Kitces: Preparing for Lower Long-Term Returns

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Originally Posted by samclem Right, but you've said a mouthful with those "if you've done" steps. There are some practical things (esp the need for spending flexibility ("cushion") and the very high utility of variable withdrawal amounts based on annual portfolio performance) that are essential for those considering retirement at high valuations to understand. ...

Those are very good points. The mouthful (which I admittedly was too lazy to go into) is that there are no shortcuts to effective PF management. If you want to retire early and do it successfully, AFAICT there is no other way than doing the hard work of learning everything there is about it. Having a cushion (or Plan B or C, or whatever) is one small part of that. Further, as I said above, variable PF withdrawal amounts based on market/PF performance is not at all new news.

[Gone4Good]

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Originally Posted by 2017ish Interesting discussion... I wondered about inflation when I saw the 4.6%. C.P.I. inflation rate in 1966 (December v. Dec. 1965) was 3.46% Inflation 1966 – Overview CPI inflation by country in 1966 Granted, the inflation measurement goal posts have moved over the years and I am not competent to attempt those adjustments, but taking it at face value, that would indicate a real yield of 1.14%. Still better than the present quote on 10 year TIPS (.53%), but closer than I would have thought.

I'm not so sure, and here's why.

We buy bonds not with the hindsight knowledge of what inflation will actually happen, but with a guesstimate of what future inflation might be. The real yield at the time bonds are sold is the nominal rate less that expected inflation component. We don't have the tools today to know with certainty what inflation investors expected back when they bought bonds in January 1966, but we can make an educated guess.

As a first order approximation I'd wager inflation expectations for the year ahead were pretty close to the rate actually experienced in the year past. And according to your same source, inflation in 1965 averaged 1.58%.

So it's possible bond buyers in 1966 thought they were getting something closer to a 3% real yield (even though future events didn't turn out the way they expected.)

And that makes sense with the data I have. When I subtract from the 10-year treasury rate the inflation rate realized during the previous 12 months, I get a median value of 2.55% and an average of 2.2% for the period from 1955-1966. So it's not unreasonable to think the real yields investors demanded were somewhere north of 2% back in the mid 60s.

Even if I'm wrong on this front, that doesn't change the fact that someone lending at 4.6% has a much greater cushion against adverse events than someone lending at 1.74%.

[photoguy]

The issue with inconsistent earnings in CAPE/PE10 has been discussed here, on bogleheads, and on other places on the web. My reading of it, as an amateur, is that the discussion is about whether equities have abnormally valuations or just high valuations. I believe the latter, but it doesn't matter as the conclusion is the same. High valuations implies lower expected returns. Lower expected returns means that a given SWR percentage will likely have a higher failure rate in the future than the past.

The size of the effect is debatable. I'm quite comfortable with treating 3% as the new 4%. But others may come to different conclusions for good reasons.

The best description of Livermore's objection to traditional CAPE is on his blog: Fixing the Shiller CAPE: Accounting, Dividends, and the Permanently High Plateau | PHILOSOPHICAL ECONOMICS . He's basically making the argument that instead of GAAP earnings, one should use pro-forma earnings. However, even by pro-forma earnings, equity valuations are still higher than historical (still implies lower expected returns).

I have also read other experts claim that using pro-forma earnings in CAPE are upward biased (i.e. too optimisitic). In any case, I know of no credible experts predicting expected returns as high as the US historical average. Livermore himself says "There is no question that the current stock market is more expensive than the averages of certain past eras–the 1910s, 1930s, 1940s, 1970s, 1980s, etc. Looking forward, long-term equity returns will obviously be lower than they were in those eras"

Another way of computing expected returns is to use the Dividend Discount Model pushed by bogle and others. This is generally more pessimistic than CAPE even without mean reversion of valuations. Again lower expected returns implies higher failure rates for a fixed SWR percentage.

[Gone4Good]

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Originally Posted by photoguy The best description of Livermore's objection to traditional CAPE is on his blog: Fixing the Shiller CAPE: Accounting, Dividends, and the Permanently High Plateau | PHILOSOPHICAL ECONOMICS .

