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.
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.
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.
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.