A Rich Life

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

New SWR Study Counts Valuations —
But Only In One Direction!

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Business Week ran an article in its recent Annual Retirement Guide issue arguing that the Old School safe-withdrawal-rate studies get the numbers all wrong — they are too pessimistic! Holy moly!

Juicy Excerpt: One expert now questioning this conventional wisdom is Michael Kitces, 30, director of financial planning for Pinnacle Advisory Group in Columbia, Md. Kitces was frustrated that the 4% rule can result in overly conservative withdrawal rates during certain market conditions and that the market’s mood at the time of the initial withdrawal could greatly affect how much money retirees can drain from their accounts for the rest of their lives.

The reason why I say “Holy moly!” is that the more pressing problem today is the millions of retirements that are likely going to fail because they were constructed in accordance with the overly optimistic claims of the Old School studies. Truth be told, though, much of the argument set forth in Kitces’ paper sounds like it was influenced by him listening in to the discussions that we have been having in the Retire Early and Indexing communities for over six years now (I don’t believe that Kitces was in fact influenced by our discussions, my point is just that he got to the same place that a lot of us did by applying more common sense to his examination of the historical data than did the authors of the Old School studies).

Juicy Excerpt: A growing body of research reveals that, in fact, longer-term returns can be predicted to some extent…. Those extended periods of expanding or contracting P/E ratios (producing long-term real returns above or below historical averages) can often be anticipated in advance — by looking at the valuation of the aggregate market at the beginning of the time-period!

Precisely so. Michael Kitces, take a bow! The testimony of six years of our discussions shows that you have it exactly right.

Almost.

Unfortunately, after getting it exactly right by accepting that valuations must affect safe withdrawal rates, Kitces drops the ball by jumping to the strange conclusion that valuations pull safe withdrawal rates up but not down. 

Juicy Excerpt: History reveals only three time-periods at which a 5% initial withdrawal rate was not sustainable.

That’s the “Holy moly!” part. Kitces here commits the analytical error core to the Old School studies. We started out trying to determine what withdrawal rate is safe and then made a sudden shift to considering what in the past has been sustainable. As if the two concepts were the same!

This would not pass for “analysis” in any field other than investing. Imagine an alcoholic arguing that it is perfectly safe for him to drive drunk because on three earlier occasions on which he did so he got in crashes but lived. The fact that retirees using a 4 percent withdrawal at times of extreme valuations have always found themselves in big trouble in the past indicates not that a 4 percent withdrawal is safe at times of extreme valuations but that it is risky. The fact that they managed to “sustain” in those three earlier cases does not transform a risky withdrawal rate into a safe one. The words “safe” and “risky” are not synonyms; they are antonyms. 

Is Kitces Old School or New School? Perhaps we should say he’s Nold School. Or Oldew School. Something like that.

How can someone smart enough to see that valuations affect safe withdrawal rates not also be smart enough to see that they affect them in both directions, that the safe withdrawal rate is both sometimes higher than 4 percent and at other times less than 4 percent? And how could the good and smart people at Business Week fail to pick up on this painfully obvious and critically important point? I blame it on the Passive Investing model. Buy into the Passive Investing mindset (and millions did during the out-of-control bull) and you give up your ability to apply human reason to your understanding of valuations-related investing topics. As shocking as it is, that’s the reality we have seen come into play time and time again over the course of our discussions of the past six years.

I view this as a positive development. As more and more of the “experts” (I don’t intend the quote marks as a dig at anyone — my view is that there is no such thing as an investing expert until we all achieve a higher level of understanding of the basics, a level that can only come when we are able to put the Passive Investing model behind us and engage in honest and informed back-and-forth discussion on all sorts of questions once again) become aware that valuations do indeed affect safe withdrawal rates (as we first demonstrated on our boards in May 2002!), it seems inevitable to me that a few will begin to wonder how it could be that this reality would always serve to push safe withdrawal rates up even higher and never to pull them even a teeney, tiny bit below 4 percent. Kitces has advanced the discussions, even if he has not yet been quite bold enough to bring it all back home.