Oh, boy.

I can't find a source for how Bloomberg arrives at the pro-forma earnings index that Livermore uses but my guess is that they're just grabbing the non-GAAP numbers reported in companies' quarterly press releases.

Those pro-forma earnings calculations include a huge number of adjustments, many of which have nothing to do with Goodwill. By and large, those adjustments just add back things that happened that companies either wish didn't or that they want analysts to exclude as "one time."

A better definition for these "pro-forma earnings" numbers might be "earnings excluding all the bad stuff."

And they're a relatively recent phenomenon, so it's no surprise that an index tracking pro-forma earnings would increasingly diverge from GAAP earnings as more and more companies issue their own better-than-GAAP calculations.

I'm not sure "pro-forma" earnings show what Livermore thinks they show.

His argument about NIPA profits might be more persuasive if he demonstrated that those cumulative profits are much higher than those reported by companies under GAAP. But that's not what he does. He only shows that the coorelation between the two isn't as high as it once was.

That doesn't mean GAAP profits are lower (or higher), just that they don't track as well. And an increase in large non-cash writedowns may well be the reason. But that just means GAAP earnings are more volatile than NIPA profits, not necessarily lower.

Count me as not convinced.

[daylatedollarshort]

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Originally Posted by newtoseattle I guess for me it means that even though real returns might only be 2%, that 3% withdrawal rate is still quite reasonable for long retirement (and even 4% swr for someone planning only 30 years)

When we decided to not work full time, 30 year TIPS were yielding ~2% real fairly risk free and we decided good enough. With spending principal over 40 years that could be up to another 2.5% (100/40 years). We aren't 100% TIPS and now yields are lower so we use 1% real instead of 2% in our plan, with the option of spending all or part of the 2.5% principal SWR there as well.

[audreyh1]

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Originally Posted by Gone4Good My approach is to discount current markets back to a level that represents the median valuation of the data set used to originally calculate your SWR. If you're using FIRECalc and PE-10, that would mean discounting the current equity market down to a valuation of about 16x from it's current 24x (a 33% haircut). I'd also do the same thing with the bond market. 10-year treasuries are yielding 1.74% versus a median of 3.89%. Using an average bond market duration of about 6 years, that 200bp lower current yield results in a price discount of about 12%. So assuming a 1MM portfolio and a 50/50 asset allocation, I'd mark the $500,000 in stocks down by 33% to $333,000 and the bond allocation down by 12% to $440,000. My resulting $773,000 portfolio puts me right in the middle of the valuations used in our historic data set. Applying a 4% SWR, I get a withdrawal of about $31,000. That means my undiscounted portfolio can support a withdrawal rate of 3.1%. Said another way, a 3.1% withdrawal today is equivalent to a 4% withdrawal at median valuations.

That is a very interesting way of looking at it.

I note that for a median valuation portfolio, the safe withdrawal rate will be higher than 4%. 4% is for a worst case scenario indicating valuations are messed up at one end or another. I don't remember what the median safe withdrawal rate was - something like 5% or slightly higher?

[samclem]

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Originally Posted by Gone4Good My approach is to discount current markets back to a level that represents the median valuation of the data set used to originally calculate your SWR. If you're using FIRECalc and PE-10, that would mean discounting the current equity market down to a valuation of about 16x from it's current 24x (a 33% haircut). I'd also do the same thing with the bond market. 10-year treasuries are yielding 1.74% versus a median of 3.89%. Using an average bond market duration of about 6 years, that 200bp lower current yield results in a price discount of about 12%. . . . . That means my undiscounted portfolio can support a withdrawal rate of 3.1%. Said another way, a 3.1% withdrawal today is equivalent to a 4% withdrawal at median valuations.

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Originally Posted by audreyh1 That is a very interesting way of looking at it. I note that for a median valuation portfolio, the safe withdrawal rate will be higher than 4%. 4% is for a worst case scenario indicating valuations are messed up at one end or another. I don't remember what the median safe withdrawal rate was - something like 5% or slightly higher?

