Most retirement planning tools don’t do the job that retirees are counting on them to do. There, I said it. I’ve been debating the flaws in safe withdrawal rate calculators for over three years now, and I have become increasingly alarmed over the grave flaws in the advice that is being given to aspiring retirees in books, magazines, and websites. The bottom-line finding of The Great Safe Withdrawal Rate Debate needs to be stated in clear and direct terms–most existing retirement planning tools simply do not do the job. They employ dangerous assumptions about the long-term returns that retirees are likely to obtain from their stock portfolios.
Will the Money Last?
Will the money last? That’s the question that retirees most need an answer to when planning their retirements, is it not? Most middle-class investors of today have a good portion of their savings invested in stocks. Stocks are not likely to provide the sorts of returns assumed in most retirement planning tools, presuming that stocks perform in the future much as the historical stock-return data shows they have always performed in the past. Many of the planning tools you come across today were constructed during the amazing bull market we enjoyed in recent decades, and employ flat-out dangerous assumptions on the question of how stocks are likely to perform starting from the valuations levels that apply today.
This is not just my personal opinion. The question has been examined from hundreds of angles during The Great Safe Withdrawal Rate Debate and the answer has always come out the same–valuations matter. Today’s safe withdrawal rate studies do not do the job, today’s retirement planning tools are leading aspiring retirees astray by causing them to feel a level of comfort in their stock allocations that the historical return data does not support. We need to get about the business of getting the word out to the people who put safe withdrawal rate analysis to practical use–the retirees who go to web sites looking for retirement planning tools to determine whether or not they have enough saved to hand in a resignation, whether the money is likely to last or not.
Here’s the problem with the existing tools in a nutshell–most retirement planning tools do not factor in the effect of changes in valuation levels when reporting whether stocks are likely to provide a return strong enough to support a retirement over the long term. The usual scenario is that the planning tool uses some form of the conventional methodology approach to safe withdrawal rate analysis. That doesn’t work.
Valuations Matter
The conventional methodology makes no adjustment for changes in valuation levels–it tells a retiree that he can take out the same inflation-adjusted percentage of his stock portfolio to cover living costs (often 4 percent) regardless of the valuation level that applies on the day the retirement begins. That is of course not the case; retirees handing in their resignations at times of low valuations can safely withdrawal far larger percentages than can retirees handing in their resignations at times of high valuations.
Tools employing Monte Carlo analyses do make adjustments for valuation levels. But these tools often have problems of their own because they do not rely on the actual historical data to determine what sorts of take-out percentages are reasonable. We need to be using realistic and accurate safe withdrawal rate studies as the foundation of our retirement planning tools, analyses of the type described by William Bernstein in his book “The Four Pillars of Investing” and of the type set forth by John Walter Russell at his Early-Retirement-Planning-Insights.com web site.
The key point is that it is not a good idea for an aspiring retiree to use any of the existing tools unless he or she studies the methodology carefully enough to understand what assumptions are being employed. If you don’t fully grasp where the numbers generated by a retirement calculator are coming from, do not trust the calculator to tell you what you need to know in putting together an effective retirement plan.
It is not just fly-by-night organizations that have put forward faulty safe withdrawal rate analyses. I have seen conventional methodology studies cited in The Wall Street Journal, in Newsweek, and in Money magazine. The most dangerous aspect of the conventional safe withdrawal rate studies is that they possess a good deal of surface plausibility. These studies have fooled some of the smartest people in the field of personal finance.
You Can’t Fool the Historical Data
They are not going to “fool” the historical data, however. In all likelihood, stocks are going to perform in the future much as they have in the past. If that possibility indeed comes to pass, many people who relied on today’s retirement planning tools to put together their investment strategies are going to be facing busted retirements. Investment strategies identified in conventional methodology studies as safe are in the real world often not safe at all, according to an informed assessment of the historical stock-return data.
Anyone using a retirement calculator to plan his or her retirement needs to ask this question before proceeding: “How does this tool adjust for the effects of changes in valuation levels?” If the tool in question appears to identify the same take-out percentage as safe for retirements beginning at both high and low valuation levels, the aspiring retiree needs to be wary of the results reported. Changes in valuation have in the past always affected long-term stock returns. In all likelihood, they always will. As William Bernstein has observed, the connection between valuation levels and long-term returns is one of “mathematical certainty.”