Kitces: Preparing for Lower Long-Term Returns

[Gone4Good]

Quote:

Originally Posted by CaliforniaMan 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.

I agree that it looks like we have a bunch of ~30 year valuation cycles, but that is from peak to peak (1901 to 1929, 1929 to 1966, 1966 to 2000).

The peak to trough, and trough to peak periods are closer to 15 years in duration. It is those periods where valuation meaningfully impacts investment returns.

For example, if we have a period where valuations start at a peak of 25x and end at a peak of 25x three decades later, your investment return over those three decades isn't influenced by changes in valuation at all. Both starting and ending valuations are the same. But your returns are hugely influenced in between the peaks when valuations may have declined form 25x to 14x and then rose again from 14x back to 25x.

So assuming a 30 year peak to peak cycle, valuations will be a more important driver of investment returns over some period shorter than 30 years.

[audreyh1]

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Originally Posted by Gone4Good 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.

I think I've kind of done this by having a ~3% withdrawal rate. The $ amount withdrawn has increased as the portfolio has gone up, and it will drop when the portfolio drops. Even if the portfolio were to drop 25%, it would still be a 3% withdrawal. Obviously income would drop 25%, but I can handle that as currently withdrawn income (after taxes) exceeds our budget by more than that.

I like that our excess income has built up over several years to have funds available even if our income is drastically cut. I have not been willing to reinvest excess, but keep it in short-term funds.

[Chuckanut]

So, maybe one of those variable withdrawal rate formulas is a practical answer to all of this confusion? One that buffers both the upside and downside withdrawal levels?

[Gone4Good]

Quote:

Originally Posted by audreyh1 I think I've kind of done this by having a ~3% withdrawal rate. The amount withdrawn has increased as the portfolio has gone up, and it will drop when the portfolio drops. Even if the portfolio were to drop 25%, it would still be a 3% withdrawal. Obviously income would drop 25%, but I can handle that as currently withdrawn income exceeds our budget by more than that. I like that our excess income has built up over several years to have funds available even if our income is drastically cut. I have not been willing to reinvest excess, but keep it in short-term funds.

That makes perfect sense.

It'd be tough to implement if you retire directly into a bear market without the benefit of having some years of excess earnings accumulate. That's why it might be better for folks to start by drawing more money than they need right out of the gate to protect against a year-1 market collapse.

[audreyh1]

Quote:

Originally Posted by Gone4Good That makes perfect sense. It'd be tough to implement if you retire directly into a bear market without the benefit of having some years of excess earnings accumulate. That's why it might be better for folks to start by drawing more money than they need right out of the gate to protect against a year-1 market collapse.

That's why I've been adamant about withdrawing the planned percentage even though the portfolio has increased a great deal in the past few years, and even when we don't spend it all in the same year. Because I know that any excess that is reinvested in the portfolio might go "poof" in a downdraft the next year. Theoretically I shouldn't need to reinvest the excess, because I'm already withdrawing at a low percentage, plus I'm prepared to take less income in $ when my portfolio does drop.

[Lsbcal]

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Originally Posted by audreyh1 That's why I've been adamant about withdrawing the planned percentage even though the portfolio has increased a great deal in the past few years, and even when we don't spend it all in the same year. Because I know that any excess that is reinvested in the portfolio might go "poof" in a downdraft the next year. Theoretically I shouldn't need to reinvest the excess, because I'm already withdrawing at a low percentage, plus I'm prepared to take less income in $ when my portfolio does drop.

This is part of the idea behind the VPW tool. One sets the AA and Last Withdrawal Age. Then one looks at some downturn's sequence of returns in really bad retirement years like 1929 (bear market + deflation) or 1968 (bear market + inflation).

The relatively high withdrawal rates (for us) can be put aside in a "poof" fund of unspent reserves. If the bad sequence shows up, the "poof" fund can be used to supplement spending until market recovery years which have always occurred ... so far. Our "poof" fund is in short term investment grade bonds right now.

[Gone4Good]

Quote:

Originally Posted by audreyh1 That's why I've been adamant about withdrawing the planned percentage even though the portfolio has increased a great deal in the past few years, and even when we don't spend it all in the same year. Because I know that any excess that is reinvested in the portfolio might go "poof" in a downdraft the next year. Theoretically I shouldn't need to reinvest the excess, because I'm already withdrawing at a low percentage, plus I'm prepared to take less income in $ when my portfolio does drop.

I like it!

In good years your portfolio naturally tilts toward more conservative investments and in down years it naturally tilts a bit more towards a riskier allocation.

It also has a built in warning system that lets you know when it's time to cut spending.

And, it has the unambiguous virtue of being 100% fail-proof, provided you don't fail to cut your spending as required to keep withdrawals within the stated fixed percentage.

Lots to like.

[samclem]

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Originally Posted by audreyh1 I like that our excess income has built up over several years to have funds available even if our income is drastically cut. I have not been willing to reinvest excess, but keep it in short-term funds.

