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 to me on August  26.

Rob,
A few quick thoughts, as unfortunately my time is a little constrained this morning but I did want to get back to you!

— As a general framework, yes I agree completely that new research builds on old research. I most definitely do NOT view the existing body of research on SWRs as the final conclusion. It is a body of research that is still developing and evolving. So I welcome all new contributions and work that seeks to build upon the body of knowledge and advance it further (and hope that my own work on SWR valuation impact will be viewed as such a contribution).

—  I do believe that Russell’s work has to be viewed as theorizing at some level. We do not KNOW how the subsequent market returns WILL operate coming off of P/E10 valuation levels upwards of 40 (i.e., circa 2000), because it’s never happened. We can apply reasonable theories to at least assume that the long term returns will be diminished – certainly, we have an ample framework within the economics body of knowledge to help us clearly understand the relationship that P/E contraction has to forward returns. But the ultimate safe withdrawal rates are not built solely upon the average returns over the time period. They are also built upon the return sequencing, and we do not know for certain how such overvalued markets ultimately will unwind (a point you make later in your email – impact of both starting valuation, and return
pattern/sequencing). Certainly, from an SWR perspective, there is a dramatic difference between correcting valuations through sideways markets with earnings growth (contraction via the denominator) versus price declines (contraction via the numerator). The timing can still be crucial from an SWR perspective, even though either can (and I expect will) validate the general framework of depressed long-term returns due to overall P/E contraction. So this is the context in which I suggest that Russell’s work still “theorizes”. I also believe it “theorizes” at some level, because to my knowledge NO ONE has good research on how the depth of today’s available diversification options will really impact the whole picture (e.g., easy ETF availability of gold, commodities, various forms of real estate, international, small caps, emerging markets, etc.). Granted, as the saying goes “diversification today isn’t what it used to be” – but there is still a lot of uncertainty here. Again, I don’t necessarily believe that Russell’s conclusions are wrong – my only point is that there’s a difference between what has actually BEEN observed, versus what we reasonably anticipate given our current framework to model the future (given the risks that our models, assumptions, logic, etc. may turn out to be wrong).

—  Likewise, I don’t really view Russell’s conclusions as being “different” from the Old School. At “worst,” they are simply additive. The Old School has never put forth the safe withdrawal rate for a P/E10 of 40, because the Old School (via its methodology of historical observation) has never SEEN such a valuation period and the subsequent market returns and the safe withdrawal rate that would have occurred. I view the Old School as agnostic on this issue (at least, if their research results are stated properly), not in disagreement. Certainly, the Old School research can and has been overgeneralized by some (in a dangerous way sometimes, I agree), and incorporating valuation gives us a language to help explain WHY the year 2000 environment was different than anything the Old School studied. But I don’t view these bodies of research as contradictions (yet – ask me again in 2029 🙂 ), but as progressions.

— I agree with you on the absurdity of the paradox between the year 2000 and 2002 retirees. Thus, my research work in this area, and the reason why I framed my research specifically in the context of that paradoxical issue! 🙂

— It’s also worth noting that I agree with you that different valuations merit not only different SWRs, but also different investment strategies. Our firm applies a tactical asset allocation approach for managing our clients’ wealth, built on this exact framework. We do NOT believe in passive investing, primarily because it unnecessarily exposes clients to high risk during high valuation periods, notwithstanding the fact that we KNOW it’s risky because we KNOW the risk and long-term impact of high valuations. This philosophical approach on the investment side is what draws many of our clients to the firm. And I still intend to follow-up my prior research and valuations by exploring the impact of basic portfolio allocation changes in response to market valuation – I expect it will also yield very interesting results! I alluded to this somewhat directly when I briefly discussed the investment implications in my newsletter research article. But the bottom line is that I agree with you fully that there are significant risks inherent in the passive investing approach that are not understood by most (consumers and financial planners) when viewed from a withdrawal lens, and today’s markets are proving the point to the detriment of many. 

– I do still disagree with you that the Old School methodology is so “rooted” in the passive approach. True, it does not make portfolio adjustments in the SWR allocations along the way, but as far as I can see neither does your calculator (it assumes that starting equity exposure is the same equity exposure throughout). These are all implicitly passive portfolios. And again, from my perspective that simply means that we still need to further explore the impact of being more “active” in investment management and its impact on SWRs – it doesn’t invalidate active management, but is simply agnostic on the issue. At the end of the day, the “worst” period studied in the Old School research was a P/E10 in the low-to-mid-20s, and it produced an SWR of about 4%. Your own methodology and calculator produces a fairly similar result. In other words, you’re both honing in on the same fundamental worst case scenario. The difference is that your research work is expanding the scope to say “what if valuations were WORSE than that” while the Old School simply never addresses that question. But I don’t view either as being particularly predicated on passive investing any more than the other. The difference is simply that the Old School assumes that the worst scenario in history by definition will incorporate the worst valuation in history (and it basically does), while you look forward at the possibility that valuations may be even worse (which the subsequently were). In essence, that means you were both right in your respective paths. Whether you should invest differently BASED on that outlook, though, is really a separate discussion from either body of work (albeit a natural extension from here – but that’s how the body of research builds on itself over time).

