An earlier blog entry described the background of my recent correspondence with Michael Kitces on safe withdrawal rates (SWRs). Set forth below is the text of an e-mail that Michael sent me on October 18.
Rob,
Thank you so much for your response here. My apologies that my response will be relatively brief, but unfortunately I am wrapping up things here in the office because I am on the road for most of the week for speaking engagements. Ironically (in the context of this conversation), this trip also includes one presentation speaking about the details of how the existing safe withdrawal rate research works (the “Old School”) in your language, with a strong focus on the caveats and risks of applying that research blindly.
I must confess that I am still lost as to why you continue to attribute this belief to me that because I respect the foundation of the old school research that “it holds me back” or that I “don’t wish to warn people”. It is not accurate at all. It is simply that I do not find the Old School studies to be “analytically invalid”. To the extent that I do share your concern with them, which I do, it is because I have concern that they may be improperly APPLIED to scenarios in which their foundation may not hold. The Old School research was, in effect, predicated on evaluating the safe withdrawal rate for all historical scenarios under a P/E10 of about 30 (because that was the highest we had ever seen in history prior to the late 1990s). So broadly speaking, I have a lot of concern any time someone wants to use the Old School framework when the P/E10 ratio is over 30. Under 30, I find it still to be quite analytically valid – except that I am concerned that in low P/E10 environments, it may actually be too conservative, and thus the reason why I published my own research on this in my newsletter earlier this year. Likewise, I do share your concern that they may be overstated in ultra high P/E10 environments, and thus the reason why I also published on this aspect of the research in my blog. In any event, yes you have my permission to publish my email from this weekend on your blog to clarify this.
The reality is that in the past century, we’ve had one instance of P/E10 ratios significantly above 30. As we know, it was the stretch in the late 1990s and very early 2000s when the P/E10 ratios got much higher. Is it risky to have applied the Old School safe withdrawal rate value in this environment? Yes, because that valuation environment was outside the scope of anything ever studied in the Old School research. Does that mean the Old School research is invalid? No, it’s not. It simply means you have to be careful where you apply it, and not to apply it in a situation where it may still have risk. Does that mean the 2000-2029 retirement time period will actually invalidate the Old School safe withdrawal rate value? Perhaps. We’ll see. I do have concern that it might do so, for all the reasons about the normal progression of P/E contraction on returns, of which we’re both well aware.
All that being said, frankly the reason I do not seem to have the alarm that you do is because I just don’t see the impact that you do. The extra-ordinary P/E10 ratios that crossed outside of the bounds of the Old School research have been gone for several years. In point of fact, we’ve gone through such a P/E10 contraction in the past 3 months, that we’re suddenly coming closer to the point where the Old School safe withdrawal rate may be too conservative, not too aggressive. The primary and sole damage here is really just for those who actually retired right around 1998 to early 2001, when the P/E10 ratios really spent a lot of time way above 30, where the Old School safe withdrawal rate may be undermined. Just for clients that retired in those years. And I have to tell you, as someone who has spoken on this topic for a few thousand financial planners over the past several years, I have yet to EVER see a single planner and client that are walking like lemmings off a cliff insistently maintaining a 4% withdrawal rate based on an account balance circa 1999. They have all monitored and made adjustments since then, in some way, shape, or form, whether it was moderating spending for a few years, shifting other goals, or making portfolio changes. Yes, in point of fact this does mean that a few people may have had to cut spending a little more than anticipated (since they were theoretically not supposed to need to cut at all since it was THE safe withdrawal rate), but they’re managing through this environment. And frankly, given the relatively short span of years, the different just isn’t that great to begin with. The client who retired in 2000 and started withdrawing $40,000 from a $1,000,000 portfolio, when they perhaps should have been spending $25,000 to $30,000, still only spent an extra $20,000 – $30,000 cumulatively over the first few years before likely considering an “adjustment” due to the severity of the bear market. Granted, those extra withdrawals do add up over time, but at the end of the day we’re only talking about cumulative spending of 2% to 3% of the original portfolio over those first few years. Frankly, for most clients, poor investment selection would have had *FAR* more of an impact on their retirement success than this extra spending in the first couple of years. And again, for all the clients I’ve seen from planners across the country, they’ve been making some kind of adjustments since then. They’re not lemmings walking off the cliff. Now, I don’t know what the general public who doesn’t work with a financial planner is doing – that’s beyond my scope of awareness – but I have trouble believing that much of the general public is walking like lemmings into retirement spending oblivion either. Frankly, I have found almost no one who doesn’t work with a planner who has enough familiarity with safe withdrawal rates to place such blind, unequivocal trust in the system in the first place, so I have to admit I am skeptical that the impact is anywhere near as broad as the “millions” you indicate in your email.
