-developer of the new retirement planning calculator) is today’s leading authority on safe withdrawal rate questions; his extensive research in this field appears at the Early-Retirement-Planning-Insights.com web site. Russell performed the statistical research into the effect of valuations on long-term stock returns that is the engine driving the new retirement planning calculator.

Other authorities who have noted the grave flaws of safe withdrawal rate studies that do not include valuation adjustments include: (1) William Bernstein (author of The Four Pillars of Investing); (2) Ed Easterling (author of Unexpected Returns); Scott Burns (personal finance columnist for the Dallas Morning News); and Peter Ponzo (a retired professor of mathematics who publishes investing research at the Gummy-stuff.org site). There have have been articles in the Wall Street Journal and at MarketWatch.com noting that many of the best-informed financial advisors have adopted a practice of taking today’s high stock valuations into account when offering retirement advice to their clients.

Question #4 on the New Retirement Planning Calculator — Do the Old School Studies of Safe Withdrawal Rates Still Have Value?

The old school studies report the Historical Surviving Withdrawal Rate (HSWR). There is value in knowing that number. But it is irresponsible in the extreme for the Historical Surviving Withdrawal Rate to be reported as the Safe Withdrawal Rate. At times such as today (this article was posted in April 2007) the Historical Surviving Withdrawal Rate (4 percent) is anything but safe. An analytically valid study of the historical stock-return data shows that withdrawal rate to be a high-risk withdrawal rate for high-stock-allocation portfolios at today’s valuations. It is possible that the retirements of retirees using the old school studies will survive for 30 years; the odds today are about 50/50. But these retirements are risky retirements. The words “safe” and “risky” are obviously not synonyms; they are antonyms.

Question #5 on the New Retirement Planning Calculator — Why Have the Old School Studies Not Been Corrected?

Free Online Retirement Planning Software We are today at one of the highest valuation levels that has ever applied in the history of the U.S. market. Many investors are emotionally invested in stocks and are highly reluctant to acknowledge what the historical stock-return data says about the effect of valuations on long-term returns. As Dallas Morning News Columnist Scott Burns noted in a column describing the New School findings, the media has been hesitant to report the breakthrough safe-withdrawal-rate findings of recent years because “it is information most people don’t want to hear.”

Question #6 on the New Retirement Planning Calculator — How Many Retirements Are at Risk of Going Bust as a Result of the Discredited Old School Findings.

Millions. It is not only retirees who make direct use of the old school studies who are at risk. Many articles in newspapers and magazines reference the infamous “four-percent rule” in offering retirement advice to their readers. The number of retirees who have made direct use of the discredited studies and calculators is likely in the hundreds of thousands.

Question #7 on the New Retirement Planning Calculator — How Can You Know in Advance What Withdrawal Rate Is Going to Work?

We do not know what withdrawal rate is going to work. What we know is what the probabilities are for various withdrawal rates, presuming that stocks perform in the future somewhat as they always have in the past. In the past, the valuation level that applied on the starting-date of a retirement has always had a big effect on the long-term success of that retirement. Presuming that that remains the case, the old school studies, which make no adjustments for starting-date valuations, encourage an unfounded confidence in retirees retiring at times of high valuations. We do not know what withdrawal rate is going to work. What we know is that the claims put forward in the old-school studies are the product of an analytically invalid methodology.

Question #8 on the New Retirement Planning Calculator — Is the Methodology Used in the Retirement Risk Evaluator the Only Analytically Valid Methodology for determining safe withdrawal rates?

No. Any methodology that employs a reasonable means of factoring in the effect of valuations is analytically valid. We will no doubt learn more about what works best as time goes on. There are no other retirement planning calculators publicly available today that employ an analytically valid methodology. But there have been stock analysts who have employed analytically valid methodologies other than the methodology employed in the Retirement Risk Evaluator. For example, William Bernstein reports accurately on the safe withdrawal rate in his book The Four Pillars of Investing. His findings are not identical to the findings of the new retirement planning calculator, but they are similar (and they are nowhere even remotely in the same neighborhood as the findings reported on in the old-school studies).

Question #9 on the New Retirement Planning Calculator — Are There Other Features of the Retirement Risk Evaluator That Are Worthy of Note?

Online Retirement Calculator Yes. The new retirement planning calculator offers the aspiring retirees using it the opportunity to examine many more strategic options than are examined in old school studies and calculators. For example, most old-school studies reveal the withdrawal rate that is safe for retirees willing to see the value of their portfolios reduced to zero over the course of a 30-year retirement. Many retirees have expressed a desire to examine more prudent options, such as crafting a retirement plan virtually sure to leave them with a portfolio balance of 30 percent or 50 percent or even 100 percent of the starting-date balance. The new retirement calculator permits retirees to examine what changes in the withdrawal rate are required to construct safe retirements leaving them with any of a number of end-point portfolio balances.