I find this appealing, too. But, like a "buckets" approach, keeping the unspent "extra" money fenced in ST bonds (or cash) for eventual spending can be expected to produce lower returns than leaving the "excess" in the major pot to be rebalanced and buy more equities as they decline in price during "down" years. Maybe there's a way to do both: Leave the unspent surplus in the "big pot" being rebalanced (just like everything else, and for the same reason: Higher volatility-adjust returns due to rebalancing), but track (in your books) the value of what was left in, adjust its value each year by the same rate as the portfolio as a whole, and know it is available for withdrawal during lean years without violating the letter or spirit of the withdrawal rules set up on day one. It's "extra money" that you were "due" in previous years.

[CaliforniaMan]

Quote:

Originally Posted by Gone4Good I agree that it looks like we have a bunch of ~30 year valuation cycles, but that is from peak to peak (1901 to 1929, 1929 to 1966, 1966 to 2000). The peak to trough, and trough to peak periods are closer to 15 years in duration. It is those periods where valuation meaningfully impacts investment returns. For example, if we have a period where valuations start at a peak of 25x and end at a peak of 25x three decades later, your investment return over those three decades isn't influenced by changes in valuation at all. Both starting and ending valuations are the same. But your returns are hugely influenced in between the peaks when valuations may have declined form 25x to 14x and then rose again from 14x back to 25x. So assuming a 30 year peak to peak cycle, valuations will be a more important driver of investment returns over some period shorter than 30 years.

I didn't mean to suggest that I think there actually are 30 year economic cycles, only that for whatever chance reason they occurred in the past in this time series, and that due to these "cycles" (note the quotes) the 15 year correlations found are probably spurious and without meaning.

I think we may be reading something into the data that is not there. We think we see a 15 year out correlation when actually it can be completely explained by these meaningless past "cycles."

[Gone4Good]

Quote:

Originally Posted by CaliforniaMan I think we may be reading something into the data that is not there. We think we see a 15 year out correlation when actually it can be completely explained by these meaningless past "cycles."

Absolutely. We basically have something like 4 cycles, so not a robust data set from which to forecast.

And considering that it's been 15 years since the last cycle peaked in 2000 . . . "Yay, that means we're at trough valuations now." Not sure anyone believes that.

[audreyh1]

Quote:

Originally Posted by Lsbcal This is part of the idea behind the VPW tool. One sets the AA and Last Withdrawal Age. Then one looks at some downturn's sequence of returns in really bad retirement years like 1929 (bear market + deflation) or 1968 (bear market + inflation). The relatively high withdrawal rates (for us) can be put aside in a "poof" fund of unspent reserves. If the bad sequence shows up, the "poof" fund can be used to supplement spending until market recovery years which have always occurred ... so far. Our "poof" fund is in short term investment grade bonds right now.

That's funny - a poof fund! It's more like an anti-poof fund.

Personally, I've been thinking of it as my war chest.

[audreyh1]

Quote:

Originally Posted by Gone4Good I like it! In good years your portfolio naturally tilts toward more conservative investments and in down years it naturally tilts a bit more towards a riskier allocation. It also has a built in warning system that lets you know when it's time to cut spending. And, it has the unambiguous virtue of being 100% fail-proof, provided you don't fail to cut your spending as required to keep withdrawals within the stated fixed percentage. Lots to like.

It's really simple too. All I have to do is calculate 3% of the Dec 31 portfolio value each year and remove that amount. I rebalance afterwards. That's it.

By the tilt I assume you mean selling from equities when they run up, and buying more equities when they correct - but any rebalancing does that.

The fail-safe - well that has to be qualified a bit. A few bad years in a row mean a combination of market drops and withdrawals. This can lead to a much lower portfolio and thus a drastic cut in income. But if you have excess funds set aside, you should be able to get through it without too much pain, and even have the fortitude to rebalance.

[Lsbcal]

Quote:

Originally Posted by samclem I find this appealing, too. But, like a "buckets" approach, keeping the unspent "extra" money fenced in ST bonds (or cash) for eventual spending can be expected to produce lower returns than leaving the "excess" in the major pot to be rebalanced and buy more equities as they decline in price during "down" years. Maybe there's a way to do both: Leave the unspent surplus in the "big pot" being rebalanced (just like everything else, and for the same reason: Higher volatility-adjust returns due to rebalancing), but track (in your books) the value of what was left in, adjust its value each year by the same rate as the portfolio as a whole, and know it is available for withdrawal during lean years without violating the letter or spirit of the withdrawal rules set up on day one. It's "extra money" that you were "due" in previous years.

If I understand you correctly wouldn't this be exposing your designated spending money to the same portfolio risk as all the other dollars? For example, suppose we are in a 1968 sequence then the table below shows a $1M portfolio for a 50/50 AA and 3.4% spending. By year 8 the real spending amount (red in withdrawal column) is reduced a lot. This is a good year to take more spending money from our set-aside pot. But if that pot is exposed to the market, it would itself be down about 40% in real term (599990/1000000).

Probably the best way to avoid the set-aside lowering portfolio returns is to spend and enjoy your yearly allocation. Don't let that grow too big as it indicates (perhaps?) a failure of planning for fun. Does this make sense? I'm not entirely sure myself.

