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By Christine Benz | 08-10-2011 04:26 PM

Valuation Matters When Choosing a Safe Withdrawal Rate

Research indicates that investors retiring when stocks look cheap can safely take out a larger percentage of their portfolios annually, according to Pinnacle Advisory's Michael Kitces.

Christine Benz: Hi, I'm Christine Benz for Morningstar. How to set a safe withdrawal rate is a hot topic among retirees. Here to discuss that topic with me today is Michael Kitces. Michael is director of research for Pinnacle Advisory Group. He is also a publisher of the Kitces Report, and he is done a lot of research in the area of withdrawal rates. Michael, thanks so much for joining me.

Michael Kitces: Thanks, Christine. Great to be here.

Benz: So, Michael, you have done some work kind of poking at that 4% safe withdrawal rate that Bill Bengen originally wrote about. It was also in the Trinity study. You've looked at whether that's a viable withdrawal rate or possibly too low for retirees. What's your take on that question?

Kitces: Well, we've seen a few increments that added to the research from Bill Bengen's original work. Notably even his first follow-up piece a few years after its original noted quite fairly, "Gee, I kind of built this thing originally with basically a two asset class portfolio, large-cap stocks and intermediate-term government bonds, and in reality, we hold, to say the least, more diversified portfolios than two positions in the entire account."

So, even with Bill's follow-up work, what happens when we add even just the third asset class like small-cap stocks in there? The answer was your withdrawal rate jumped up from about 4% to 4.5%.

We've seen a lot of follow-up research, as well, that looked at what happened when we add anything from small-cap stocks to international stocks to commodities in real estate and lots of other asset classes. Some of those are difficult to research because our time history is limited in terms of the data that we have, but the clear trip we're seeing at least is that once you account for the kind of diversification that we typically hold in portfolios today, 4% is clearly too low. We don't quite know if its 4.5% or 5% or even something a little bit higher, but we're generally using at least 4.5% as the starting point simply to reflect the kind of diversification we hold in portfolios today.

Benz: Right. That's very valuable research. So, the reason that you would conclude 4% is too low, and the reason that would be a drawback, is that people would live more frugally than they really needed to during their lifetimes, correct?

Kitces: Well, the importance of setting a withdrawal rate properly right out of the gate, almost by definition, is that it defines your standard of living on an inflation-adjusted basis for rest of your life. So, it's an important number to get right.

Benz: Right. So, Michael, you have also done some work on this idea of fluctuating withdrawal rates and actually tying that to market valuation. Can you talk about the work you've done there?

Kitces: Absolutely. One of the things that I have noticed as we look back in the research, when we say, "The safe withdrawal rate is safe because it's what worked in the worst times period in history," well, when we go back and look, it's no sheer coincidence that there are certain environments where it turned out that the low safe withdrawal rates were really crucial. Examples of this are the time periods leading into the Great Depression and leading into the 1970s. If we actually widened the data window as well, there is a third time period in the early 1900s leading up to the market crash and the credit crisis of 1907.

And we see these different time periods where basically markets have a huge run. Then bad stuff happens. Then the economy is really sluggish for a decade or two, and then it eventually recovers and gets back on track again. I started looking for what are the similar trends that seem to define these periods, and one of the things that jumped up very quickly was they were all characterized by environments that had very high valuations at the start. That's not to say that high valuations necessarily caused market crashes or bad things to happen, but when bad things happen and they start in high-valuation environments, they always turn out a whole lot worst by the end.

So, what I found as we looked through the research is that not only do high-valuation environments characterize all of these bad situations that happened, but looking at it from a reverse perspective, any time we're not in a horribly high-valuation environment, the bad stuff actually isn't that bad. We only do so much damage to ourselves. The economy tends to recover more quickly. The markets tends to recover more quickly. The declines tend to not be as severe in the first place. So, what I found coming from the other direction is, you know what, as long as you're retiring in what's not already a high-valuation environment, the amount of bad stuff that happens is pretty limited.

Now, you can still have bear markets; you can still have market declines. You're certainly not immune to any kind of bad news. But the damage tends to be much briefer. The drawdown tends to be more limited, and recovery tends to come more quickly. So how I ultimately boiled that down in the research was to find if, in essence, that 4.5% withdrawal rate is a great starting point when you're actually dealing with a bad-valuation environment. But when you're dealing with merely average valuations, just things that aren't real bad, you should be talking about a number that's more like 5% than 4.5%. And if you're actually in a favorable-valuation environment, the number you should be talking about is more like 5.5%, and in fact there is a good chance you're going to be able to raise your spending further from there because you tend to get enormous bull-market runs that start in really low-valuation environment. So to say the least, taking only 4.5% on the eve of a great bull market is a dramatically unnecessary cut in your personal spending.

Benz: So, on the flip side, though, if you're unlucky enough to retire into what is a very high-valuation environment like the poor folks who retired in 2000, for example, you'd want to be at the more frugal end of that range?

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