—  The Old School never said that valuation doesn’t matter, per se. To the contrary, it said that you should ALWAYS take an SWR of about 4%, REGARDLESS of valuation, inherently forcing people to be conservative even when valuations are favorable. It is anchored ONLY to bad valuations (at least as measured by those we’ve seen in history with a subsequent 30-year track record to show the outcome). If valuations do matter, then the New School will tell you to target a 4% SWR with valuations in the low-to-mid-20s, and so will the Old School. The difference is that when valuations are MORE favorable, the Old School is unnecessarily conservative (one of the points of my research), and when valuations tread outside the range ever seen by history, the New School TRIES to theorize the likely outcome while the Old School waits to see what happens and makes prescriptions thereafter. The latter point is probably the most effective criticism of the Old School from a public policy perspective, because it doesn’t do anything for the “first” generation to actually live THROUGH a new-record high valuation period (as the retirees circa 1999-2001 did).

Well, that didn’t turn out to be as short as I’d planned. Time to wrap up a few other projects for the morning. 🙂

With warm regards,
Michael

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 I sent to Michael on August 25 .

Michael:

Thanks so much for crafting that e-mail. We do not agree on everything, but we agree on a great deal. And on several of the points re which we do not agree, I think you are making points that need to be given careful consideration.

As I mentioned earlier, I intend to post both your e-mail and my e-mails as blog entries (please let me know if there are any comments that you would like to keep private). Your comments are going to be a big help to my readers. I hold strong beliefs re SWRs and I worry at times that my blog presents too unbalanced a take. I of course need to state my own views at the level of confidence that I hold on them. But I am grateful when someone is able to offer some reservations about my views as effectively as you do in the words below. That will cause those who tend to agree with me to think things through more carefully and that is obviously a good thing for all concerned. I’m less likely to change my mind given how much effort I have already put into understanding this stuff, but your comments at least prompt me to do some rethinking as well, and that too is of course a very good thing. So — thanks, man!

I don’t think it is right to say that Russell is “theorizing.” He uses the same data that the Old School researchers use. He does not employ Monte Carlo techniques. So he is not speculating about what may happen different in the future. He is REPORTING what the SWR is presuming that stocks perform in the future somewhat as they always have in the past. That’s just what the Old School researchers purport to be doing.

Both cannot be doing this and coming to such different conclusions! You are absolutely right to say that John’s findings are only as good as his model. The same is true of the Old School researchers. One of the models is wrong, and the findings produced by that model is doing the aspiring retirees who use it to plan their retirements great harm. I honestly do not see any way that that conclusion can be sidestepped.

Before I go on, please let me note that I do not mean by those words to show any disrespect for the researchers who constructed the earlier methodology. Nothing could be farther from the truth. Bill Bernstein has described the Trinity study as “breakthrough research.” I view that comment as being right on the mark.

That said, though, I strongly believe that the methodology used in the Old School studies is analytically invalid. Both things are so. The Old School studies took us to levels of understanding that were not possible before they came out and those new levels of understanding opened the door to the further advances achieved with the New School studies.

New research always builds on old research. It is by collectively saying the words “I” and “Was” and “Wrong” that humankind moves forward day by day.

To determine who is right, you need to look at the two models used to report what happened in the past and form an assessment as to which model is proper. That’s what this comes down to.

There’s a paradox in the Old School studies that you made mention of in your study. The paradox is that the take-out percentage that is declared “safe” for the fellow who retired in 2000 is also declared “safe” for the fellow who retired in 2002 even though the fellow who retired in 2002 has only half the assets because of the drop in prices suffered during those years. This makes zero sense, Michael. It is absurd and the Old School researchers need to come to terms with the analytical error that made this absurd paradox a reality of SWR research for all these years now.

It cannot possibly be “safe” for the fellow who retired in 2000 to take double the money out each year (because he is applying the 4 percent withdrawal rule to a portfolio value double the size of the one to which the 2002 retiree is applying the 4 percent rule).  A model that produces such absurdities is a gravely flawed model.

The flaw is the failure to adjust the SWR for the effect of valuations.

There are two things that affect the SWR: (1) the return pattern that happens to come up (which cannot be known at the time of retirement); and (2) the valuation level that applies at the start date of the retirement (which is known). At a P/E10 level of 19, an 80 percent stock-allocation portfolio has an SWR of 4.1 percent. That obviously doesn’t mean that nothing above 4.1 percent will work. It means that 4.1 works in the worst-case scenario. In a best-case scenario (the most favorable returns sequence we have seen in the historical record), a withdrawal rate of 7.1 percent works. So the range of possibilities covers three percentage points of withdrawal rate.

