Another Look at Safe Withdrawal Rates and PE Ratios

This article was first posted September 1, 2008.

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Back in June 2002 Retire Early used Prof. Robert Shiller's 1870-2000 stock market database to examine the correlation between safe withdrawal rates and P/E ratios. At the time, we decided the measure wasn't a strong enough predictor to recommend using it as a basis for taking larger retirement withdrawals. As the graph below illustrates, for P/E10s of 14 and above an initial withdrawal of about 4% is maximum rate that survived all periods examined.

In a recent article on his web site, Financial Planner Michael Kitces argues for higher retirement withdrawals when P/E ratios are low. Segmenting the data from Shiller's database into three ranges, Kitces recommends a withdrawal of 4.5% when P/E10 is above 20, 5.0% when P/E10 is between 12 and 20, and 5.5% when P/E10 is below 12. (For today's S&P 500 in the 1,200 range, the P/E10 is about 23.) The chart below illustrates these results.

The other interesting relationship that Kitces describes is the correlation between optimal asset allocation and P/E10. He found that even in times of high valuation (i.e., P/E10 = 20 - 44), a stock allocation of at least 60% resulted in larger survivable withdrawal rates. If your risk tolerance forces you to hold more fixed income securities and less stock, your withdrawal rate should be reduced accordingly.

Where are the fees and expenses?

While our 2002 study included a 0.18% annual expense ratio for an S&P 500 index fund, Kitces analysis doesn't seem to include investment expenses. Mutual fund fees have declined quite a bit since 2002. You could easily assemble a diversifed portfolio of low-cost index funds (such as the one below) for a lot less than 0.18% of assets today.

Adding a financial advisor to the mix greatly increases the annual investment expenses you'd pay. Though Kitces' firm Pinnacle Advisory Group doesn't disclose its fees on their website, similiar high-overhead firms charge as much as 1% of assets or more on a $1 million portfolio. (That's a $10,000 cut from a retiree's $45,000 annual withdrawal.) Potential clients need to look very closely at what value is being added and whether a 20% to 25% reduction in their spendable income is worth whatever "expertise" the financial advisor brings to the party.

What to conclude from this analysis?

Kitces presents a welcome piece of research for those retirees looking for a rational to support a larger retirement withdrawal. However, no one knows in advance whether they'll be retiring on the eve of a stock market crash or the next leg of a bull market. Personally, in an abundance of caution, I'd still limit my initial withdrawal rate to 4%. You can still spend more in the future if investment returns are favorable.

Resources for further information

Business Week 07/03/2008 - Spending Safely - an overview of some recent research on retirement withdrawals.