If we had a very big decline in equity prices (thus, a lower PE10 and lower valuations), Gone4Good's method would require (or at least allow) for a much higher withdrawal percentage that year--maybe 8% or more if we got down to CAPEs of about 10. Emotionally, after a drop in my stock portfolio of more than 60%, I don't think it would be easy (or even possible), to withdraw that much of the beaten-down equities unless it were truly a necessity (i.e. needed for the most Spartan essential spending). I believe in the utility of the CAPE, and I believe in mean reversion, but that would be quite a leap.

[audreyh1]

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Originally Posted by audreyh1 I note that for a median valuation portfolio, the safe withdrawal rate will be higher than 4%. 4% is for a worst case scenario indicating valuations are messed up at one end or another. I don't remember what the median safe withdrawal rate was - something like 5% or slightly higher?

Median SAFEMAX - for the 30 year period, of course.


From http://retirementresearcher.com/will...ngens-safemax/

[audreyh1]

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Originally Posted by samclem If we had a very big decline in equity prices (thus, a lower PE10 and lower valuations), Gone4Good's method would require (or at least allow) for a much higher withdrawal percentage that year--maybe 8% or more if we got down to CAPEs of about 10. Emotionally, after a drop in my stock portfolio of more than 60%, I don't think it would be easy (or even possible), to withdraw that much of the beaten-down equities. I believe in the utility of the CAPE, and I believe in mean reversion, but that would be quite a leap.

I thought he was talking about 33% drop from a bit above today's levels (we are under 24% now), not 60%?

You are talking more about undershooting?

[audreyh1]

Since I use % of remaining portfolio as my withdrawal rate, I can't really project lowering the withdrawal % now in anticipation of a reversion to mean 10 years from now.

I would have to have a dynamic withdrawal % that dropped when valuations were high, went to a median level when valuations seemed to be median, and raised when valuations were low.

Using the initial portfolio value and adjusting withdrawals for inflation each year kind of does that - but the starting point is arbitrary in terms of valuation. That is why SAFEMAX ends up being low so it is a conservative choice.

[Gone4Good]

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Originally Posted by audreyh1 I note that for a median valuation portfolio, the safe withdrawal rate will be higher than 4%.

I think that is probably true, at least from a historic perspective.

I also think statements like "my withdrawal strategy is 95% successful" is only applicable if you're starting point is solidly within the middle of the data set.

[samclem]

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Originally Posted by audreyh1 I thought he was talking about 33% drop from a bit above today's levels (we are under 24% now), not 60%? You are talking more about undershooting?

Sorry, I'm not following you. I was trying to say that if we are at a CAPE of approx 24X now and the median is about 16X, then if we had a plummet in equity values of 60% (from today's prices), we'd be at a CAPE of about 10. My stocks worth $500K today would (after the drop) be worth $200K. But, because of the new low CAPE of 10, G4G's method would have us "recalibrating" their value to 16/10 (or 1.6) = $320K. We'd take the "standard" 4% of that (or 5% if we follow your suggestion of using the median rather than the 4% "covers the worst case" WR). So, we'd be withdrawing $320K x .04 = $12.8K or $320K x .05 = $16K. In the real world, if my portfolio has gone from $500K to just $200K, and I withdraw $16K, that's 8% of what I've got, 8% of my beaten-down equity shares that I'm hoping may mean-revert to something close to their former value (or at least to the median 16x value) to avert a future, final dip of my portfolio to FIRECalc's dreaded X-axis.
Selling more (%age-wise) when share prices are in the dumpster seems counterintuitive. What seems logical is to shift allocations and increase bond allocations when equity prices are high, and then buy more equities (selling bonds to do it) when their prices are low (by historic standards). As far as withdrawals--keep 'em at a constant percentage (taken from year-end values). That seems like a good fit to my emotional preferences (tighten the belt in tough times) and to the requirement to preserve the future growth potential of the portfolio (don't cash out those beaten-down shares at a >higher< rate when the history of CAPE tells us they are ripe for a comeback in the near future).

