A Rich Life

The Old Ideas on Saving & Investing Don't Work -- Here's What Does

“Everyone in This Field Should Be Urging the Authors of the Studies to Make Corrections”

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Set forth below is the text of a comment that I put to a blog entry at Wade Pfau’s site titled Trinity Study Updates:

we will not know if there is going to be an increased failure rate for another 20-30 years.

This statement is of course 100 percent true. However, I have a different and I think far more realistic and prudent and proper way of looking at things.

A safe withdrawal rate study is not supposed to tell us what withdrawal rate may work. It is supposed to tell us what withdrawal rate absolutely will work (presuming that stocks perform in the future as they always have in the past). A possibility that has only some small chance of coming to pass cannot properly be referred to as one that may “safely” be assumed. When aspiring retirees turn to research to learn the safe withdrawal rate, they are seeking to learn the withdrawal rate that will work in a worst-case scenario, not a best-case scenario or even a typical scenario.

In the past, valuations have always affected long-term returns. So the proper way to look at this question is to apply a valuation adjustment and see how well the 4 percent rule works then. The answer is — presuming that stocks perform in the future as they always have in the past, there is a 30 percent chance that a 4 percent withdrawal rate will work for retirements that began at the top of the bubble (January 2000).

Yes, there is a chance that the 4 percent rule will “work” for a third time. But those who are willing to speak frankly about these matters can say today that the odds are very much against it. The Old School safe withdrawal rate studies tell us not the safe withdrawal rate but the withdrawal rate that may or may not work depending on what sort of return sequence happens to pop up. Those are two very, very different concepts.

In the event that stocks perform in the future as they always have in the past, we are likely to see millions of failed retirements as a result of the analytical errors contained in the methodologies employed in the Old School studies. It is my strongly held view that everyone in this field should be doing all he or she can to urge the authors of the studies to make corrections and to warn the millions of retirees who have used these studies in their planning efforts of the dangers associated with using them.

William Bernstein, author of The Four Pillars of Stock Investing, once said that those considering making use of one of these studies to plan a real-world retirement would be well-advised to “FuhGedDaBouDit!” You gotta love a New Yawker’s way of getting to the heart of the matter in a whole big bunch fewer words than I put forward in this blog comment!

Rob

Retirement Planning As If Valuations Mattered

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I’ve posted a Guest Blog Entry at the Retire Happy blog. It’s called Retirement Planning As If Valuations Mattered.

Juicy Excerpt: Safe withdrawal rate analyses look to worst-case scenarios. If you want the highest safe withdrawal rate possible when stock valuations are high, you need to go with a very low stock allocation. But you might be able to juice up your return a bit by going with a higher stock allocation so long as you understand that you are taking on more risk by doing so.  How much more risk?

In this scenario, a stock allocation of 20 percent offers a safe withdrawal rate of 3.90 and a stock allocation of 60 percent offers a safe withdrawal rate of 3.43. The safe withdrawal rate is defined as the withdrawal rate that has a 95 percent chance of working out, presuming that stocks perform in the future at least somewhat as they have always performed in the past. Please move your eye from the “Safe Withdrawal Rate” column to the “Reasonably Safe” column for the 60 percent allocation. The withdrawal rate moves up to 3.89 percent, as good as the safe withdrawal rate for the 20 percent stock allocation.

There is a 20 percent chance that a retirement plan using only a “Reasonably Safe” withdrawal will fail. So there’s some added risk here. But, if you are willing to live with that risk, you can feel free to go with the much higher stock allocation and the possibly higher returns that may go with it.

“Wall Street Has Polluted the World with Self-Serving Theories. The Entire Debate Is Debased & Devalued”

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Reuters Blogger Felix Salmon has written an article applauding the retirement planning approach developed by Wade Pfau and described by him in the blog entry posted here a little over a week ago titled Wade Pfau: This Paper…Suggests that the Traditional Approach to Retirement Planning is Counterproductive and Possibly Damaging.”

