When you’re finally ready to retire and start accessing your money, mainstream advice says to follow the 4 percent rule. For anyone who doesn’t know, the 4 percent rule says you can start your retirement by withdrawing 4 percent of your total retirement portfolio to live on, and then doing the same each year thereafter with small adjustments for inflation. Research suggests that you’ll have a pretty good chance of success for about the next 30 years. Although this method is very popular for retirement income planning, there have been some studies to that show you can do better!
Take a look at the graph above. It’s the S&P 500 stock index between the years of 2007 and 2011. Let’s say the three orange diamonds represent different times when three different people retired. How would you feel about the outlook of your retirement if you were Number 1 and your portfolio was unfortunately cut in half by 2009? How optimistic would you feel about your retirement income planning if you were Number 2 and the market was looking brighter in 2010 and 2011?
Solin’s Suggestion for Retirement Income Planning:
Recently while reading The Smartest Retirement Book You’ll Ever Read by Daniel R. Solin, I came across a unique twist on the 4 percent rule for safely withdrawing your money. Chapter 23 introduced me to an alternative strategy for retirement income planning that may allow you to take out as much as 5.5 percent!
That means on a portfolio of $1,500,000, you might be able to take a retirement income of $82,500 instead of $60,000. Sounds pretty good so far, right? Wouldn’t it be nice if you could take out MORE money with the same or less risk?
Solin describes the research of investment advisor Michael Kitces. Confounded by the phenomenon described in the beginning of this post, Kitces concluded that you could safely use a withdrawal rate as high as 5.5 percent for your retirement income planning as long as you know how the market is going to react during the first 15 years of your retirement.
How Do I Know What the Market is Going to Do in the Next 15 Years?
Exactly – how are you supposed to know this? Simple. Kitces’s research found that there was a strong correlation between market behavior and the ten-year price-to-earnings ratio (P/E ratio) from the previous ten years.
Here are a few examples of how this would work:
• If the P/E ratio is high (stocks are over-valued), then it might be reasonable to expect that the market will drop in the coming years. Therefore, a new retiree should start their retirement off with modest withdraws to weather the storm. Consider 1999 when the market was flying high at a P/E ratio of 44.2. Then all the sudden the dot-com bust happened. A new retiree would have had to make serious reductions to their withdrawals or risk destroying their portfolio.
• Inversely, if the P/E ratio is low (stocks are under-valued), then you could probably expect the market to rise over the upcoming years. Therefore, you could start retirement with a higher withdrawal rate. Consider 2008 after the big housing market fall-out. The market was ripe for improvement so a higher withdrawal rate could be considered.
The ten-year price-to-earnings ratio is available on the website of Yale Professor Robert Shiller. Go to where it says “Stock Market Data”, download his Excel file, and look at the column of data that says “Cyclically Adjusted Price Earnings Ratio P/E10 or CAPE”.
Summary of Kitces’s Research for Retirement Income Planning:
• If the P/E ratio is greater than 20, use a safe withdrawal rate of 4.5%
• If the P/E ratio is between 12 and 20, use a safe withdrawal rate of 5.0%
• If the P/E ration is less than 12, use a safe withdrawal rate of 5.5%
Just like the 4 percent rule, this theory is only designed to be successful for approximately 30 years. If you’re like me and anticipate needing more than 30 years, then you may want to back off each of these figures by a few points. You can play around with your own retirement withdrawal rate using my Monte Carlo analysis.
Readers – What do you think of Kitches’s theory? Is there merit in basing your retirement income planning on the rise and fall of the whole market? Do you think we could use the ten-year P/E ratio to help us decide if this is going to happen or not?
1) Six Easy Steps to Figuring Out Your Retirement
Photo Credit: Yahoo Finance, MMD