Question #10 on the New Retirement Planning Calculator — What’s Next for the New School of Safe Withdrawal Rate Analysis?

Our findings on safe withdrawal rates have led to exciting research on a host of investing questions. The Stock-Return Predictor, the calculator available at the “Return Predictor” tab at the left, is a product of the community learning experience we enjoyed during The Great Safe Withdrawal Rate Debate. The Valuation-Informed Indexing approach to investing is also the fruit of those discussions. There are hundreds of articles at Russell’s site (early-retirement-planning-insights.com) reporting on research that has its roots in the New School findings. Russell and Bennett are at work on a third calculator, The Investor’s Scenario Surfer, which will permit investors to run simulations of how stocks may perform on a year-by-year basis in the future assuming that they continue to perform in the future somewhat as they always have in the past (and that valuations continue to exert a strong influence on long-term returns). The Scenario Surfer too is the fruit of The Great Safe Withdrawal Rate Debate, soon to enter its sixth year.

The most pressing need today, however, is to inform retirees who have made use of the old school studies of the risks to which they have put their retirements by doing so. Russell and Bennett hope that release of the new calculator will help to spread the word about the New School findings.

The Retirement Risk Evaluator (15-Year Version)

This 15-year version of the Retirement Risk Evaluator is intended as an add-on tool for those seeking to examine the safety of a retirement portfolio over a 45-year time-period rather than a 30-year time-period. Some who retire early might be particularly in need of such a tool. Of course, the 15-year version could also be used by those who retire late enough in life that they want to determine the safety of a portfolio that only needs to survive for 15 years.

For background on the workings of this Retirement Planning Tool, please check the material that appears with the 30-year version of the calculator. The 30-year version appears when you click the “Risk Evaluator” tab to the left of this screen.

For a description of how to combine the two calculators, please read the article on this topic posted by John Walter Russell (co-developer of the calculator) at his Early-Retirement-Planning-Insights com web site.

 

Retirement Planning Calculator Smashes Safe Withdrawal Rate Myths

The Retirement Risk Evaluator is a new type of retirement Planning calculator. It is the first retirement planning calculator developed by the “New School” of safe withdrawal rate analysis, a school that requires the consideration of the effect of valuations in determining safe withdrawal rates.

Retirement Planning Calculator The default results above show in dramatic fashion why valuations must be considered in any analytically valid safe-withdrawal-rate study. The old-school safe-withdrawal-rate studies report that a 4 percent withdrawal is safe for a high-stock portfolio used in a retirement beginning at any possible valuation level. The default results above report a very different reality. At the valuation levels that apply today (this article was posted in April 2007), the safe withdrawal rate for a high-stock allocation portfolio is 3 percent. At the top of the recent stock bubble, the safe withdrawal rate for a high-stock-allocation portfolio was 2 percent.

This retirement planning calculator reports good news as well. The good news is that it remains possible even today for a retiree to obtain a safe withdrawal rate of 4 percent so long as he is willing to reduce his stock allocation to reasonable levels for times when stocks are at the prices that apply today. Moreover, the safe withdrawal rate for high-stock-allocation portfolios climbs to well above 5 percent at times of moderate valuations. It climbs higher yet at times of low valuations.

The new retirement planning calculator allows aspiring retirees to construct four scenarios and to compare the results for each in an effort to decide on the best choices to make in a retirement plan. The aspiring retiree enters choices for four factors affecting his retirement plan’s success: (1) the P/E10 (valuation) level that applies at the start of the retirement; (2) the real return being paid on Treasury Inflation-Protected Securities (the non-stock investment class examined by the calculator); (3) the stock-allocation percentage; and (4) the percentage balance that the retiree desires at the end of 30 years.

Simple Retirement Calculator The retirement planning calculator reveals the safe withdrawal rate (the annual inflation-adjusted withdrawal that stands a 95 percent chance of success, presuming that stocks perform in the future at least somewhat as they always have in the past) that applies. It also reveals the withdrawal rate that is “Reasonably Safe” (80 percent chance of success), the withdrawal rate that provides for “Likely Success” (50 percent chance of success), the withdrawal rate that provides for “Likely Failure” (20 percent chance of success) and the withdrawal rate that provides for “Almost Certain Failure” (5 percent chance of success).