Juicy Excerpt #1: Pfau’s insight is that thanks to mean reversion, the number you need at the end of a bear market is actually lower than the number you need at the end of a bull market — if the market’s about to head up, your retirement savings can grow even post-retirement, while if the market is about to fall, you’re liable to lose much more than just your annual expenditures.

Juicy Excerpt #2: Instead, says Pfau, stop thinking about stock, and just think about flows. Save a set percentage of your salary every year, stick to it, and, it turns out, you’ll be fine:

Juicy Excerpt #3: Investing can be exciting, especially when it’s done wrong. You follow the markets rising and falling, you obsess about your retirement-fund balance, you rotate out of this and into that, you read books and magazines and blogs to try to learn more about what to do. You might even, in a moment of weakness, find yourself watching CNBC. Budgeting, by contrast, is like going on a diet: it’s a drag, and it’s hard to get any pleasure or excitement out of it. But the latter is much more likely to get you well-set in retirement than the former.

Juicy Comment #1: Investing would be so easy if we could just assume that markets are mean reverting, like Pfau. Unfortunately, Taleb’s insight, that mean reversion is bullshit, is far more persuasive.

Juicy Comment #2: Subzero annualized real total returns over 10 year periods can persist for up to a decade – it only recently went below zero in 2008.

Juicy Commeent #3: The 8% returns assumed by many pension fund managers today are ludicrous at best and criminally fraudulent at worst. Just another example of the governing class of people gaming the system to buy themselves another handful of years raking money off the top before their bubble world bursts.

Juicy Comment #4: My other source of valuation is to pay attention to what insurance companies are willing to payout in annuitized payments. They seem to be the only part of the financial sector living in the same world that the average person inhabits.

Juicy Comment #5: If Wall Street had not been polluting the the world with self serving theories about stock returns “for the long run,” 90% of the posts on this thread would not be here. The entire debate is debased and devalued. Hopeless.

Juicy Comment #6: Original idea for you, MGK: asset prices are meaningless, only cash flow counts. Cash flow is the life blood of any business, any household. Cash flow from operations, not from financing. Whether you invest in the stock market, in bonds, in real estate, or in “hard commodities”, be certain that the free cash flow generated is sufficient for your needs. Anything beyond that is speculative.

Wade Pfau: “This Paper…Suggests that the Traditional Approach to Retirement Planning is Counterproductive and Possibly Damaging”

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Set forth below are some words that Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan (Wade is the fellow who recently posted preliminary research showing that Valuation-Informed Indexing beats Buy-and-Hold is 102 of the 110 rolling 30-year time-periods in the historical record), posted as a comment to yesterday’s blog entry. My responses will appear in the comments section.

Dear Rob,

We haven’t talked for a while, and I thought I’d drop by to say hi.

I’m still working on the valuations-based investing topic, but it has been going a bit slower. I have noticed you’ve been writing many interesting articles about my blog post, and I appreciate all your comments. It is hard to keep track of all your articles, but I do especially like the one with six criticisms of my research.

Admittedly, I lost some enthusiasm about the topic when I found out I was only rehashing the stock formula investing plans of the 1940s and 1950s. But I think it is still an interesting topic. I’m slowing the pace down as well, because I am trying to more formally explore the risk side as well by looking at things such as Sharpe ratios. I had the goal of finishing the paper by the end of February, and I think that is still a reasonable goal, but not guaranteed.

One thing that slowed me down is on February 4th I started looking at the issue of using overlapping historical data to combine the working and retirement phases of retirement planning into a complete whole. I was quickly amazed by the results, and I’ve spent the last 8 days writing a paper about this. This paper doesn’t rely on valuations, at least in an explicit sense, because I am trying to make it as uncontroversial as possible. But it is still going to be controversial, as it suggests that the traditional approach to retirement planning (as described on pages 10 and 11 of the Bogleheads’ Guide to Retirement Planning, for example) is counterproductive and possibly damaging. I think you might enjoy reading this paper. It may provide you a fresh angle on your own work, as I am also suggesting that the idea of “safe withdrawal rates” is not particularly useful as well. This may be some counter-intuitive stuff. I’ve got a blog post about it:

http://wpfau.blogspot.com/2011/02/safe-savings-rates-new-approach-to.html

The paper is complete, and in the actual paper I go into more detail about the situation for recent retirees, which I don’t mention much in the blog post. I will email you the paper, because it will be a few days before the place I submitted the working paper to will make it available for public viewing. They have editors check the papers first.

