As the market soars to new highs and breaches high valuation levels, I felt it was time to look back at research completed by Michael Kitces that focuses on withdrawal rates based on market valuations.
Specifically, in “Dynamic Asset Allocation and Safe Withdrawal Rates” from an April 2009 article in The Kitces Report, Kitces considers the valuation effect alone by testing both optimal asset allocations and safe withdrawal rates based on Shiller’s PE10, which is the price earnings ratio based on the average of earnings over the last 10 years. By using a decision rule based on market valuation, Kitces found that an individual can increase withdrawal rates in retirement.
Kitces indicates that “a volatile market with an unfavorable sequence of bad returns, stacked on top of ongoing withdrawals, can cause a client to run out of money before the good returns finally come.” Consequently, the returns may not improve but the ability to take sustainable withdrawals throughout retirement progresses.
By reducing exposure to stocks in higher risk environments, as measured by market valuations, and increasing stock exposure in favorable markets, as measured by low valuations, individuals can increase the safe withdrawal rate above the 4% rate.
The purpose is not to time the market but to increase a client’s probability of success in retirement.
Understanding Market Valuations
By using a decision rule based on market valuations, individuals can sustain withdrawal rates above the original 4% rate. In his study, Kitces indicates that “through this methodology, clients can actually sustain safe withdrawal rates closer to the 5% – 5.5%+ range. They can do this by simply making periodic asset allocation changes based on valuation and looking to the market’s starting valuation in the first place.”
Kitces’ research suggests two critical factors that advisors should consider:
- Look at valuation when an individual enters retirement
- Adjust portfolios annually based on stock market valuations.
He found that “using market valuation to forecast returns for the first years of retirement helps to predict when a higher withdrawal rate is actually safe and when a lower starting withdrawal rate may be necessary.” By using a valuation approach, individuals can increase spending by 18%, two thirds of the time.
Rather than the typical combination of 60% stocks and 40% bonds, Kitces found that a base equity exposure of 40% was more favorable. An overweight stock exposure represented 60% in stocks and underweight exposure represented 20% in stocks.
Safe Withdrawal Rates Vary Based on Stock Exposure
Safe withdrawal rates (SWR) increased across the spectrum by using a dynamic asset allocation approach of increasing and decreasing stock exposure depending on how favorable or unfavorable the markets are. In favorable markets (PE10< 13), dynamic SWR rate increased to 5.4% from 5.1%. In moderate market environments (PE10 between 13 and 18), dynamic SWR increased to 5.0% from 4.8%, and during risk market environments (PE10 > 18), SWR rates increased to 4.8% from 4.4%.
Although understanding the initial valuation when entering retirement is important, reducing stock exposure in the face of a higher valuation market appears to help significantly, regardless of the starting market valuation.
In addition, understanding how compounding and linking returns from one year to the next is extremely crucial when taking withdrawals, because taking withdrawals when the market has had a significant decline makes it more difficult to return to previous levels.
Dynamic Allocation Strategy in a High Valuation Environment
In order to have the upper hand with stock market valuations in today’s economy, Kitces found that “the dynamic allocation strategy may be more helpful for retirees who begin in a high valuation environment, than for those who begin in a low valuation environment with the intention of reaching a risky environment later on.”
Fifteen years is time period most predictive of 30-year withdrawal rates and starting valuations are predictive of 15-year returns. Therefore, looking at one, two and three year returns is not optimal.
Overall, applying a dynamic approach reduces risk and improves the sustainability of retirement income.
These are not revolutionary variations from the conventional 4% rule, but they highlight a clear point– valuations matter.