And who knows? Maybe Kitces will devote a bit more thought to all this and make the shift from being a Nold School SWR guy to being a true New School Hero of the First Rank. After posting this blog entry, I will send Michael an e-mail letting him know about our findings and about The Retirement Risk Evaluator.

We’re getting there, people. Slowly. Reluctantly. With feet dragging. With men moaning. With women sobbing. With cats meowing. With babies banging their rattles. But we are over time working ourselves to that place where deep in our hearts we all really want to be.

Or so I pray!

Today’s Passion: William Bernstein is another “expert” who has combined top-notch commentary on the safe-withdrawal-rate matter with some words that suggest that he has been drinking the Passive Investing Kool-Aid a bit too long. Some time back I wrote a blog entry on Bill’s thinking entitled Ball of Confusion.

Can a 9 Percent Withdrawal Ever Be Safe?

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We all know that The Retirement Risk Evaluator shows that the Old School studies get the safe withdrawal rate wrong. The number isn’t always 4 percent. At the top of the bubble, it was less than 2 percent. Today, it’s 3.6 percent.

That’s only one side of the story. When the historical stock-return data is examined using an analytically valid methodology, it tells us something else of equal importance. When stock valuations are low, the Old School studies are wildly off the mark not on the high side but on the low side. When the P/E10 level drops to 8 (this is what usually happens in the aftermath of out-of-control bull markets), the SWR rises to — 9 percent?

9 percent.

A lot were shocked to learn that the number can drop to 2 percent in an out-of-control bull. Can it really rise to 9 percent in the aftermath?

That’s what the historical data says. That’s the number you get when you use an analytically valid methodology. That’s the rate that applies at that valuation level if you are willing to assume that stocks will perform in the future at least somewhat as they always have in the past.

But would I advise a retiree actually to withdrawal 9 percent from his or her portfolio? Is that not a crazy-with-risk idea?

I don’t think so. There are caveats that apply for those using the 9 percent number. But that is the number you get when you do the analysis and, when you come to an informed understanding of how stocks work in the real world, you come to see that that number actually makes a good bit of sense.

The fair-value P/E10 value is 14. When the P/E10 value is 8, stocks are selling for a price not much above half of their fair value. Given the fantastic 10-year return that stocks provide when selling at fair value, would you not expect a super-fantastic 10-year return when they are selling at only half of fair value?

The Reversion to the Mean phenomenon exerts a powerful pull on stock prices, bringing them in the direction of fair value. When the price drops all the way down to 8, that pull is very powerful indeed. For the P/E10 value to move up even a notch, stocks need to pay a return in excess of the normal 6.5 percent real. For the P/E10 value to move up enough notches to take us from 8 to 14, stocks need to pay a return in excess of the normal 6.5 percent real for a good number of years in succession.

One of our most important findings is that it is just about always the first 10 years of a retirement that determine whether it will succeed in the long term or not. If you do well in the first 10 years, you will see enough of an increase in wealth to get you through 30 years, especially after the compounding returns effect is counted in. If you do poorly in the first 10 years and continue taking out a withdrawal that seemed to make sense back when you had much more in the way of assets, you stand a good chance of sinking your plan somewhere down the line.

Leverage. That’s the hidden factor. Do well early on and leverage works for you. Do poorly early on, and leverage kills you. The retiree very much wants to get leverage on his side.

When stocks are at extremely low prices, the odds of leverage working against you are almost nil. The conventional wisdom when we are at a P/E10 of 8 will be that stocks are for losers. But think about it from the standpoint of leverage. What are the odds that the P/E10 level is going to drop still lower when it is already at one of the lowest levels ever seen in U.S. history? Stock prices might not go quickly up when we are at 8. But they are almost certainly not going to go down much. If prices merely remain stable, you will be earning an annual return of about 6.5 percent real. That translates into a safe withdrawal rate well above 6.5 percent (the withdrawal rate is higher than the return earned because SWR studies assume that the portfolio will be gradually depleted over the course of a 30-year retirement).

