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?
Related Posts:
1) Six Easy Steps to Figuring Out Your Retirement
2) Be Careful With The 4% Rule for Retirement Withdrawals
3) How to Pick Good Mutual Funds for Your 401k or Retirement Plan
Photo Credit: Yahoo Finance, MMD
That’s a pretty cool theory but it sounds like an awful lot of work. When I retire I (1) hope that I’m fairly well-off so I don’t really have to worry about what percentage I need to draw down or (2) use an annuity which will do everything for me. Some annuities will pay out 5 or 5.5; just depends on how old you are.
Don’t forget you’ve got Yale Professor Robert Shiller doing all the hard work for you. All you have to do is look up the number he calculates and then make your decision. For me, this is going to mean the difference between a 2 or 3% draw down, so I feel pretty safe regardless. And that annuity doesn’t sound too bad either!
I’m going to be on the other side of Jason on this: this part of the book reflects my comments from earlier. Michael’s suggesting that you temper your withdrawals based on market expectations and your needs rather than on a formula. By the way, I follow Michael Kitces on Twitter and have had some great conversations with him about financial planning. He a very nice, incredibly talented man. Follow him at @michaelkitces.
Great drop! I’ll have to sign up for his tweets. I always like when a big name makes time to interact with us regular guys.
MMD, I keep enjoying reading nicely distilled information on your blog, and this post is no exception. I also sent it out to my friends. Taking this away with me:
• 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%
Thanks Alik! I hope they can put this to use!
Sounds like a solid strategy to base your withdrawals on how the market is doing. Personally I’ll probably be planning for 30 years. With any luck I’ll still have extra money if I live beyond that. As long as I save up as much as I can, I should be fine. Also I plan on getting lots of dividend producing stocks in my portfolio to act as my income.
You’ll sell Modest Money for millions long before that!
Hmmm……I want to figure out how to take out as little as possible for as long as possible by figuring out different passive income strategies, such as vacation rentals. I feel like nowadays people live to be 90 and 100 more often and I feel like I need to figure out a way to really make that money stretch. Good advice!
All my financial plans have me living to age 100! It would be the greatest shame and irony to live that long and then run out of money after all this planning!
I would like to 2nd Nurse Frugal’s plan. My former plan was to save as much as possible in stock investments then plan to withdraw more like 8 to 10% annually (yeah, I’m one of these weirdos who still expects average annual returns of 10 to 12%). BUT, my new plan is to create as much passive income as possible before retirement and hopefully not NEED any of my savings at all to live on. My savings will be used for things like luxury purchases.
Why not both? I plan to save a ton AND create passive income. Who can stop you when you’ve become a double-threat? 🙂
I find that a lot of those books seem to completely ignore dividends. For example if my dividend account keeps growing then I won’t have to worry about withdrawing ANY of principal as the stocks could be providing 3 to 5% of just income nevertheless principal growth. This also ignores how high yield on cost may be. Does the book reference this at all?
Seconding Joe Michael is AWESOME on Twitter
Not spending much time on dividends was one disappoint from this book. However, in its defense, the book can’t cover everything. And there are volumes of great literature on dividend investing. I’m a fan of them and certainly plan to use them to my advantage for my early retirement and thereafter.