This article examines eight retirement planning strategies developed through use of the Retirement Risk Evaluator, the first calculator developed by followers of the New School of safe withdrawal rate analysis. It will help you follow the discussion if you open a new window on your web browser and click on the tab at the left marked “Risk Evaluator” to bring up the calculator. As each new strategy is discussed, construct the scenarios described on the window containing the calculator:
The Retirement Risk Evaluator
To make use of the strategies discussed in this article, you need to understand the safe-withdrawal-rate concept. The safe withdrawal rate is the inflation-adjusted percentage withdrawal that you can take from your portfolio each year to cover living expenses without any significant risk of having your retirement plan fail, presuming that stocks perform in the future at least somewhat as they always have in the past. The safe withdrawal rate for a 30-year retirement is a number a good bit less than the annualized 30-year real return for that portfolio. The reason is that losses suffered in the early years of a retirement can require retirees to sell stocks to cover living expenses. Those who are forced to sell miss out on the price recovery that the historical stock-return data indicates is likely to come along in later years.
The withdrawal rate you choose determines how much you can spend in retirement. For example, a withdrawal rate of 4 percent from a portfolio of $1,000,000 permits annual spending of $40,000 (inflation-adjusted).
#1 of 8 Retirement Planning Strategies — Lower Your Stock Allocation to Increase Your Safe Withdrawal Rate
Enter “27” as the P/E10 value for each of the four scenarios (this article was posted in April 2007, when the P/E10 value was 27). Enter “2.0” as the TIPS return. Enter “0” as the Year 30 Percentage Balance. Enter stock allocations of 80 percent (Scenario One), 60 percent (Scenario Two), 40 percent (Scenario Three) and 20 Percent (Scenario Four).
The highest stock allocation yields a safe withdrawal rate of 3.02. Lower your stock allocation by 20 percent and the safe withdrawal rate increases to 3.43. Another 20 percent drop brings the safe withdrawal rate to 3.72. The lowest stock allocation yields a safe withdrawal rate of 3.90.
#2 of 8 Retirement Planning Strategies — Increase Your Stock Allocation to Increase Your Safe Withdrawal Rate
Change the P/E10 value used in all four scenarios to “14,” a moderate valuation level. Leave all other entries the same.
Now we see a very different story. At moderate valuation levels, it is increases in your stock allocation that yield higher safe withdrawal rates. As the stock allocation moves from 20 percent to 80 percent, the safe withdrawal rate increases from 4.45 to 5.41.
#3 of 8 Retirement Planning Strategies — Trade Off Safety for Return
In our discussion of Strategy #1, we saw that, at times of high valuations, higher stock allocations translate into lower safe withdrawal rates. Does it follow that all of today’s retirees should be going with stock allocations of 20 percent? It does not.
Stocks are certainly not the safest of asset classes. The appeal of stocks is the strong long-term returns they offer. There are circumstances in which it is worth accepting a lower safe withdrawal rate in exchange for the possibility of having a higher portfolio value at the end of your 30-year retirement (either to cover the possibility that you might live longer than 30 years or to have more money to pass along to heirs).
Say that a P/E10 value of 27 applies at the beginning of your retirement, and that a withdrawal rate of less than 3.50 is unacceptable to you because it does not provide for enough annual spending. That rules out stock allocations of 80 percent and 60 percent. It doesn’t rule out a stock allocation of 40 percent. Depending on your personal circumstances and preferences, you might decide on a stock allocation of 20 percent (higher safe withdrawal rate) or a stock allocation of 40 percent (good chance of a higher end-point portfolio value).
The Retirement Risk Evaluator doesn’t reveal to you what stock allocation is best. There is no one correct answer to that question because we do not know precisely how stocks are going to perform in the future and because retirees in different circumstances and with different preferences need to make different choices. The purpose of the calculator is to better inform your choices. Looking at the historical data in an analytically valid way permits us to explore the nature of the trade-offs involved in a realistic way. The calculator gives you some idea of the extent to which you have to give up safety to obtain better returns.
#4 of 8 Retirement Planning Strategies — Trade Off Return for Safety
In our discussion of Strategy #2, we saw that, at times of moderate valuations, higher stock allocations translate into higher safe withdrawal rates. Does it follow that all retirees retiring at times of moderate valuations should be going with stock allocations of 80 percent? It does not.
Even when purchased at reasonable prices, stocks have their ups and downs. There are more uncertainties in a retirement portfolio comprised of 80 percent stocks than there are in a retirement portfolio comprised of 60 percent stocks. If you are particularly concerned about safety, and if you are in circumstances in which the safe withdrawal rate available by choosing a lower stock allocation is acceptable, you might quite reasonably elect the stock allocation yielding the lower safe withdrawal rate.
Again, the Retirement Risk Evaluator is not making your choices for you, but informing your decision-making process. If you require a safe withdrawal rate of 5 percent for a retirement in which the numbers cited in Strategy #2 apply, you would need to rule out stock allocations of 20 percent and 40 percent. But you might prefer the 5.18 safe withdrawal rate that applies for a 60 percent stock allocation over the 5.41 safe withdrawal rate that applies for an 80 percent stock allocation. You might like the 5.03 safe withdrawal rate that applies for a 50 percent stock allocation better yet.
