Retirement planning as if valuations mattered
I advocate Valuation-Informed Indexing. This investing strategy is rooted in many of the same principles as Buy-and-Hold, but with one important difference. Valuation-Informed Indexers make adjustments for valuations in all their investing analyses (we believe that the research of Yale Economics Professor Robert Shiller showing that valuations affect long-term returns requires this). You can read more about Valuation-Informed Indexing in Guest Blog Entries that I recently wrote about it that appeared at the Free From Broke blog (“A Better and Less Risky Way to Invest in Stocks”) and at theMapleMoney (“The Five Big Benefits of Valuation-Informed Indexing”).
The purpose of this blog entry is to show how retirement planning changes if you take into consideration Shiller’s findings that valuation levels predict long-term returns.
1) You can sometimes retire sooner by lowering your stock allocation
For the entire time-period from 1996 forward (except for a few months in early 2009), stocks have been priced very high. At such times, it is often possible to retire much sooner by lowering your stock allocation.
Try entering a P/E10 value of 27 into the calculator (P/E10 is the current price of the S&P Index over the average of its past 10 years of its earnings — a P/E10 value of 27 is about double the fair-value P/E10 of 14). Enter 2 percent real as the return you can obtain from the non-stock assets in your portfolio and “0 Percent” as the “Year-30 Percentage Balance.” In the four allocation boxes, enter “80 Percent,” “60 Percent,” “40 Percent,” and “20 Percent.”
2) At other times you can retire sooner by increasing your stock allocation.
3) You can determine how much safety you must give up in exchange for the possibility of a greater return
Let’s return to the scenario described in Section (1) above. The highest safe withdrawal rate comes with the lowest stock allocation examined (20 percent). Does this mean that there is zero chance that stocks will outperform the non-stock asset class which you are presuming will be able to generate a return of 2 percent real? It does not.
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.
4) You can determine the cost of not following a “die broke” assumption.
The conventional retirement calculators use a “Die Broke” assumption. That is, they identify the safe withdrawal rate for a retiree who is okay with the possibility that his portfolio may be reduced to nothing at the end of 30 years. What if you want to be sure to be able to leave something to family members or to charities?
Enter “14” as the P/E10 value for all four scenarios to be examined by the calculator. Enter “2.0” as the non-stock return. Enter “40 percent” as the stock allocation for each of the four scenarios. Enter 30-Year Percentage Balances of “0,” “30 Percent”, “50 Percent,” and “100 Percent.”
Now you can see the cost of rejecting the “Die Broke” assumption. The safe withdrawal rate drops from 5.18 percent to 4.83 percent as the result of a demand on your part that your portfolio retains at least 30 percent of its starting-point value at the end of 30 years.
For those with a portfolio of $1 million, that’s the difference between living on $52,000 per year and living on $48,000 per year. Is it worth it to get by on $4,000 less per year to be sure to be able to leave at least $300,000 in inflation-adjusted funds to family members and charities? You decide.