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Safe Withdrawal Rates and P/E Ratios.

Safe Withdrawal Rates and P/E Ratios.


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The article was first posted on June 1, 2002.

At least a few Retire Early readers have wondered what today's historically high price/earnings ratio for stocks mean for retirement withdrawals. The "100 safe" withdrawal rates often mentioned in the context of retirement withdrawals were based on 130 years of data (1871-2000) and include periods of high, low and average P/E ratios. If we look at the one hundred 30-year pay out periods from 1871 to 2000 for a 75% stock/25% cash portfolio, we see that the maximum initial inflation-adjusted withdrawal rate that would have survived for 30 years ranged from 4.265% for a retirement starting in 1966 to 10.722% for a retirement starting in 1879. The results for each 30 year pay out period are included in the data table.

75% S&P500/25% Cash Portfolio

Plotting the maximum withdrawal rate against the P/E ratio for the year prior to the start of the 30-year pay out period yielded the graph below. There is a discerable trend showing that higher P/E ratios at the beginning of one's retirement result in a lower withdrawal rate, but in no period did the initial inflation-adjusted withdrawal rate fall below 4.265%. It's difficult to make much of an extrapolation from this graph given that the three highest P/E ratios examined supported withdrawal rates from 6% to 10% (the years 1896, 1923, and 1935.) See data table.

The correlation coefficient for the plot below is -0.55, R-squared is 0.30.

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(Note:A few readers have asked, "Why does the Excel spreadsheet show a "100% safe" withdrawal of 4.26% while the online calculator shows 3.93%?" Click here for the explanation.)

100% Cash Portfolio

Making the same graph for a 100% cash portfolio (see below) illustrates the danger of holding all or most of one's retirement assets in fixed income securities. The "100% safe" withdrawal rate was only 2.352% and about one-quarter of the 30-year pay out periods examined supported maximum initial inflation-adjusted withdrawal rates below 4%. Looking at each year individually, there were seven 30-year periods out of 100 where the 100% cash portfolio beat the 75% stock/25% cash portfolio (1881, 1882, 1883, 1965, 1966, 1968, and 1969.) I'm not aware of any strategy that would allow the risk-adverse retiree to identify these seven 30-year periods a priori.

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100% I-Bond Portfolio

The plot for a 100% I-Bond portfolio (just below) shows much less variability than either of the first two charts above. Looking at each 30-year period individually, I-Bonds beat the 75% stock/25% cash portfolio in only 5 out of the 100 30-year periods examined (the years 1929, 1965, 1966, 1968, and 1969.) The maximum "100% safe" withdrawal rate for the 100% I-bond portfolio was only 3.790% for the 30-year period beginning in 1877 versus the 4.265% "100% safe"withdrawal rate for the 75% stock/25% cash portfolio in 1966.

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What to conclude from this study?

Whether or not we can conclude anything from this data depends on its confidence interval. All things being equal, more data points means more confidence. The results for P/E ratios from 10 to 20 where most of the data points fall have higher confidence than those that fall below a P/E of 10 or above a P/E of 20 where we have fewer observations. The P/E for the S&P500 has averaged about 14 over the past 200 years. The chart below shows safe withdrawal rates of about 4.5% to 10% for a P/E of 14. I'm not sure what you'd conclude from that other the obvious "lower is safer".

The correlation coefficient for the plot below is -0.55, R-squared is 0.30.

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Alternate Definition of P/E?

A few readers have questioned whether it would be "more proper" to use Shiller's Price/Earnings ratio based on trailing 10-Year average earnings. The data is replotted on that basis below.

The correlation coefficient for the plot below is -0.76, R-squared is 0.58.

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For more details on retirement withdrawals, check out the 68 page report How much can you safely withdraw from your retirement portfolio? (2nd Edition) available in our Retirement Reports Center


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Copyright 2002 John P. Greaney, All rights reserved.

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