When looking at safe withdrawal rates, higher numbers are always better than lower numbers. But when planning a retirement, safe withdrawal rates are never the only factor to be taken into consideration. It often makes sense to trade off the greater return possible by investing in stocks with the greater stability of portfolio value available through other investment classes. Knowing the numbers leaves you better able to make good trade-offs.
#5 of 8 Retirement Planning Strategies — Deliberately Take On Risk
Few of us will be able to save enough money to be able to retire without risk. Our goal should be not to avoid risk altogether, but to learn enough about the risks involved to take on only acceptable risks.
Enter a P/E10 value of “18” for all four scenarios, a TIPS rate of 2.0 for all four scenarios, and a Year-30 Percentage Balance of “0” for all four scenarios. Enter stock allocations of 20 percent, 40 percent, 60 percent, and 80 percent. At this valuation level, increasing your stock allocation increases the safe withdrawal rate. But not by much. Going from a stock allocation of 20 percent to one of 80 percent brings the safe withdrawal rate up from 4.19 to 4.30. It hardly seems worth taking on the uncertainties associated with going with a high stock allocation to receive that little of an increase in the safe withdrawal rate.
Say that you require a safe withdrawal rate of 4.50. What should you do? Move your eye from the column in the Results Table reporting the safe withdrawal rate to the one reporting the “Reasonably Safe” rate; that’s the withdrawal rate that stands an 80 percent chance of working out, presuming that stocks perform in the future at least somewhat as they always have in the past. The number for portfolios with a 20 percent stock allocation is 4.44. The number for portfolios with a 40 percent stock allocation is 4.68.
I see an argument in these circumstances for going with a low stock allocation and accepting a 20 percent chance that the plan will fail rather than taking on the uncertainties of stocks for a high percentage of the portfolio. The reasonably safe rate will fail only if a particularly bad returns sequence happens to turn up in the early years of your retirement. In that event, there will be things that you can do to repair the retirement plan. You could take on part-time work. Your could reduce annual spending. You could increase your stock allocation (stocks will be offering a better long-term value proposition after the price drop than they did at the beginning of the retirement).
Risk is not really a four-letter word. There are circumstances in which it makes strategic sense to take on risk deliberately.
#6 of 8 Retirement Planning Strategies — Time the Market
There’s great confusion among investors today on the merits or lack thereof of “timing the market.” Many believe that the word “time” really is a four-letter word. The reality is that the word “time” is no more a four-letter word than is the word “risk.”
Short-term timing doesn’t work (or, if it sometimes does, it is extremely hard to pull off and not to be recommended for the typical investor). Long-term timing (timing with no expectation of seeing the strategy pay off within one or two or five years) does work; at least the historical stock-return data shows that it has always worked in the past and it is hard to imagine a reason why it would not continue to work in the future.
The Retirement Risk Evaluator provides you with a means to assess the strategic value of adopting a long-term timing approach as your means of setting your stock allocation. Create a scenario using the choices examined in the discussion of Strategy #5 except for the stock allocation choice. Select “Switch Option B” as your stock allocation choice. “Switch Option B” means that you will be changing your stock allocation in response to changes in valuations.
Employ Switching Option B, and the safe withdrawal rate for the circumstances examined in the discussion of Strategy #5 moves up to 4.98 percent. With Switching Option B, the retiree uses a 0 percent stock allocation when P/E10 is above 24, moves to 20 percent stocks at a P/E10 below 24, moves to 30 percent stocks at a P/E10 below 21, moves to 50 percent stocks at a P/E10 below 12, and moves to 100 percent stocks at a P/E10 below 9.
#7 of 8 Retirement Planning Strategies — Watch for Good TIPS Returns
Enter “18” as the P/E10 value for all four scenarios. Enter “40 Percent” as the stock allocation. Enter “0” as the 30-Year Percentage Balance. Enter TIPS returns of 1.0, 2.0, 2.5, and 3.0.
The calculator shows that the safe withdrawal rate increases from 4.08 to 4.85 as the TIPS rate increases.
If your retirement is not far off, and TIPS become available at good rates, it makes sense to buy them before the rates change. Having TIPS at good rates in your portfolio makes all of your stock-choice options more attractive.
#8 of 8 Retirement Planning Strategies — Don’t Plan to “Die Broke”
I am not a fan of the “Die Broke” approach to retirement planning. Many retirement calculators assume that you are willing to have your portfolio depleted to zero over the course of 30 years and aim to identify the withdrawal rate that is likely to succeed under that assumption. It’s a dangerous assumption because it leaves you no slack in your plan. If stocks do not perform as expected (and no one knows the future, of course), the retiree is faced with a risk of seeing his retirement go bust. Plan to have 30 percent or 50 percent of your portfolio remaining at the end of 30 years, and you are covered in the event that the unexpected happens.
Enter “14” as the P/E10 value for all four scenarios. Enter “2.0” as the TIPS return. Enter “40 Percent” as the stock allocation. Enter 30-Year Percentage Balances of “0,” “30 Percent,” “50 Percent,” and 100 Percent.”
The safe withdrawal rate drops from 5.18 to 4.83 with the change from a “Die Broke” plan to a plan to have at least 30 percent of the initial portfolio balance (in inflation-adjusted terms) remaining in the portfolio at the end of 30 years. I don’t think that’s such a terrible price to pay for the added security. My preference would be to go with the lower safe withdrawal rate and the added security of having some slack in my plan.