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Another Look at Safe Withdrawal Rates and PE Ratios

Another Look at Safe Withdrawal Rates and PE Ratios

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This article was first posted September 1, 2008.

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Invest with DFA Funds, 12-Step Program

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.

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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.

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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.

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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.

$1 Million Retiree Portfolio Using Low-cost Index Funds
Fund Name Expense
$200,000 VFSUX Vanguard Short-Term Bond Admiral Shares 0.10% $200
$200,000 VAIPX Vanguard Inflation-Protected Securities Fund-Admiral Shares 0.11% $220
$300,000 VTI Vanguard Total Stock Market ETF 0.07% $210
$50,000 VBR Vanguard Small-Cap Value ETF 0.11% $55
$150,000 VEU Vanguard FTSE All-World ex-US ETF 0.25% $375
$50,000 VWO Vanguard Emerging Markets ETF 0.25% $125
$50,000 VNQ Vanguard REIT ETF 0.10% $50
------- . ------- -------
$1,000,000 = Total Portfolio Total Portfolio Expense = 0.12% $1,235

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.

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Copyright 2008 John P. Greaney, All rights reserved.

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