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?
Kitces: Absolutely. I mean, frankly, that's the consolation, I think, for what our research has done so far. We've all been talking about this 4% to 4.5% withdrawal rates for the past 10 or 15 years since the research has been out. And the answer is, that's probably good because we've basically been in an overvalued environment for about 10-15 years. So, I'm actually glad that we've been using the research in the way that we have that we have in the past, but as the markets do moderate, the economy is still growing, granted with some hiccups.
Even the fact that the market is now about the level it was 10 years ago, but the economy is bigger than it was 10 years ago, it means we're compressing that valuation, and were getting to a more favorable environment. And so we will soon be at a point where the spending levels we should be talking about really are 5%-5.5% and higher, not the 4%-4.5%, we have been talking about in the past. I'm glad, we were there then, but that's not going to define the environment going forward.
Benz: Right. So, just to clarify, Michael, when we're talking about the role of valuations here, do retirees want to be thinking mainly about what valuations are like when they retire, or do they want to be monitoring valuations on an ongoing basis and maybe calibrating their withdrawal rate in those years accordingly?
Kitces: So, the research I have done has focused very specifically on what is your valuation look like on the eve of your retirement, and that's really for a few reasons. One, we have to set some starting level, and valuation environment at the start of your retirement has clearly had an impact on what spending level is appropriate with which to start.
The second reason why we're focused specifically at the start is because the entire nature and framework of safe withdrawal rates is that we set some spending floor in real dollars because we're adjusting annually for inflation; so we never have to do spending cuts.
So, at least the traditional interpretation of safe withdrawal rates is basically that you don't care what the valuation is after the starting point because you never look at it again. You've already defined a floor of spending. Now, I suppose we could look at it from the context of if things are going better than planned, you can spend more, and in fact that should be part of any safe withdrawal rate's usage in the real world.
But frankly, we're not likely to define that by valuation. We're likely to define that by saying, "I started with $1 million, spending $45,000 a year. Now it's 10 years later, and I am spending $70,000 as a result of inflation. But because I have a huge bull market, my portfolio is up to $2.5 million." And I don't really need a lot of valuation research to say, "If you are up to 70-something years old, and you are spending $70,000 on a $2.5 million portfolio, it's probably OK to keep your spending a little bit higher. You are going to be OK.
Benz: Right. So finally Michael, a question for you is, what are some general tips that you have for people as they go about setting these withdrawal rates? It's obviously a very important and impactful question for retirees. Any key takeaways that you would impart to investors trying to figure this out?
Kitces: Well, certainly, I think one starting point is to acknowledge through this conversation, your valuation matters. Not all starting points for your retirement are the same. Some of them entail a lot more risk, and some of them entail a lot less risk. And you should be cognizant of the environment that you are in when you are starting.
I think one of the other important things to note is that safe withdrawl rates is not an autopilot program. It defines a starting standard of living and a floor to your standard of living. But it's not the ceiling; it's not the end point. The endpoint maybe very well be much higher. In fact, what we see in the research is that the odds are overwhelmingly high that you will be able to raise your spending in the future if you start at 4.5%. It's a spending level that's low enough to defend against disastrous environments, but almost 96% of time you still have your principal left over after 30 years.
If you merely get average returns, you accumulate wealth on top of you spending. If we look at the basic math, 60-40 portfolios on average earn about 8%; you are only spending 4%. If you merely get average returns, you are going to have a lot of money left over. So, it does define a floor, and we tend to like that as starting point because most people really don't enjoy cutting their standard of living at all.
Benz: Or worrying about it?
Kitces: Right, you won't even have to worry about it. So we certainly like to start it as a floor, but frankly what the research tells us is, while on the one hand it is a safe floor, on one the other hand, there is a high likelihood that you are going to be able to sit down and review in five to 10 years and ratchet your spending upward. This is because things have not turned out as badly as you feared. And if it turns out things are going badly, and you are in one of those tough environments, well, that's why we set the spending where we did so that we can keep it where it is, and we still don't have to cut that standard of living.
Benz: OK. Well, Michael, thanks so much for your time and your advice. This is a really important topic, and we appreciate you being here.
Kitces: My pleasure. Happy to be a service.
Benz: Thanks for watching. I am Christine Benz from Morningstar.com.