[Gone4Good]

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Originally Posted by samclem If we had a very big decline in equity prices (thus, a lower PE10 and lower valuations), Gone4Good's method would require (or at least allow) for a much higher withdrawal percentage that year--maybe 8% or more if we got down to CAPEs of about 10. Emotionally, after a drop in my stock portfolio of more than 60%, I don't think it would be easy (or even possible), to withdraw that much of the beaten-down equities unless it were truly a necessity (i.e. needed for the most Spartan essential spending). I believe in the utility of the CAPE, and I believe in mean reversion, but that would be quite a leap.

Some of that happens naturally. The portfolio declines, withdrawals stay the same, so the withdrawal percentage goes up in a down market. The worse the market, the larger the increase in WR.

Now if you've provisioned for that decline in portfolio value, then it's not that big of a deal. Your WR goes from 3% to 4% or 4.5% and that still feels OK.

Would anyone really increase their WR beyond that because return expectations have increased? Doubtful. But they might just feel comfortable enough with their financial situation to rebalance back into equities while in the teeth of the bear just like the unemotional FIRECalc bot assumes you will.

Some of us might even use the opportunity to increase our equity allocations beyond simple rebalancing.

[audreyh1]

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Originally Posted by samclem Sorry, I'm not following you. I was trying to say that if we are at a CAPE of approx 24X now and the median is about 16X, then if we had a plummet in equity values of 60% (from today's prices), we'd be at a CAPE of about 10. My stocks worth $500K today would (after the drop) be worth $200K. But, because of the new low CAPE of 10, G4G's method would have us "recalibrating" their value to 16/10 (or 1.6) = $320K. We'd take the "standard" 4% of that (or 5% if we follow your suggestion of using the median rather than the 4% "covers the worst case" WR). So, we'd be withdrawing $320K x .04 = $12.8K or $320K x .05 = $16K. In the real world, if my portfolio has gone from $500K to just $200K, and I withdraw $16K, that's 8% of what I've got, 8% of my beaten-down equity shares that I'm hoping may mean-revert to something close to their former value (or at least to the median 16x value) to avert a future, final dip of my portfolio to FIRECalc's dreaded X-axis. Selling more (%age-wise) when share prices are in the dumpster seems counterintuitive. What seems logical is to shift allocations and increase bond allocations when equity prices are high, and then buy more equities (selling bonds to do it) when their prices are low (by historic standards). As far as withdrawal rates--keep 'em at a constant percentage (taken form year-end values). That seems like a good fit to my emotional preferences (tighten the belt in tough times) and to the requirement to preserve the future growth potential of the portfolio (don't cash out those beaten-down shares at a >higher< rate when the history of CAPE tells us they are ripe for a comeback in the near future).

But that's how the system works with the % of initial portfolio value method. If the portfolio drops a lot right a year after you retire, your withdrawal in a given year be much higher percentage wise.

If you have several years of increasing portfolio value before the drop, then it might just be reverting back to where you started.

I didn't understand why you were using the scenario of the CAPE dropping to 10.

[Gone4Good]

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Originally Posted by audreyh1 I didn't understand why you were using the scenario of the CAPE dropping to 10.

I think he was trying to apply the logic in reverse.

I'd restate it this way, if we were currently at a CAPE of 10x, my suggestion is that a "safe" withdrawl rate would be something higher than 4%.

I think the confusion came in when trying to apply that logic to a portfolio that has been hit by a down market and suggesting it implies higher dollar withdrawals. I'm not sure it works that way.

If I was drawing 3% of a 100% equity portfolio valued at 24x, that same draw would be 4.7% if equities declined to 16x and would be a 7.4% draw if equities declined to 10x.

So yes, the approach says you can draw ~7% at 10x. It just doesn't envision you actually increasing the dollar amount of your withdrawals.

