The Search for a Safe Withdrawal Rate

In this article, I highlight work by Michael Kitces, who looks at stock market valuation levels as guides to setting retirement withdrawal strategies.

Current financial market conditions pose a number of challenges for financial planners, not least of which is the determination of safe withdrawal rates for retired clients.

To solve this problem, many advisors rely on research by fellow planner Bill Bengen, who demonstrated in the early 1990s that, based on history, a 4% to 4.5% initial withdrawal rate, with yearly inflation adjustments, would have been safe for 30 years.

But because an individual who holds funds in retirement accounts would likely need more than $1.3 million to generate an inflation-adjusted, after-tax income stream of $40,000 to $45,000, his numbers are not good news for clients contemplating retirement.

Since Bengen’s initial work, he and other researchers have reexamined withdrawal strategy issues to see if it’s feasible to frame the problem differently or to manage retirement accounts so that retirees can take higher initial withdrawals without undue risk of ruin.

In this article, I highlight work done by Michael Kitces, who looks at stock market valuation levels as meaningful guides to setting withdrawal strategies. I also discuss the use of guaranteed products, like annuities, and how their attractiveness may vary with such factors as P/E levels, interest rates, and market volatility.

P/E ratios and withdrawal rates
Kitces, director of financial planning for Pinnacle Advisory Group and publisher of The Kitces Report, has produced a study showing how stock market valuation levels at the inception of a planning period impact safe withdrawal rates.

P/E’s and Stock Returns By Decade
Period Beginning of
Period P/E
Stock Return
1930-1939 21.5 -.92%
1940-1949 16.9 8.50%
1950-1959 10.6 19.46%
1960-1969 18.3 7.74%
1970-1979 16.9 5.92%
1980-1989 8.8 17.34%
1990-1999 17.2 18.05%
2000-2009 42.5 -.91%
Avg 1930-2009 17.3 11.12%
Sources: Shiller Data Base, Stern NYU Data Base

To remove the impact of earnings cycles, he uses a price/earnings ratio with the past 10 years of earnings in the denominator. This measure has been called “P/E 10” and “Cyclically Adjusted P/E or (CAPE).” Graham and Dodd used it in the 1930’s, and Yale economist Robert J. Shiller popularized it in his 2006 book, “Irrational Exuberance.”
Testing based on historical data shows that beginning P/E levels have been predictive of long-term stock returns, as the following chart shows.

This chart shows initial P/E’s and equity returns for each decade since 1930. It demonstrates a clear tendency for high P/E’s to presage below average returns and vice versa. (Although PE’s have been good forecasters of long-term returns, they have not been useful in the short run. In the late 1990s, P/E’s rose into the high 20’s, and 30’s and stock prices kept climbing. We remember how that ended.)

Safe Withdrawal Rates Based on P/E 10 Quintiles and 60/40 Stock/Bond Mix
Quintile Lower P/E Upper P/E Lowest SWR Average SWR
1 5.4 12.0 5.7% 8.1%
2 12.0 14.7 4.8% 6.7%
3 14.7 17.6 4.9% 6.3%
4 17.6 19.9 4.9% 5.8%
5 19.9 28.7 4.4% 5.1%
Source: The Kitces Report 05/08

Kitces recognized that long-term returns matter most in retirement planning, and that advisors should consider P/E’s at the beginning of the retirement period when choosing a safe withdrawal rate. The following chart, taken from his study, shows the relationship between P/E’s and safe withdrawal rates. (The P/E Quintiles are based on P/E’s at the beginning of rolling 30-year periods starting in 1881.)

Except for Quintile 5, all of the P/E levels allow higher withdrawal rates than those prescribed by Bengen. The Lowest SWR’s could be used for clients who need to be sure of not running out of money, while the Average SWR’s could be used for clients who have backup resources for use in below-average return scenarios.

Immediate annuities and interest rates
Planners might ask: What investment strategies should I recommend when P/E’s are high and Kitces’ approach dictates low withdrawal rates? How can I raise the withdrawal rate without subjecting the client to undue risk? As of early January PE’s have edged above 20, so we are now in Quintile 5 and these questions apply.

