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How Inflation and Valuation Affect Safe Withdrawal Rates

Bill Bengen builds off his groundbreaking 1994 research that led to the creation of the 4% rule.

Prolific researcher Bill Bengen joins The Long View to discuss his new research breakthroughs on safe withdrawal rates.

Hear more about the CAPE Ratio, new ways to look at withdrawal rates, and what inflation means for people early in their retirement from Bengen's conversation with Morningstar's Christine Benz and Jeff Ptak:

Valuation and Withdrawal Rates

Ptak: I did want to explore the relationship between valuation and withdrawal rates. I think that your research points to there being a high inverse correlation between the CAPE Ratio and withdrawal rates--the lower the CAPE Ratio, the higher the withdrawal rates--that would have been supported. But there can also be outlier situations where even though the CAPE Ratio was high at the start of someone's withdrawal period, they were able to take more because price multiples expanded during their retirement. So, the question is, how should retirees and their advisors incorporate valuations into their withdrawal systems and what role might inflation play in that calculation?

Bengen: Back in 2008, Michael Kitces, a renowned advisor, developed a chart which showed there was a strong correlation between stock market valuation, or CAPE, and the safe withdrawal rate for a particular year. I thought that was an amazing discovery. When you look at it closely though, it's very hard to use the CAPE to predict what a safe withdrawal rate is, because it's only about a 74%, 75% correlation. And you can choose several years that had identical market valuations and have a variation of up to 50% in the safe withdrawal rate. So, although it was a big step forward, it wasn't enough to provide predictive power. Last summer, I made a breakthrough when I found that if you add inflation, the starting inflation regime, into the picture, you get a much higher correlation. And using stock market valuation and using inflation together, you get a really good fix on what a safe withdrawal rate should be, at least historically.

Inflation and Valuation

Ptak: Maybe you can elaborate on that. What is the framework that you're describing using inflation in tandem with valuation in order to predict what might be a sustainable withdrawal rate in the future?

Bengen: When I took a look at the data, I discovered that you could aggregate withdrawal rates by inflation rate--the starting inflation rate creates what I call six inflation regimes. Each regime is about 2.5 points of inflation, like a low inflation regime would be from 0% inflation to 2.5%; modern inflation would be 2.5% to 5%, and so on. You could divide all the historical data into six inflation regimes. And when you sort that, and then within that, by the Shiller CAPE, it's an astoundingly close correlation. When you have low inflation and you have cheap stock market valuations is when you get your very high withdrawal rates as high as 13%, historically. And when you get a scenario like you had in the late '60s, early '70s, when you have high inflation and coming off high stock valuations, that's when you had your worst withdrawal rates. So, that's the framework that has emerged from all this work.

Can We Predict Safe Withdrawal Rates?

Benz: To follow up on that, and thinking about the current time frame, it does seem like in some respects, from that standpoint, we're looking at a perfect storm right now, and that we do have fairly high equity valuations, rising inflation, and very low bond yields. So, what does that translate into, from your standpoint, with respect to, say, starting withdrawal rates? Bengen: The current environment it just sends you off the charts. We have valuations--we're almost 40 on the CAPE, which is only achieved once before, but we have higher inflation than was present when we reached that 40 level before. So, literally, it's almost impossible to tell what the safe withdrawal rate will be from this environment. It's unprecedented. I'm hoping that the 4.7% rate I developed recently holds, but there's possibility it might not if inflation becomes sticky and becomes like a 1970's kind of phenomenon. Of course, that's not certain yet. We don't know--it may return; it may be transitory.

How Does Inflation Affect Early Retirement Withdrawal Rate?

Ptak: Does it depend on when in the retirees' drawdown period the high inflation occurs? Is it the high inflation early on that is especially worrisome because it inflates all subsequent withdrawals? Bengen: That's exactly right. The early years in retirement are crucial. Both for inflation and for stock market action. What happens in those first five to seven years pretty much are going to set the tone for the rate in your retirement. And it's true of inflation. If you take a look at investors who retired in the late 1950s, they didn't really experience high inflation for about 10 or 12 years. And in the late '50s, a safe withdrawal rate was 6%, 6.5% because of the low inflation and the moderate valuation. So, yes, inflation early in retirement is particularly dangerous because it permanently inflates your withdrawal.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.

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