I think I will talk the weekend off (Lost Season 6 with Japanese subtitles – so my wife can properly enjoy as well – has finally been released). But next week I will be working on the valuations stuff again.

Best wishes, Wade

“I Cite You and John Walter Russell as the Earliest Advocates of [New School SWR Research]”

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Wade Pfau, an Associate Professor at the National Graduate Institute for Policy Studies in Tokyo, wrote a comment to an earlier blog entry this morning that describes a research paper he has written (the paper is still in its first draft) about the New School Safe Withdrawal Rate concept that I developed with John Walter Russell (and with the help of hundreds of our fellow community members in the Retire Early and Indexing discussion-board communities). Set forth below is the text of his words. I sent an e-mail to Wade thanking him for letting us know of this exciting development. Who could have predicted on the morning of May 13, 2002, where this New School SWR business was going to lead?

Dear Rob,

I just became aware of your past research in September.  Since then, I’ve read archives from many Discussion Boards and websites, and I always find your writing to be very interesting and intriguing.

I just finished writing up a paper about using earnings valuations to predict withdrawal rates.  But I think it is also important to consider dividend yields and bond yields as well, since these are the income sources of returns.  With these measures, I find that withdrawal rates continue falling even after 2000.  With PE10, you found the lowest withdrawal rates in that year.

I do cite you and John Walter Russell in my paper as the earliest and strongest advocates of this approach.  I understand that John Walter Russell has passed away, sadly.

If you wish to see my paper, it is at:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1726225

I’m hoping it will be publishable in a finance journal. This is just the first draft, so if you have some comments or anything, I can still make revisions.  Thank you very much for your consideration.

Best wishes,

Wade

“By Definition, There’s Only
One Worst-Case Scenario”

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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 my way on August 23.

Rob,

My punctuation emphasis regarding the idea of predicting long-term returns by looking at initial market valuation was deliberate. The reality is that a significant portion of the financial planning community also still ascribes to the passive investing approach – thus the “surprise” of the predictability of long-term returns. Not all of these planners necessarily believe fully in the Efficient Markets Hypothesis, but at the least they believe that the markets cannot be predicted in advance in any reliable manner (which means they still use a passive approach).

However, I don’t believe that this was necessarily an influence on much of the SWR research. The reason a single number was used for the SWR is simply because its purpose is to BE the “worst case scenario”. By definition, there’s only one worst-case scenario. In addition, bear in mind that Bengen set the framework for this research back in 1993, and at that time the historical valuation ranges he focused on WERE the most extreme points ever seen. The outsized valuations of the technology era didn’t exist when the research started; it was an underlying implicit assumption (granted, one that may be ultimately proven false) that the worst-case scenario markets being viewed in history (as of 1993) DID represent the worst case scenario, and that something materially worse wasn’t anticipated. Thus, the “one” SWR worst-case scenario was developed. 

From my perspective, this is why it was important to put forth the research that I did. To believe that market returns CAN be predictable over the long run based on market valuation is still not part of the generally accepted viewpoint for most financial planners. Likewise, then, the safe withdrawal rate implications that accompany different market valuations are likewise not part of the outlook. Thus, my attempt to advance the body of knowledge in this area. As I’ve said earlier, the purpose wasn’t to suggest that valuation couldn’t also someday lead us to a different, even WORSE scenario than what the historical record suggests – I do believe there is a high probability that a 2000-2029 retirement time period will prove to be such a scenario – but I believe that exploring the hypothetical safe withdrawal rates that might come from valuations never before seen in history is a worthwhile but separate line of research in this area. Although at this point, I suspect the impact will be more retrospective for those who did retire earlier in the decade, and unfortunately not applicable again anytime soon – although markets can cycle to valuation extremes, I also do believe that the valuations we saw earlier in the decade are not likely to be revisited for many, many years in the future.