There’s a good chance, of course, that returns are going to go up from very low levels. The odds are that the investor handing in his resignation at a time of low prices is going to enjoy extraordinary leverage. His first 10 years are going to be good years. Even if a worst-case return pattern happens to pop up, a plan calling for a 9 percent withdrawal will work.

I noted above that there are caveats. The most important caveat is that the entire U.S. economy could go kerplooey. Most people laugh at mention of that possibility today. Not too many will be laughing when we get to a P/E10 of 8. The middle-class will have suffered the largest loss of wealth in U.S. history at that point. Lots of people will be predicting that our economy will soon go under and lots of others will be saying that that sounds right to them. Neither the Old School not the New School SWR studies factor in that possibility. If the whole shebang goes down, your retirement could go down too.

How big a risk is that? Bill Bernstein has put it at about 20 percent. It happens to every economy sooner or later, and so sooner or later it is going to happen to ours. So it’s not entirely right to say that a 9 percent withdrawal is 95 percent safe at a time when the P/E10 level is 8. If you count in the possibility that the entire economy could go down, the odds of success are less than 95 percent.

That’s so for those taking a 3.6 percent withdrawal on a retirement beginning today too, though. There’s always a chance that the economy is going to go bust, both at times when stock prices are high and when they are low. The fact that people will be talking about it when we get to a P/E10 of 8 doesn’t make it more likely that it will happen in the course of a 30-year retirement, it only makes you more aware of the possibility.

Remember, a retirement that lasts 30 years is going to see times of high valuations and low valuations. Just about all 30-year retirements will see times when everyone is saying that national bankruptcy is just around the corner and times when everyone is saying that anyone who sees national bankruptcy as even a remote possibility belongs in the loony bin. What people are saying about this topic on the day you retire does not affect the safety of your 30-year plan (although it of course affects your feelings about the safety of your plan — which is something very different).

The bottom line is that neither the 3.6 percent number that applies today nor the 9 percent number that applies for retirements beginning at a P/E10 of 8 are perfectly safe. But they are equally safe. The 3.6 percent number is the number that comes up if you look at what happens in a worst-case scenario for someone retiring today and the 9 percent number is the number that comes up if you look at what happens in a worst-case scenario for someone retiring when the P/E10 value is 8.

Does it make sense that the SWR could vary so much? Yes, it makes sense.

The stock investors of the 1990s borrowed massive amounts from future returns to finance the sickest and most twisted bull ever experienced in U.S. history. The investors of today are the investors whose returns were being borrowed. We’re like the people who get stuck covering someone else’s credit-card bill. The need to pay off the huge debt holds us back. We cannot be sure of earning returns large enough both to cover that debt and to support a retirement plan calling for a withdrawal of more than 3.6 percent.

When we get to a P/E10 value of 8, the debt will have been fully paid off and then some. When prices drop that low, investors are leaving a windfall inheritance to those who come after them rather than a huge credit-card bill. It’s not fair (that’s one reason why I don’t view wild price swings as a good thing), but that’s the way it goes.

Retire today, and you are taking on at least some risk if you go with a withdrawal of greater than 3.6 percent. Retire when the bull-market debt is paid off and when prices have dropped low enough to provide an inheritance windfall for stock investors, and you can take a withdrawal of 9 percent with the same level of safety that applies for a 3.6 withdrawal for those retiring today.

Today’s Passion: There’s a thread at the Early Retirement Forum showing that more people are losing confidence in the phony baloney Old School SWR studies all the time. Please note the poll results — there are a lot more people at that forum who understand why ignoring valuations cannot work than they are who are willing to say so for so long as there are Goons present in the room. I found the same thing to be so at the Financial WebRing Forum. There was a poll in which a large percentage of the board community expressed a desire that honest posting on Techncal Analysis be permitted (I do not personally believe in Technical Analysis but I certainly believe that honest posting on it should be permitted) despite the fact that there were few willing to say so in posts put to the board. When the ownership of a board makes clear that it will not tolerate honest posting on any particular topic, the board becomes a corrupt enterprise. You can never know what a board community really thinks about a topic for so long as a ban on honest posting on that topic remains in effect.

