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Wednesday, June 27, 2012

A Safe Withdrawal Rate Calculator

Things in the stock market many times are upside down.  This is part of what makes it interesting and a challenge.  This is why investors who rush in when all the news looks rosy and depart the ship like wharf rats (see graphic on left) when the news is horrible ( read "fiscal cliff approaching") underperform over the long run.  Unless you are a bloodless zombie ( read: "a really good financial advisor"), you are emotionally constructed to buy high and sell low.

Another upside-down event that affects investors is that they retire when markets are high and don't when they are low.  Some of you know exactly what I'm talking about - you looked at your nest egg in 2000 or in 2007 and figured you had reached your number and gleefully announced your retirement. And then had your head handed to you.

On the other hand, if your nest egg was sufficient to handle retirement in early 2009, it was a great time to retire.  The market was cheap on a valuation basis after stocks fell 37% in 2008.  It was, of course, a scary time and took some guts to actually carry through at the time.

These ideas have been researched by what I refer to as "the valuation school."  They argue that retiring without considering market levels and just taking 4% or 4.5% as a safe withdrawal rate in retirement is simplistic--that, in fact, the overall level of the stock market should  be considered.  A leading proponent of this view is Rob Bennett who has built on the work by John Walter Russell and constructed a neat calculator embodying these ideas.

The Retirement Risk Evaluator

To get to the calculator, click "risk evaluator" and you'll see:

CLICK TO ENLARGE  As you can see, you have a number of inputs you can put in for the calculator.  The P/E10 is the Shiller P/E discussed in yesterday's post.  The TIPS real return can be gotten at Bloomberg by clicking "Market Data" and then "Government Bonds" on the drop-down list.  There find the yield on the 10-year Treasury (1.63% today), scroll down and find the 10-year TIPS yield (-.50% today) and subtract (1.63 - (-.50)) to get 2.13%.

I also set the stock allocation at 60% and set my own P/E10s around the base case ("Scenario 3").  Click "calculate" and find:

CLICK TO ENLARGE As you can see, 4.43% is indicated as a safe withdrawal rate, given the assumptions, input into the calculator. A really useful outcome of the results is that individuals can calibrate withdrawal rates to their own risk tolerance levels.

If instead P/E10 was 17, the safe withdrawal rate, as shown in the table, would be 5%.

Scroll down the page below the calculator and you'll find an excellent write-up on the genesis of the calculator and its functionality.  I believe it is an excellent resource to be revisited from time to time as markets change and investors think about retirement.

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