But yes, at the end of the day, many planners still focus on passive investing as well, and don’t believe future market returns can be reliably predicted. Thus, the financial planning body of knowledge has never explored the impact of valuation on SWRs. But in the context of the original research being designed in the way that it was – yes, I suppose it inherently assumed passive markets at some level, but it was also done at a time when the historical range of valuations from 1870 to 1990 really WAS the maximum historical range!

I hope that helps a little!

With warm regards,
Michael

The Boglehead Wiki Statement on Safe Withdrawal Rates

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The Bogleheads wiki contains the following statement on safe withdrawal rates (SWRs) under the heading “Controversy”:

“Unfortunately, the term ‘Safe Withdrawal Rate’ is necessarily an ambiguous term. This is because initial methods utilized historical data to statically determine what would have been safe given the actual results that past portfolios would have generated with the variables given. The next logical step, of course, was to use that information to predict future SWRs. Either use is technically correct, but one should always be sure to be clear whether the use is in reference to past or projected SWRs, so that unnecessary argument can be prevented.”

Set forth below are my reactions:

1) The statement is a positive development. There was a time when “defenders” of the Passive Investing approach were asserting that the Old School SWR studies are accurate. This statement implicitly (but not explicitly, to be sure) acknowledges that they are not. The SWR is the product of a mathematical calculation. It is obviously not possible for the Old School studies (which include no adjustment for the valuation level that applies at the beginning of the retirement) and the New School studies (which do) to both be accurate. For years, the Goons have asserted that anyone arguing that an adjustment for valuations is needed is “mentally ill.” This statement says that the New School studies are “technically correct.” This is a big advance from the former Goon position and represents an implicit acknowledgment that the Old School studies are analytically invalid (if it is “technically correct” to include a valuation adjustment to calculate the SWR, it is analytically invalid not to include such an adjustment).

2) The statement is logically incoherent. It is obviously not possible for both the Old School studies and the New School studies to be “technically accurate.” Either an adjustment for valuations is required to determine the SWR or it is not. The historical stock-return data shows beyond any reasonable doubt that a valuations adjustment is required. Many experts have confirmed this. For example, William Bernstein, author of The Four Pillars of Investing, has advised any investor giving thought to using one of the Old School studies to plan a retirement to “FuhGedDaBouDit!”

3) The statement is disingenuous. The statement asserts that the New School studies are “technically correct.” Yet the remainder of the wiki article contains references only to Old School studies. Did the Bogleheads that crafted the remainder of the article not bother to read the “Controversy” statement?

4) The statement is unhelpful to its readers. The statement does not include a link to The Retirement Risk Evaluator, the first New School SWR calculator. There is no excuse for the failure to provide such a critical link in a wiki treatment of this topic.

5) The statement is false. It is not so that the SWR phrase is “ambiguous.” The “safe withdrawal rate” is the withdrawal rate that is safe presuming that stocks perform in the future at least somewhat as they always have in the past. I have seen thousands of discussion–board threads in which investors saw references to safe withdrawal rates and were quite naturally led by them to believe that the matter being discussed was what withdrawal rate was safe. The Old School studies identify the withdrawal rate that would be safe in an imaginary world in which valuations have zero effect on stock returns. There is nothing “ambiguous” about the error made in these studies. It is a clear error and an obvious error and a highly significant error.

6) The statement is reckless. The statement appears in a wiki article that contains links (without warnings) to both the Greaney SWR study and to the FIRECalc SWR calculator. I notified Greaney of the errors in his study six years ago. I notified Bill Sholar, author of FIRECalc, of the errors in his calculator not too much later. Neither the Greaney study nor FIRECalc have been corrected in the time since. Both Greaney and Sholar have advocated bans on honest posting on SWRs at discussion boards at which they participate.

7) The statement is silly. It urges that “unnecessary argument” be avoided. I have had a front-row seat to the first six years of The Great Safe Withdrawal Rate Debate. I am not able to recall a single incident in which a poster supporting the idea that honest posting on SWRs be permitted on our boards engaged in any “unnecessary argument.” I witnessed tens of thousands of cases in which “defenders” of the Old School studies engaged in endless rounds of word games and abusive posting. The way to avoid unnecessary argument is for those now “defending” the Old School studies to urge corrections of the errors in them. Once the Old School studies are corrected, there is nothing to argue about.