[Lsbcal]

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Originally Posted by audreyh1 That's funny - a poof fund! It's more like an anti-poof fund. Personally, I've been thinking of it as my war chest.

Yes, a better name.

[audreyh1]

Quote:

Originally Posted by samclem I find this appealing, too. But, like a "buckets" approach, keeping the unspent "extra" money fenced in ST bonds (or cash) for eventual spending can be expected to produce lower returns than leaving the "excess" in the major pot to be rebalanced and buy more equities as they decline in price during "down" years. Maybe there's a way to do both: Leave the unspent surplus in the "big pot" being rebalanced (just like everything else, and for the same reason: Higher volatility-adjust returns due to rebalancing), but track (in your books) the value of what was left in, adjust its value each year by the same rate as the portfolio as a whole, and know it is available for withdrawal during lean years without violating the letter or spirit of the withdrawal rules set up on day one. It's "extra money" that you were "due" in previous years.

I still have plenty of fixed income in the big pot for rebalancing. I don't see that as a problem or a constraint.

Reinvesting the excess will increase the very long-term returns, but I'm more interested in surviving the next 10 years in reasonable comfort and not so much having a high remainder value. I really don't want to subject withdrawn funds to market risk.

When CDs and high-yield savings accounts are yielding almost as much or more than short-term bond funds, or even intermediate treasuries for that matter, with no credit or interest rate risk, you aren't really being penalized on those short-term investments either.

[samclem]

Quote:

Originally Posted by Lsbcal If I understand you correctly wouldn't this be exposing your designated spending money to the same portfolio risk as all the other dollars?

Yes, it does. But we can't know when the market will turn around, and unless you need to spend it all on the way down or at the bottom, leaving the funds in the "big pot" for rebalancing means buying cheaper shares and having more money later when the market bounces back. I understand Audrey's counterargument, and it's just as valid (probably more).

Quote:

Originally Posted by Lsbcal Probably the best way to avoid the set-aside lowering portfolio returns is to spend and enjoy your yearly allocation. Don't let that grow too big as it indicates (perhaps?) a failure of planning for fun. Does this make sense? I'm not entirely sure myself.

It depends on the scenario. To my thinking, we want to maximize the utility (fun, pleasure, etc) of the money over the years. If I buy a first-class airplane ticket for $3K in the "good times" and it means later during a downturn I don't have $3k to spend on a frugal-but-fun 2 week camping trip to a national park, then I haven't maximized the utility of that money. And if the situation is more dire still at a later date, I sure would have preferred to have that $3k to keep the electricity and gas turned on for a year.

[Lsbcal]

Quote:

Originally Posted by samclem ... It depends on the scenario. To my thinking, we want to maximize the utility (fun, pleasure, etc) of the money over the years. If I buy a first-class airplane ticket for $3K in the "good times" and it means later during a downturn I don't have $3k to spend on a frugal-but-fun 2 week camping trip to a national park, then I haven't maximized the utility of that money. And if the situation is more dire still at a later date, I sure would have preferred to have that $3k to keep the electricity and gas turned on for a year.

Yes, I can see your point.

I never buy first-class tickets and last year we "should" have spent 4.5% but only wound up spending 3.4%. That included a redesign of our back yard and a long trip to Italy. Yet if we'd spent another 1.1% it would not have made our year much or any better (DW might disagree ).

So how to maximize fun over the long haul? I don't know what I'll want in 10 years (first class tickets?) and I don't know if I'll be around then.

[FUEGO]

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Originally Posted by Gone4Good How many 30+ year periods in the data set start with valuations of both stocks and bonds as high as those currently? I count 0. How many started with just equity valuations above 24x? Basically 2, around 1900 and again in 1928-29. If we're using data to project for periods where we know the starting conditions lie outside the data set then it is wise to proceed with caution . . . or, at the very least, make adjustments to bring your starting position back in line with the available data.

For stocks at least, there have been more than a few 30 year scenarios that start with PE10's above 20 (most of the 1960's, for example).

I see what you are saying, but I'm not sure that we are far enough outside the historical data set to need to apply a discount to today's starting portfolio value and THEN run the newly discounted values through FIREcalc.

[FUEGO]

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Originally Posted by Lsbcal I never buy first-class tickets...

I'm not sure I could ever justify spending money on first class tickets. If someone offered me a tax free $200 per hour (delta between 1st and coach) simply to sit in a 17" wide lightly cushioned seat (coach class) while drinking half cans of soda and reading a book or watching a movie or sleeping, I'd probably do it.

[Gone4Good]

Quote:

Originally Posted by audreyh1 By the tilt I assume you mean selling from equities when they run up, and buying more equities when they correct - but any rebalancing does that.

Not exactly. I guess I was thinking that you'd exclude your "poof fund" from the investment portfolio for rebalancing purposes. That money is technically spent, after all.

In that case you'd have a growing cash balance during up markets that you wouldn't rebalance away from. I kind of like that idea. Almost like an automatic way to lean against bull markets.

But I can see doing it the other way too and just lumping the "poof fund" in with the rest of your portfolio AA.