The same three percentage points of withdrawal possibilities applies at the other valuation levels (since the range of possible returns sequences is the same). But the starting point of the three percentage points of withdrawal possibilities (it is this point on the spectrum of possibilities that we call the “safe withdrawal rate”) is NOT the same. At a P/E10 of 26, the range is from 3.12 to 6.13. At a P/E10 of 14, the range is from 5.41 to 8.41. At a P/E10 of 8 (which we may be seeing in the not-too-distant future), the  range is from 9.13 to 12.13.

The strategic implications are huge. It’s not just that the Old School studies report the SWR wrong (although that in itself is a big deal as it is likely going to cause great amounts of human misery). What the historical data is telling us is that people should be changing their stock allocations when prices change dramatically. The long-term value proposition of stocks is just too different at dramatically different valuation levels to justify a strategy (Passive Investing) in which the investor stocks to a single stock allocation no matter what.

When we debate SWRs, what we are really debating is whether Passive Investing makes sense or not. I certainly do not say that people who believe in Passive Investing should not put forward their views. We of course need to hear those views. But the reality today is that the Old School studies are claiming that Passive Investing is “safe.” They are using the Passive Investing model (without even knowing it in most cases) to determine how we should construct our retirement plans and then declaring that is is “safe” to not even consider the possibility that the Passive Investing model is gravely flawed. This is arrogant, dangerous, and irresponsible. I don’t say that the intent of the researchers is to be those things. I say that the consequence of their too easy acceptance of the merits of the Passive Investing model is to fall guilty of generating claims that in fairness can be so characterized.

The problem would`largely go away if the researchers added caveats saying: “This study reports what is safe in the event that the Passive Investing model holds up; those who do not have confidence in the Passive Investing model should review the New School studies, which are rooted in an entirely different model of understanding how stock investing works (I call the alternate model “Rational Investing,” because it is rooted in an acceptance of the obvious [to me, at least] reality that valuations affect long-term returns). If such a caveat were included, investors using the studies would know what they were getting when they took them into consideration.

As things stand today, the investors making use of these studies view them as “scientific.” The common belief is that the studies are just reporting what the numbers say. The debate that rages today below the surface of much discussion of most financial planning discussions (whether valuations truly affect long-term returns or not and whether long-term returns are thus to a large extent predictable) is not mentioned. Most investors are not aware that, when they read the Old School studies, they are reading findings rooted in one particular school of thought only, a school of thought that very much appears (at least to me) to be well on its way to being entirely discredited.

I’d like to move away from discussion of the numbers for a moment to illustrate the critical importance of this last point. We have been discussing the flaws in the Old School SWR studies for over six years at the Retire Early and Indexing discussion-board communities. We have had thousands of people respond in extremely positive and constructive ways. We have also had a good number respond in hostile and abusive ways. Here is a link to an article at my site in which community members ask that the abusiveness that has so marred our discussions (resulting in bans on honest SWR posting at numerous boards!)  be reined in:

http://www.passionsaving.com/investing-discussion-boards.html

Many of the people who have come to place their confidence in the Old School studies have reached a point where they have given up on the idea of being able to present their views in a civil and reasonable way. Why? What does this say about the methodology used in these studies? What it says is that the methodology gives the appearance of being science when in reality it is very much not science. The Old School methodology is rooted in an implicit acceptance of the Passive Investing model. People need to know this. When people use those numbers to plan their retirements, they are buying into an investing philosophy that may or may not hold water (I strongly believe that the Passive Investing model does not hold water). This should be stated up front as a caveat.

Again, I do not say that people should not be permitted to say that Passive Investing holds up. Just as it would be dishonest for me to say that I believe in Passive Investing, it would be dishonest for those who believe in it to say that they do not. But retirement advice that reflects only one point of view on how investing works (a point of view that has certainly not been proven to be the right one) should not be presented as “science.” These studies need to be questioned. For them to be effectively questioned, there needs to be a widespread understanding that they reflect a particular point of view, one that is itself not science.

You said earlier that you view the Old School and New School approaches as different research pathways. There’s a sense in which that is right, but there is also a sense in which it understates the problem we are facing today. The two approaches do indeed explore different pathways. What needs to be better understood is that the two pathways cannot both be proper pathways. Either valuations affect long-term returns or they do not. If they do not  (or if for some reason effective predictions of long-term returns are not possible), the Old School studies are right and the New School studies are wrong. If valuations do affect long-term returns (and effective predictions are to at least some extent possible), the New School studies are right and the Old School studies are wrong.

