Wade Pfau, Ph.D., CFA, RICP®

Are market valuations the most important factor for retirement income strategies?

Classic safe withdrawal rates studies such as the works of William Bengen and the Trinity study investigate sustainable withdrawal rates from rolling periods of the historical data, giving us an idea about what would have worked in the past. For a 30-year retirement period, we can learn about the historical sustainable withdrawal rates beginning up to 30 years ago. The question remains as to whether those past outcomes provide sufficient insight about what can reasonably be expected to work for more recent retirees.

It does not follow that we can extrapolate the historical success rates from the Trinity study forward and apply them to future retirees. But this was known well even before the Trinity study was ever written in the first place. Understanding about this comes from the theory of life-cycle finance, which had gotten moving with independent works by Nobel laureates Paul Samuelson and Robert Merton, both published in the same August 1969 journal issue of Review of Economics and Statistics. Before getting into more detail about that, just who was the first to link withdrawal rates to valuations?

An alternative way to look at the historical data is to consider not just the past withdrawal rate outcomes, but rather to consider how past withdrawal rates were related to the retirement date values of the underlying sources of returns. The methodology for doing this was provided in a 1998 article by John Campbell and Robert Shiller, “Valuation Ratios and the Long-Run Stock Market Outlook,” from the Journal of Portfolio Management. Campbell and Shiller found predictive power for market valuations to explain real stock returns over the subsequent 10 years. Sustainable withdrawal rates from a diversified portfolio including stocks can also be expected to also share this relationship with market valuations. The real credit for establishing this link belongs to Campbell and Shiller. 

But getting back to life-cycle finance, Campbell and Shiller may not feel much pride in receiving credit for this ’discovery.’ They are both financial economists who are trained in life-cycle finance theory, which views hedging (such as with a bond ladder) and insuring (such as with fixed income annuities) as important risk management tools beyond precautionary savings (saving enough to use a ‘safe’ withdrawal rate) and portfolio diversification. They might even find it rather perplexing that people talk about ‘safe withdrawal rates’ from a portfolio of volatile assets. After all, look at what can happen to stock markets

Life-cycle finance tells us that current market conditions are much more relevant than historical averages. Rather than using historical averages to define our capital market expectations, we can get better information about this by looking at the term structure of interest rates and the implications for expected returns and volatilities provided by the prices of various financial derivatives. Financial economists have been saying this since the 1970s. Campbell and Shiller’s work follows along those lines.

And when viewed in this context, valuations are an interesting issue for retirement income, but they may not really be of central importance when building an overall retirement income strategy. That is because just as historical withdrawal rate outcomes don’t guarantee future safety, the relationship between valuations and withdrawal rates can change as well. We are still prone to black swans. Past is not necessarily prologue. Don’t treat the predictions coming from a model incorporating valuations as a guaranteed annuitization rate from your portfolio, especially when trying to extrapolate outcomes when valuations reach previously unseen levels. And don’t forget to account for fees, taxes, and whether your investment returns actually match the underlying indices used in research studies.

After all, markets may not behave as planned, and retirees only get one whack at the cat. As Mike Zwecher indicated in that link, retirement income strategies should work by construction and it is not enough that they would have worked historically. Modern Retirement Theory also informs us that basic expenses should be covered by income sources that are “secure, stable, and sustainable.” Systematic withdrawals from a volatile portfolio do not fit that bill, no matter what you think the safe withdrawal rate might be. With the exception of Moshe Milevsky, no major financial economist has spent time discussing traditional safe withdrawal rates, except for brief asides such as when Laurence Kotlikoff refers to the “4% rule of dumb.”

William Bengen made an incredibly important contribution when he demonstrated that sequence-of-returns risk means that you cannot withdraw at the same rate as the average investment return, and he naturally did this by looking at a simple spending pattern: spend a constant inflation-adjusted withdrawal amount each year for as long as possible until wealth runs out. The truth is that this is not an optimal spending strategy. 

More generally, optimal retirement income strategies will involve building a “secure, stable, and sustainable” floor with Social Security, bond ladders, and perhaps some annuitization. With the leftover funds to be used for more discretionary expenses, the optimal strategy will be to then spend something along the lines of 1 / remaining life expectancy (using the life expectancies provided by the IRS for the Required Minimum Withdrawals from IRAs is fine) for each year of retirement. That can be made more conservative if leaving a bequest or greater consumption smoothing is desired, or it can be made more aggressive for retirees who wish to spend more now while they know they can and are willing to spend less later should they live longer than expected or should financial markets not cooperate.

While looking at market valuations at the retirement date can provide some useful guidance and insight, ultimately valuations are just one piece of a much larger retirement income puzzle. Efforts to elevate market valuations into an overwhelmingly central role that trumps are other considerations are not well-founded. Incorporating valuations does not provide any further assuredness about the safety (or lack thereof) of a strategy.

Next, read Why Investing During Retirement is Different.

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