8 ) The statement provides a false history of the development of our knowledge of how to calculate SWRs. Investing experts have been using the Old School studies to advise aspiring retirees for a good number of years now. The claim has always been that these studies report the SWR, not “what would have been safe” under the convoluted scenario described in the wiki statement. This is so for obvious reasons. An aspiring retiree is not seeking to learn what withdrawal rate “would have been safe” under some convoluted scenario; she is seeking to learn what withdrawal rate is safe for someone beginning a retirement at the time she is planning to begin her retirement. Even Ataloss, one of the lead Goons, has said that, if the Old School studies get the SWR number wrong, they are “worthless” (I view this as an overstatement, but I certainly do not believe that aspiring retirees should be using the Old School studies to determine what withdrawal rate to use in their plans).

9) The statement contains no apology to the thousands of fine community members in the Retire Early and Indexing communities who either participated honestly in our discussions or expressed a desire that honest posting be permitted. Given what these community members have been put through for six years now by the “defenders” of the Old School studies, an apology is obviously appropriate.

10) The statement does not explain the importance of our discovery that the Old School studies are analytically invalid. The Old School studies are the product of a Passive Investing mindset. Passive Investing advocates recommend that investors not adjust their stock allocations when valuations move from reasonable levels to dangerously overpriced levels. The Old School studies posit that the SWR is a constant number. The connection is clear; the idea that the SWR is a constant number follows from the idea that one’s stock allocation need not be adjusted when stocks go through dramatic price changes — the flaw in both claims is a belief that valuations don’t matter. Our finding that the Old School studies are analytically invalid throws serious doubt on all valuation-related claims made by those advocating Passive Investing, not just the Old School SWR claims.

11) The statement contains no discussion of a publicity campaign to warn the retirees taken in by the false claims of the Old School studies. This is our most pressing need today. The point of learning about investing is to help investors to avoid falling into traps. The point of SWR analysis is to prevent retirees from suffering busted retirements. What purpose is served by talking about the “controversy” without outlining the steps that need to be taken for the controversy to lead to positive action?

12) The statement does not explore the implications of our SWR findings. Our finding that the Old School studies get the number wrong served as the beginning of The Great Safe Withdrawal Rate Debate, not as its ending. The Stock-Return Predictor is the product of these discussions. We have been using what we learned about retirement investing from our examination of the flaws in the Old School studies to develop tools and strategies to help investors in the asset accumulation stage for some time now.

13) The statement ignores the Goon phenomenon. It is impossible to discuss The Great Debate in a fair and complete and accurate and balanced way without making reference to the role played by the Goons and by the site administrators, experts, and ordinary investors who have tolerated their presence in our community for so long now.

14) The statement fails to discuss investor emotions. It is clear from our discussions that many of today’s stock investors are emotionally invested in stocks and in all likelihood will remain so for so long as prices remain at sky-high levels. This is a reality of critical importance to any informed understanding of the “controversy” that has evidenced itself in our investing discussions of recent years.

15) The statement offers no recommendations for dealing with the abusive posting that has destroyed or damaged a number of Retire Early and Indexing boards. Again, why not address the practical?

It’s not a perfect statement. The reality remains, however, that it evidences an inching in the right direction. At this rate of progress, honest posting will be permitted at all the boards well before the close of the 23rd Century.

I’m joking! I do see positive signs and I think it is fair to classify this statement as one. We need more, a lot more. But progress is being made over time and it’s every bit as much a mistake to become too pessimistic as it is to become too optimistic. Let’s hope that a good number of our fellow community members are taken aback by this wiki statement and prompted by it to study the SWR matter in a good bit more depth. I see it as being entirely possible that that will happen and in that event the statement will end up pushing things forward. Let us pray!

Today’s Passion: Dallas Morning News Columnist Scott Burns has described my efforts to get the Old School SWR studies corrected as “catastrophically unproductive.” No, honestly!