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!

Putting a Human Face on the
“Save the Retirements!” Story

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Here are ten angles that we might pursue in our efforts to get publicity for the “Save the Retirements!” initiative:

1) The Consumer Protection Angle: Think of what would happen to the chief executive officer of a company who made safety claims that he knew to be false for a trampoline or for a diving board. He would face serious financial liabilities or possibly even jail time, right? Should the rules be so different for those who knowingly or negligently put forward false claims about the historical stock-return data that cause thousands of busted retirements?

2) The Paradigm Breakdown Angle: The discrediting of the conventional-methodology safe withdrawal rate claims has implications far beyond the busted retirements that are likely to be a direct result of the false claims. The same analytical errors responsible for the flaws in today’s retirement planning tools are the cause of many other misperceptions of what the historical stock-return data says about how to invest successfully for the long run. What is really at issue is the replacement of the Stocks-for-the-Long-Run Investing Paradigm with a new and more realistic understanding of how to invest successfully for the long term.

3) The “Rise of the Internet Discussion Board as a Powerful Communications Medium of the Future” Angle: Scores of community members helped us identify the flaws of today’s retirement planning tools during our four-year research project. This experience shows how the internet discussion-board can come to serve as an important communications medium of the future.

4) The Emotional Investor Angle: A core premise of the Efficient Market Theory is that investors generally pursue their self-interest in rational ways. We have generated a great deal of evidence to the contrary during The Great Safe Withdrawal Rate Debate. We have seen that in many circumstances investors are willing to suffer large financial losses rather than face realities that cause them emotional discomfort, even in cases in which those realities relate to something as objective in nature as the calculation of a number. I think it is fair to conclude from our experiences of the past four years that investing is primarily an emotional endeavor.

5) The “Triumph of Common Sense” Angle: We have seen many cases of “experts” getting tripped up by things they thought they knew for sure which turned out to be just not so. In contrast, we have seen numerous cases of ordinary investors who possessed greater insight into what works because they employed their common sense to the task of developing investing strategies in ways that the “experts” did not.

6) The “Everything Old Is New Again” Angle: Many of our findings are in an important sense not new. Many community members at first found them shocking because our findings are so at odds with the conventional investing wisdom of today. But many of our findings are very much in tune with the conventional wisdom of earlier eras. We have even turned up comments by Benjamin Graham (co-author of the classic investing guide entitled Security Analysis) endorsing the long-term timing concept!

7) The Self-Deception Angle: The promoters of today’s retirement planning tools are often fooling themselves as much as they are fooling the aspiring retirees who use their tools to plan their retirements. This is a case where the guy who is selling the defective trampoline has one of his dangerous products in his own backyard for his own kids to jump around on.

8 ) The Reluctant Heroes Angle: William Bernstein, author of The Four Pillars of Investing, and Dallas Morning News Columnist Scott Burns are heroes to our movement for telling it straight on the safe withdrawal rate matter. Still, neither has done much to publicize what they know about the false safe withdrawal rate claims put forward in many of today’s retirement planning tools. It’s obviously a big story likely to affect the financial futures of millions. Why haven’t Burns and Bernstein (and others who have gone public with their knowledge of the flaws of the existing tools) done more to publicize the matter?

9) The “Media Watchdogs Who Didn’t Bark” Angle: It shouldn’t be entirely our job to publicize the flaws of today’s retirement planning tools. Given how long the flaws in the existing tools have been public knowledge, shouldn’t there have been lots of articles written about them long before now? I sure think so. Why is it that media watchdogs have been revealed as toothless when it comes to protecting the public from misleading and dangerous investing research?

10) The “Failure of the Investing Research Community” Angle: What ever happened to the concept of peer review? Some of the names attached to the flawed retirement planning tools are respected names in academia. How is it that they came to employ such transparently absurd assumptions in the retirement planning tools they helped build? How is it that they failed to learn of the flaws in these tools in a timely way?