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Retiring in a Low-Return Environment

January 20, 2015

by David Blanchett, Michael Finke and Wade Pfau

Low bond yields and high equity valuations suggest lower spending for retirees. Prior research forecasted the impact on safe-withdrawal rates (SWRs), but a more sophisticated model can improve the accuracy of those predictions. We show just how low the SWRs should be for today’s retirees.

SWR research, such as the well-known 4% rule, is based on a portfolio of stocks and bonds using historical return data.  As we have shown in recent studies published in the Journal of Financial Planning, the Journal of Wealth Management1 and the Retirement Management Journal, the sustainability of retirement portfolios is highly sensitive to asset returns – particularly in the first decade of retirement.  Even if bond yields rise, today’s retirees face greater shortfall risk because the value of portfolios invested in bonds will fall. 

Equities are also not as safe as they have been historically.  When prices are high (based on P/E ratios), future returns are more likely to be disappointing.  In our paper published in the Retirement Management Journal, we demonstrated how using returns calibrated to current asset valuations instead of historical average returns leads to a much more pessimistic estimate of SWRs for retirees.

Most retirees don’t annuitize and most investment advisors don’t recommend annuities.  Without an annuity, a retiree needs to select an amount to spend each year from a portfolio.  A reasonable goal is to withdraw as much as possible from an investment portfolio without running out of money.  In order to estimate how much can be safely withdrawn each year, an advisor must make a number of assumptions about things like life expectancy and portfolio returns, typically using historical return data for projections.

The problem with prior research

William Bengen developed the 4% rule-of-thumb for retirement withdrawals in 1994.  He found that an individual could have withdrawn 4% of their retirement-date assets, with spending adjusted each year for inflation, over a 30-year retirement period using a portfolio invested in 50% to 75% stocks. The Trinity Study from 1998 updated this approach for a variety of scenarios and confirmed that a 4% withdrawal rate based on 20th century U.S. portfolio returns would have allowed a retiree to withdraw the same real income each year with only a small chance of failure.

A problem with using historical U.S. asset return data is that future market performance (and retirement outcomes) will depend on the price of stocks and bonds today. Stock returns depend on dividend income, earnings growth and changes in the valuation multiples placed on those earnings.  If the current dividend yield is below its historical average, then history suggests that equity returns following periods of high valuations will also be lower than average. This is mainly because earnings growth is relatively stable.  Stocks are priced based on supply and demand; higher prices indicate a lower required equity risk premium and/or a lower risk-free rate.

Returns on bonds depend on the current bond yield and on subsequent yield changes. Low bond yields predict lower holding period returns from less income and the heightened risk associated with capital losses if interest rates rise.

SWRs are directly related to the returns provided by the underlying investment portfolio. In particular, the returns experienced in early retirement will weigh disproportionately on the final outcome. Current market conditions are much more relevant than historical averages.

We question the relevance of research based on what worked in the past. The U.S. historical record is relatively slim for determining how much can be safely withdrawn from a rather aggressive investment portfolio. Past outcomes have little bearing on the unique situation facing today’s retirees.

This is much more than just an academic exercise. Relative to their historical averages, bond yields are very low and stock prices are high.  Generally, low bond yields have coincided with flights to safety from stocks resulting in attractive equity valuations that subsequently bailed out a balanced portfolio.  But today bond rates are low and equity valuations are high at the same time. 

Fortunately, we do know how well bonds have done after a period of low yields.  And we also know how equities have performed after a period of high valuations.  We can simulate a portfolio that consists of expensive equities and low yielding bonds in the future to determine how such a portfolio will theoretically perform in the future, even if no expensive stocks and bonds existed simultaneously at today’s levels.

In this analysis, we’ll use bond yields to forecast bond returns and the cyclically-adjusted price-to-earnings (CAPE) ratio to forecast equity returns. Results provide guidance for advisors as to the appropriate SWR to recommend to clients. 

  1. See the working paper version here