Of course, that doesn’t mean I don’t value the importance of developing the research further, and getting the word out about these issues; my point is simply that the “failure” time zone where the Old School studies may actually cause failure was relatively brief, that most individuals seem to have already adjusted themselves (if only because they didn’t have THAT much faith in the original research to begin with), and that I am skeptical about whether we will ever again in our lifetimes see P/E10 ratios significantly above 30 again (which means the Old School research may continue to be relevant for every retiree I ever meet for the rest of my life). On that basis, I certainly think that developing the body of research is important, and I have no qualms about seeing old research debunked or to otherwise evolve into better models. It’s just that I don’t find them to be THAT broken when I look prospectively at how to advise clients going forward, and the clients from the past that might have gotten into trouble seem to already be making adjustments.
To answer your original question about how this came to my attention – someone contacted me through my website because they read your quote (which I cited below) on the message boards here: http://www.s152957355.onlinehome.us/cgi-bin/yabb2/YaBB.pl?num=1224342317, and was shocked to hear that I would state I don’t want to warn people about risks because it would disrespect past studies. I responded to him, as I responded to you, that it is not at all an accurate characterization. I have never, ever said that I don’t think this area is an issue, and I most certainly have NEVER said that I am reluctant to speak about it for fear of “disrespecting” past research. To the contrary, I have both written to point out these issues, and regularly address them in my speeches on this topic at numerous conferences throughout the country all year long.
Sorry I don’t have time to write more, but I hope that helps a little!
With warm regards,
– Michael
Clap, clap, clap!
Kitces letter is the best post I have read in weeks!
Thanks for sharing your thoughts, TimeCube.
Rob
I have to tell you, as someone who has spoken on this topic for a few thousand financial planners over the past several years, I have yet to EVER see a single planner and client that are walking like lemmings off a cliff insistently maintaining a 4% withdrawal rate based on an account balance circa 1999. They have all monitored and made adjustments since then, in some way, shape, or form, whether it was moderating spending for a few years, shifting other goals, or making portfolio changes.
Many people trash financial planners. I do not. I believe that they often add value, as indicated by these words.
In contrast, I have seen many words on discussion boards advocating that people stick with the 4% (plus inflation) number in spite of what is happening.
Have fun.
John Walter Russell
“I have seen many words on discussion boards advocating that people stick with the 4% (plus inflation) number in spite of what is happening.
John Walter Russell”
Mr. Russell,
Isn’t that what Mr. Kitces is proposing? I may have misunderstood his letter (in which case, you will correct me), but isn’t he saying in plain English that 4% is at least adequate, and sometimes far more than adequate, as an SWR for all likely P/E10s, including those up to P/E10 30, which only occurred once in history, and which he considers unlikely to see again in his lifetime?
isn’t he saying in plain English that 4% is at least adequate, and sometimes far more than adequate, as an SWR for all likely P/E10s, including those up to P/E10 30, which only occurred once in history, and which he considers unlikely to see again in his lifetime?
I of course do not speak for John.
My view is that the words above are a fair description of Michael’s views.
Rob
They have all monitored and made adjustments since then, in some way, shape, or form, whether it was moderating spending for a few years, shifting other goals, or making portfolio changes.
And so, I believe that Michael Kitces would do even from lower levels of P/E10 if he discerned warning signs.
Have fun.
John Walter Russell
A counterpoint on your “Panic” podcast of a few days ago from Burton Malkiel
Keep Your Money in the Market
We’ve been through ups and downs before.
By BURTON G. MALKIEL
As the world economy reels under the weight of the worst financial crisis since the Great Depression, we have been left with a broken financial system. Financial institutions around the world have suffered life-threatening, self-inflicted wounds by purchasing over a trillion dollars of complex mortgage-backed securities backed by dodgy loans based on inflated real-estate values. These assets have been financed with enormous leverage and with short-term debt. Just prior to its “rescue,” Bear Stearns had a debt to equity ratio of over 30 to 1, making it susceptible to a “run on the bank,” although Bear was not a commercial bank but rather part of the “shadow banking system” built on derivatives.
