My good friend Michael Kitces has posted an important article re safe withdrawal rates (and valuation-informed strategies in general) at his blog. It is called Should Equity Return Projections Be Reduced for Today’s High Shiller CAPE Valuation?
Juicy Excerpt #1: A look at the available market data suggests that realistically, it would be appropriate to reduce equity return assumptions by about 100bps (or 1 percentage point) over the next 30 years, to reflect the current valuation environment. Ironically, the reduction is not greater, because 30 years is such a long time that even if returns are bad for a period of time, there are enough subsequent years to recover as well.
Juicy Excerpt #2: Ultimately, then, the ideal way to adjust return assumptions in a retirement plan in today’s environment may not be to reduce long-term returns at all, but instead to do projections with a “regime-based” approach to return assumptions. This would entail projecting a period of much lower returns, followed by a subsequent period of higher returns, in a manner that more accurately reflects the impact of market valuation on returns – and better accounts for the sequence-of-return risk along the way as well!
Juicy Excerpt #3: While over 30 years, market valuation suggests that the long-term return should only be changed about 100bps above or below the overall average, on a 15-year basis low-valuation environments have an average real return of 10.4% while high-valuation environments average only 1.9%!
Juicy Excerpt #4: High valuation actually predicts good future returns beginning in 15+ years, albeit only at a “cost” of bad 15-year returns between now and then. In today’s context of high market valuation, this implies below-average returns between now and 2030, but unusually high above-average returns in the 2030s and 2040s!
Juicy Excerpt #5: The optimal way to adjust retirement projections for extreme levels of high market valuation is not to reduce long-term returns by a little, but to reduce “intermediate” term returns by a lot for the current low-return “regime”, followed by a subsequent period of significantly higher returns (as the first 15 years of low returns amidst any level of ongoing economic growth eventually results in a low return environment). Doing so is superior because it more properly matches the true risk of high-valuation environments: exacerbated exposure to sequence of return risk, as valuation extremes trigger an especially high likelihood of a bad decade of returns, which is especially problematic for retirees sensitive to the first decade’s worth of returns!
Juicy Excerpt #6: Today’s financial planning software packages are incapable of modeling regime-based retirement projections – not because it’s impossible, or even difficult, to program, but simply because it’s not be programmed to do so. Hopefully that will change soon!
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