The retirement planning calculator’s default results (the results that apply until a user enters choices of his own) show the odds of success for a retirement portfolio in which the TIPS rate is 2.0 percent, the stock allocation is 80 percent, and the retiree is willing to see the portfolio balance decline to zero at the end of 30 years. In these circumstances, the safe withdrawal rate for a retirement beginning today (when this article was written, the P/E10 level was 27) is 3 percent. At the top of the recent stock bubble (when a P/E10 level of 44 applied), the safe withdrawal rate in these circumstances was 2 percent. For a retirement beginning at moderate valuations (a P/E10 level of 14), the safe withdrawal rate in these circumstances is 5.4 percent. For a retirement beginning at low valuations (a P/E10 level of 8), the safe withdrawal rate in these circumstances is 9.1 percent. (Explanatory Note: The default results for Scenario Three will be updated to reflect changes in valuation, and thus the safe withdrawal rate for Scenario Three may not be 3 percent when you read this article.)

The safe withdrawal rate is not a stable number, as is claimed in the conventional-methodology retirement calculators. Valuations affect long-term returns as a matter of “mathematical certainty,” according to William Bernstein, author of The Four Pillars of Investing. The new retirement calculator shows in compelling fashion that this is indeed so. The safe withdrawal rate varies with changes in valuations. There are indeed some circumstances in which the safe withdrawal rate is 4 percent or close to it. There are other circumstances (times of low valuations) in which the safe withdrawal rate can rise to 6 percent or higher and still other circumstances (time of high valuations) when the safe withdrawal rate can drop to 2 percent or lower.

Today’s retiree can bring his safe withdrawal rate up to close to 4 percent by bringing his stock allocation down to 20 percent, according to the new retirement calculator. Alternatively, he can settle for a retirement that has only an 80 percent chance of success and take a 4 percent withdrawal from a portfolio with a stock allocation of 40 percent.

The retirement planning calculator’s results are based on John Walter Russell’s regression analysis of what the historical stock-return data shows regarding the effect of stock valuations on long-term stock returns, published at the www.Early-Retirement-Planning-Insights.com web site. Russell’s research grew out of The Great Safe Withdrawal Rate Debate, an ongoing exploration of the stock valuation question that has generated intense controversy at half a dozen Financial Freedom Community discussion boards for five years now, beginning with a post put to a Motley Fool board by Rob Bennett on May 13, 2002. Those discussions also led to development of the Valuation-Informed Indexing approach  to investing, examined in articles posted by Bennett to the www.PassionSaving.com web site. The new calculator taps into the insights developed during those discussions in an effort at providing realistic guidance to aspiring retirees.

Retirement Calculator The article Valuation Ratios and the Long-Run Stock Market Outlook: An Update by John Y. Campbell and Robert J. Shiller, provides background on the P/E10 tool and its use in making reference to stock valuation levels in predicting stock returns. P/E10 fell to between 5 and 6 in 1921 and 1932, and to between 6 and 7 in 1922 and 1982 (the starting-point of the huge bull market). The highest recorded P/E10 value is 44 (reached in early 2000, perhaps the ending point of the huge bull market). A moderate P/E10 value is 14. P/E10 exceeded 24 in 1928, 1929, 1930, 1966, and in all the years from 1995 through early 2007.

The retirement planning calculator is intended to serve as a guide to how changes in stock valuation may affect long-term retirement success. The authors of the calculator (John Walter Russell and Rob Bennett) believe that it is a useful tool for determining safe withdrawal rates. But they also stress that the study of how changes in stock valuation affect safe withdrawal rates is very much an ongoing effort. The calculator’s authors very much do not want any users of the calculator to read into the results generated by the retirement calculator any more certainty than is warranted by the nature of the research project that produced it. Please check what you learn from the calculator against the information provided by other sources.

About Our Unique Retirement Planning Calculator
Retirement Planning Calculator Article #1 — Ten basic questions and answers on our unique retirement planning calculator, the first to consider the effect of starting-point stock valuations on a retirement plan’s long-term success.
Using the Risk Evaluator to Develop Retirement Planning Strategies
Retirement Planning Calculator Article #2 — A host of insights on retirement planning strategies open to us when we quantify the effect of valuation changes.
The Experts Speak on the Risks of Holding Overvalued Stocks in Retirement
Retirement Planning Calculator Article #3 — Ssssh! Please do not say a word about what you read here to any of the authors of the Old School SWR studies. This sort of thing greatly upsets them.
Rise of the New School of Safe Withdrawal Rate Analysis
Retirement Planning Calculator Article #4 — The Old School of safe-withdrawal-rate analysis is dead! Long live the New School of safe-withdrawal-rate analysis!
Community Comments on Using Stock Data to Diminish Retirement Risks
Retirement Planning Calculator Article #5 — What the change from the Old School to the New School means for those who make use of safe withdrawal rates to plan real-world retirements.
The Retirement Risk Evaluator (15-Year Version)
Retirement Planning Calculator Article #6 — The 15-year version of the Retirement Risk Evaluator permits you to examine the safety of retirement plans extending 45 years by combining the results obtained from the 30-year version with the results obtained from the 15-year version.