Advertisement Altering the stock/bond mix in favor of bonds might appear to be the best approach under these circumstances, and Kitces examines this strategy in his study. But he concludes that emphasizing bonds would probably do more harm than good. Even at high P/E levels, expected returns for stocks exceed expected bond returns.

Buying annuities or other guaranteed products offers another course of action. Immediate annuities convert investments into lifetime income streams. Based on late-January Vanguard/AIG rates, a 65-year old female could purchase an immediate annuity that pays $426.33 per month with annual increases based on actual inflation for $100,000. That equals a 5.1% initial withdrawal rate, so using an annuity could improve the safe withdrawal rate.

But annuities would not necessarily deliver a huge improvement, because the current environment is not particularly favorable for them. Prices of inflation-adjusted annuities reflect both real interest rates and spreads between Treasury bonds and corporate bonds. Real rates as measured by 10-year Treasury Inflation-Protected Securities (TIPS) are currently only 1.35%, compared to a long-term average of 2%.

Real rates may well rise as the economy recovers, however. The spreads between corporate bonds and Treasuries have narrowed over the past year, and it’s not clear whether they will continue to do so. I expect immediate annuity payout rates to trend higher.

At this time, few companies offer inflation-adjusted life annuities and the pricing may not be as competitive as it is for straight fixed-payout annuities. For example, if we compare the Vanguard/AIG rates for the inflation-adjusted annuity with their current rates for annuities with pre-set annual increases, we find an implicit inflation assumption of 3.3%.
Expected inflation based on the TIPS/Treasury spread is currently around 2.3%. A client could purchase an annuity with preset 2.3% annual increases that would pay $478.52 per month, equivalent to a 5.7% initial withdrawal rate. In this environment, I would not recommend investing large sums in annuities, but a planner might advise clients to begin purchasing a series of small immediate annuities over a number of years.

Purchasing an investment product with retirement guarantees, such as a variable annuity with a guaranteed lifetime withdrawal benefit (GLWB) or a so-called Standalone Living Benefit (SALB), is another approach. The relatively new SALB product, now offered by four insurers, is simply an unbundled version of the GLWB attached to a managed investment account.

Both the GLWB and SALB combine longevity insurance with protection against poor investment performance. The investment protection piece is effectively a purchase of long-term put options on the stock market. The best time to purchase these products is when stock market volatility is low and options are cheapest.

Looking back, there were times during 2005 and 2006 when the VIX index, a measure of anticipated volatility, fell to between 11 and 12, or well below its long-term average of about 20. During this period, insurers offered GLWB riders with annual charges of only 30 to 50 basis points, causing Moshe Milevsky of York University and others to question whether those charges were high enough to cover potential losses.

During the financial crisis, the VIX soared to 70. Insurers raised GLWB prices to 80 to 100 basis points, placed stricter limits on investment choices and, in some cases, pulled their GLWB products from the market. The VIX subsided as the market partially recovered, but it still stands at around 25 and insurers have not yet reduced the charges for these guarantees.

Even with reduced rider fees, however, SALB products and variable annuities with GLWBs tend to be expensive. Total annual charges typically run 2% to 3% for products that provide only a 5% income guarantee that does not adjust for inflation. Based on an estimated future inflation of 2.3%, that’s equivalent to an inflation-adjusted withdrawal rate of just 3.75% over 30 years, which is below Bengen’s or Kitces’ lowest recommended safe withdrawal rates.

Clients would therefore not enjoy a better withdrawal rate by moving money into these products at today’s pricing levels. SALBs and GLWBs may eventually play a key role in retirement portfolios, but they will need to be more attractively priced. A no-load SALB based on an underlying portfolio of low-cost index funds could be the answer.

Final thoughts
With its low interest rates, high P/E’s, and keen memories of record volatility, the current environment poses challenges for advisers who hope to recommend withdrawals rates and choose investments or guaranteed products for their older clients. Planners who work with clients contemplating retirement might consider the “Don’t Retire Now” strategy.

© 2010 RIJ Publishing. All rights reserved.