The long-run solution to the present crisis must involve substantial deleveraging and a recapitalization of our financial institutions. In the meantime, credit has been essentially frozen and a world-wide recession seems almost inevitable.
But just because stock markets have panicked, investors should not. The best position for investors today is not “fetal and 100% in cash.” We are not going to have a depression, and we have survived financial crises before. A century of investing experience, as well as insights from the field of behavioral finance, suggest that investors who bail out of equities during times like these are almost always making the wrong decision.
It is very tempting to try to time the market. We all have 20/20 hindsight. It is clear that selling stocks a year ago would have been an excellent strategy. But neither individuals nor investment professionals can consistently time the market. The herd instinct is extraordinarily powerful. When the economy and the stock market were booming in early 2000, investors could easily convince themselves that prosperity would continue without interruption and that stocks catering to the “New Economy” were surefire tickets to wealth. Individuals poured more money into equity mutual-funds during the last quarter of 1999 and the first quarter of 2000 than ever before. And not only was the timing wrong but so was the selection of funds. The money flow was directed to the hot Internet funds. Investors liquidated “value” funds that owned less exciting businesses, whose stocks sold at only modest multiples of their earnings and book values.
The herd instinct works exactly the same way in bear markets. Nervous investors convince themselves that every “light at the end of the tunnel” is a train coming in the opposite direction. Panic is just as infectious as blind optimism. During the third quarter of 2002, which turned out to be the bottom of a punishing bear market, investors redeemed their mutual funds in droves. My own calculations show that in the aggregate, investors who moved money in and out of equity mutual-funds underperformed the buy-and-hold investors by almost three percentage points per year during the 1995-2007 period.
Look at history: The market eventually bounded back from the damaging stagflation of the 1970s and the savings-and-loan crisis of the early 1990s, when a whole industry had to be rescued. Stocks also recovered from the Asian crisis of the late 1990s. Similarly, investors who held on after the more than 20% one-day stock-market decline in 1987 were eventually well rewarded.
So what should investors do? By all means, young 401(k) investors, and those in their prime earnings years, who are stashing away funds from every monthly paycheck, should stay the course. If you decide to eschew equities during periods of ubiquitous pessimism, you will lose all of the advantage of “dollar cost” averaging (buying more shares when prices are low than when they are high). Asset allocations should be shifted to safer securities over time as the investor ages, but only gradually and on a set schedule as through a “target maturity fund.”
If you are now approaching retirement and failed to move to a more conservative asset allocation, you should not do so now in response to a time of panic. If anything, well diversified investors should, at the end of each year, consider rebalancing to ensure that your portfolio composition remains consistent with the risk level appropriate for your financial circumstances and tolerance for risk. But this is likely to mean shifting into equities and not out of them.
Suppose you started the year with a portfolio of half stocks and half Treasury bonds. You are likely to find that the value of your bonds has gone up, as Treasury yields have fallen, and your stock portfolio has declined. Suppose the allocation at rebalancing time is two-thirds bonds and one-third stocks. The appropriate strategy is then to sell safe bonds and buy more equities to bring the stock/bond ratio back to 50%. Over the past decade, rebalancing a 50-50 portfolio each year has added to investors’ returns and reduced risk.
We will have a serious recession now, but a 1930s-style depression is highly unlikely. We will not let the money supply decline by 25%, as we did in the ’30s, and automatic stabilizers (like unemployment insurance) are now a significant element of fiscal policy. Don’t forget that the U.S. economy is still the most flexible in the world and our “innovation machine” is alive and well.
No one has consistently made money by selling America short, and I am confident the same lesson is true today.
Mr. Malkiel is a professor of economics at Princeton University and the author of “A Random Walk Down Wall Street,” 9th ed. (W.W. Norton, 2007).
Thanks for your contribution, Index Enthusiast.
Please in the future provide a link rather than the full text of an article. I do not own the rights to that article. It is okay to provide a few snippets of text from the article as well as a link as that is permitted under the Fair Use Doctrine.
Rob