I’ve posted Entry #251 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Applying a Racheting Concept to Safe Withdrawal Rates Makes Sense But Only If Valuations Are Taken Into Consideration.
Juicy Excerpt: The core idea here is valid. Retirements fail because of big hits taken in the early years of a retirement. Even a retirement that called for a 4 percent withdrawal that started in 1996 (when prices were insanely high) will almost certainly survive 30 years because we did not see a crash until 2008, more than 10 years after the starting date for the retirement. Compounding is a powerful force. If a retirement enjoys 10 years of compounding, it is in good enough shape to withstand a major hit. If the hit comes in the early years of the retirement, the compounding cushion has not yet had time to develop to the extent needed to protect the retirement from the effects of a big hit.
The flaw in the Kitces’ concept is his idea of using a 4 percent withdrawal as the starting point. Shiller showed that valuations affect long-term returns. An obvious implication is that risk is not stable but variable. There can be no standard starting withdrawal rate for a research-based retirement plan. In some cases, the starting withdrawal rate should be 2 percent. In others, it should be 8 percent. In all cases, ratcheting makes sense if the early years of the retirement produce good results. But it is a terrible mistake to use 4 percent or any other percent as a standard starting point. The valuations factor is the biggest factor of all. It must be taken into consideration in all cases.
Imagine a retirement that began in 1996 and that employed a 4 percent withdrawal. That was a dangerous retirement plan because valuations were so high in 1996. However, as noted above, that retirement eventually became safe because we did not see a crash until 2008. However, had the retiree employed the logic behind the ratcheting concept to increase his withdrawal rate to something even higher than 4 percent, he would have increased the risk of retirement failure to a point where even the 12-year delay until a crash occurred might well not have saved it.