Either there is a  need to make an adjustment for valuations in determining the worst-case scenario or there is not. If there is a need to make such an adjustment and the adjustment is not made, millions of middle-class retirees will likely suffer busted retirements in days to come as a result. The financial planning community should be doing all that it possibly can to prevent this frightening scenario from becoming a reality. No?

Rob

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 to me on August 24 .

Rob,

I don’t mean to understate the impact, but I think the essence of your disagreement with the Old School SWR research really boils down to nothing more than the implicit assumption of the original SWR research that “by definition” the worst case scenario that has ever occurred in history IS the worst case scenario. Obviously, you believe differently – with what I believe is a reasonable basis for doing so – particularly to the extent that valuations since the first SWR research have left the range of the original SWR research history (i.e., the valuations at the start of the decade were beyond anything measured in any mid-1990’s historical SWR research).

However, I don’t entirely agree with your analogy example. It is true that the original SWR research looked at ALL scenarios, regardless of valuation. But I don’t believe that, in and of itself, is necessarily a flaw. If you look at every case scenario in history – all the good ones, and all the bad ones – and pick the absolute worst, by definition you have already included all of the worst valuation periods in history. This is supported not only theoretically, but in practice – the worst SWR in history, using the Old School approach, correctly identified that the worst case actual historical scenario really WAS 1966-1995, and as WE know it turned out this way BECAUSE that was in fact the secular valuation peak of that era. By your drunk driver example below, the comparable analogy of the old school research is to say that because there was at least one instance ever where a drunk driver had an accident, the conclusion is to NEVER drive AT ALL, because it might turn out that you’re drunk and that an accident may result. Likewise, the old school SWR research indicated that because anything more than 4% might have failed once in history, you should never take anything above 4%, and therefore you will never fail under any historical scenario. By definition, that already incorporates EVERY bad valuation scenario (because the research looked at all of them).

The “flaw” of the research, in essence, is the implicit assumption that a withdrawal that survives EVERY historical scenario (REGARDLESS of valuation, good or bad) must be safe in any future scenario. It assumes that nothing in the future could ever be (materially) worse than the historical record. Ironically, Bengen did his first research on this in 1993, and it only took 7 years for us to produce a dramatically worse valuation environment, that ultimately probably WILL demonstrate a “new low” in required safe withdrawal rates.

But for better or for worse, the fault of the research is simply the assumption that “any withdrawal rate which survives every historical scenario will survive every future one.” Now of course, I don’t believe any prudent practitioner quite delivers the advice that way – there’s always an *asterisk footnote that indicates the future might really produce a scenario worse than any historical scenario – but the progress of John Walter Russell’s research is to provide a better framework about HOW those failures might happen and WHEN they might happen. At the end of the day, Russell theorizes that there was only a 1-in-3 chance of actually surviving the 1966 retirement at 4% [Editor’s Note — I believe that Michael meant for this to be a reference to retirements beginning in January 2000; a 4 percent withdrawal had a 2-in-3 chance of surviving for retirements beginning in the mid-1960s, according to Russell’s research]. That’s ostensibly because his models deliver a wider range of potential results than “just” what happened in history. Realistically, either he’s right, OR his model is wrong.

Obviously, I’ll grant that I think there’s a lot to the approach he utilizes, and I don’t mean to claim that I think his model is invalid. But the reality is that his model is a THEORY of what other alternatives might have happened, and likewise what might happen in the future. The 4% SWR still has never ACTUALLY failed any of the historical scenarios we can produce using the real data, which by virtue of being what really happened automatically accounts for all the economic complexities that Russell’s models MIGHT be failing to fully incorporate (e.g., to what extent are the correlations, cross correlations, serial correlations, cross-serial correlations, etc. REALLY fully modeled, and to what extent do simplifying modeling assumptions create a model that deviates from reality?). 

Again, I agree with the approach that Russell is exploring, PARTICULARLY to the extent of valuations that are larger than anything our historical SWR research has ever been able to observe in full. And I think it’s a valid criticism to at least question whether the 4% SWR approach might be pushing it a little too tightly at simply any valuation point that happens to coincide with a similar historical high valuation point (which we still see at today’s valuation levels). But I still feel compelled to show some respect to research implying a safe withdrawal rate that really WOULD have genuinely survived every historical scenario our markets have ever actually followed.

But that’s why it’s still an evolving body of research. 🙂

On a sidenote, I’m moderating a panel session at the NAPFA Northeast Regional conference in Hershey, PA, this November – and the topic is entirely about safe withdrawal rates, and my panelists will be Bill Bengen and Jon Guyton (arguably THE two leading researchers on SWRs from the financial planning community). One of my goals for the session is to invite both of these individuals – who are both researchers and planning practitioners who work with clients – about how their views may have changed over the past 8 years of market history and in their work with clients. I’m very curious to see how the session goes! 

With warm regards,
Michael