[samclem]

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Originally Posted by Gone4Good My approach is to discount current markets back to a level that represents the median valuation of the data set used to originally calculate your SWR. If you're using FIRECalc and PE-10, that would mean discounting the current equity market down to a valuation of about 16x from it's current 24x (a 33% haircut). I'd also do the same thing with the bond market. 10-year treasuries are yielding 1.74% versus a median of 3.89%. Using an average bond market duration of about 6 years, that 200bp lower current yield results in a price discount of about 12%. So assuming a 1MM portfolio and a 50/50 asset allocation, I'd mark the $500,000 in stocks down by 33% to $333,000 and the bond allocation down by 12% to $440,000. My resulting $773,000 portfolio puts me right in the middle of the valuations used in our historic data set. Applying a 4% SWR, I get a withdrawal of about $31,000. That means my undiscounted portfolio can support a withdrawal rate of 3.1%. Said another way, a 3.1% withdrawal today is equivalent to a 4% withdrawal at median valuations.

Okay,I see where I got off course, You aren't proposing doing this adjustment every year to adjust withdrawal rates based on changing valuations. This is a calculation you do one time at the start of retirement to determine the WR to be used forever.

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Originally Posted by Gone4Good Some of that happens naturally. The portfolio declines, withdrawals stay the same, so the withdrawal percentage goes up in a down market. The worse the market, the larger the increase in WR.

Yes, it doesn't work that way for those of us taking a %age of year end portfolio values. Now, though, I understand your explanation.

[Gone4Good]

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Originally Posted by samclem You aren't proposing doing this adjustment every year to adjust withdrawal rates based on changing valuations.

Nope. It's just a sanity check that helps me keep these paper portolio gains in perspective.

We're not always as rich as we think we are. And that's never more true than after a seven year bull market.

[CaliforniaMan]

There is really something fishy about this. The best predictability is at 15 years. Really? I don't buy it. More likely this is an artifact of a limited data set. If we just look at a plot of the CAPE over time we see three near thirty year "cycles". Approximately 1901 to 1929, then from 1929 or 1936 to 1966, and then to 2000 or so. For whatever the cause, these quasi-periodic cycles would make it appear that there is some roughly 15 year predictability. I have wondered about this for some time and thought I might delve into the statistics at some point, but so far too lazy. Wish someone would.

This supposed 15 year predictability could be simply an artifact of these approximately 30 year "cycles," which to me seems far more likely than actually being able to predict something about the economy 15 years out.

[Gone4Good]

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Originally Posted by audreyh1 Since I use % of remaining portfolio as my withdrawal rate, I can't really project lowering the withdrawal % now in anticipation of a reversion to mean 10 years from now. I would have to have a dynamic withdrawal % that dropped when valuations were high, went to a median level when valuations seemed to be median, and raised when valuations were low.

I haven't thought hard about a % of portfolio withdrawal method, but it seems to me a similar concept would apply.

All I'm doing, after all, is calibrating my initial withdrawal rate to the median market valuation. I'd want to do the same thing with my initial withdrawal rate for a percentage of portfolio approach too.

Say you want $40K in living expenses and have a portfolio currently valued at $1MM. If you started drawing 4% today and the market is really over valued you'll face long periods where you're withdrawal amounts are well below what you originally wanted to spend.

One way to guard against that is to mark down your current portfolio to a level reflecting "normal" valuations. If I use my previous calculation to arrive at a "fair value" for my $1MM portfolio of $773,000, then I might want to start with a 5.2% withdrawal rate rather than a 4% rate to make sure I'm still getting my $40K in income if markets mean revert.

Maybe I'm comfortable drawing 5.2% or maybe I'm not. Either way it seems to me this is a reasonable way to calibrate one's initial withdrawal amounts in an over valued market.

[Gatordoc50]

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Originally Posted by Gone4Good I think that is probably true, at least from a historic perspective. I also think statements like "my withdrawal strategy is 95% successful" is only applicable if you're starting point is solidly within the middle of the data set.

+1
This is just common sense but I appreciate the way you have expressed it mathematically. Very helpful.