## Overview: Using both Initial and Current Valuations

Research on Safe Withdrawal Rates

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JWR1945
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### Overview: Using both Initial and Current Valuations

Overview: Using both Initial and Current Valuations

Scroll down to read the last two sections. Then read the entire post.

Cursory Data Analysis

This is a minimal review. It brings out some of the key features about the new algorithm. This provides a starting point from which to build.

Withdrawals have two components.
1) The first depends only on the portfolio's initial balance. Its amount equals (standard withdrawal rate term)*(inflation)*(portfolio's initial balance).
2) The second component depends on the portfolio's current balance. It has the form: (slope term)*(100 E10/P + offset)*(the portfolio's current balance).

The term 100E10/P is the earnings yield of the S&P500 index using Professor Robert Shiller's P/E10. That is, 100E10/P = 100 / [P/E10]. P/E10 is the current price (or index value) divided by the average of the last ten years of earnings.

The portfolios that I have examined are designed to last 30 years. They consist of stocks as represented by the S&P500 index and TIPS at a 2% interest rate. For purposes of analysis, I have assumed that we can still buy and sell 2% TIPS throughout the full 30 years with neither capital gains nor losses.

I assert that, when 2% TIPS are unavailable, it is still possible to put together a suitable portfolio of high dividend stocks, cash, TIPS and Ibonds. I have not proved this. I have not demonstrated this. Putting together an adequate combination of securities that is equivalent to 2% TIPS is far from trivial.

I looked at portfolios with 50% stocks and 50% TIPS and at portfolios with 80% stocks and 20% TIPS. I used the variable withdrawal formula that I have described already. I used a fixed withdrawal formula as well to make baselines. In such cases, I held the second component of withdrawals constant (at 0.20% of the portfolio's current balance to cover expenses).

I followed what has become a standard procedure. I determined the 30-year Historical Surviving Withdrawal Rates (of the first component of withdrawals) for 1921-1980. I calculated regression lines using the 1923-1980 data (for better curve fits) of Historical Surviving Withdrawal Rates versus the percentage earnings yield 100E10/P. I made eyeball estimates of the confidence limits about these regression lines. The Safe Withdrawal Rate as a function of earnings yield 100E10/P is the lower confidence limit.

Because the scatter generally increases with earnings yield, I made my eyeball estimates using 100E10/P values of 10% (or less). That is, I narrowed the confidence limits by excluding bargain levels of stock valuations (with P/E10 less than 10).

[Plots of Historical Surviving Withdrawal Rates versus P/E10 have great statistical characteristics related to the scatter (or standard deviation). But the curves themselves are distinctly non-linear. Plots of Historical Surviving Withdrawal Rates versus 100E10/P (or 100 / [P/E10] ) are wonderfully linear (except for saturation at the very highest levels of earnings yield), but their scatter behaves poorly. It increases noticeably with earnings yield.]

Selected Data Set

These are minimal sets of data for purposes of comparisons. There are many other ways of making comparisons, but these are sufficient for our purposes at this time.

80% stocks and 20% TIPS at 2% interest

Slope = 0.25.
Offset = (2.5) or minus 2.5%.
Today's initial withdrawal rate: 2.9%.
Withdrawal amounts for the worst case sequence based on an initial balance of \$100000:
1) Start: \$3625
2) Peak: above \$3900.
3) Minimum: \$3183 at year 30.
4) Start year: 1966.
Maximum balance: \$259329 at year 20 of the 1948 sequence.

Slope = 1.0.
Offset = (2.5) or minus 2.5%.
Today's initial withdrawal rate: 2.1%.
Withdrawal amounts for the worst case sequence based on an initial balance of \$100000:
1) Start: \$4770.
2) Peak: above \$5400.
3) Minimum: \$1792 at year 30.
4) Start year: 1969.
Maximum balance: \$200355 at year 15 of the 1950 sequence.

Baseline:
Slope = 0.0
Expenses = 0.20%.
Today's withdrawal rates:
1) Safe Withdrawal Rate: 2.7%
2) Calculated Rate: 4.1%.
3) High Risk Rate: 6.7%.

50% stocks and 50% TIPS at 2% interest

Slope = 0.25.
Offset = (2.5) or minus 2.5%.
Today's initial withdrawal rate: 3.3%.
Withdrawal amounts for the worst case sequence based on an initial balance of \$100000:
1) Start: \$3838.
2) Peak: above \$4300.
3) Minimum: \$3365 at year 30.
4) Start year: 1966.
Maximum balance: \$155096 at year 15 of the 1950 sequence.

Slope = 1.0.
Offset = (2.5) or minus 2.5%.
Today's initial withdrawal rate: 2.4%.
Withdrawal amounts for the worst case sequence based on an initial balance of \$100000:
1) Start: \$4566.
2) Peak: above \$6100.
3) Minimum: \$1908 at year 30.
4) Start year: 1968.
Maximum balance: \$134412 at year 5 of the 1924 sequence.

Baseline:
Slope = 0.0
Expenses = 0.20%.
Today's withdrawal rates:
1) Safe Withdrawal Rate: 3.4%
2) Calculated Rate: 4.4%.
3) High Risk Rate: 5.9%.

Excursion:
Slope = 0.25.
Offset = (5.0) or minus 5.0%.
Today's initial withdrawal rate: 2.9%.
Withdrawal amounts for the worst case sequence based on an initial balance of \$100000:
1) Start: \$3550.
2) Peak: above \$4200.
3) Minimum: \$3479 at year 30.
4) Start year: 1966.
Maximum balance: \$165721 at year 15 of the 1950 sequence.

Comparisons

Slopes

With 80% stocks, increasing the slope term from 0.25 to 1.0 caused the following changes:
1) Today's initial withdrawal rate decreased from 2.9% to 2.1%.
2) The minimum amount in the worst case sequence decreased from \$3183 to \$1792.
3) The initial withdrawal amount in the worst case sequence increased from \$3625 to \$4770.
4) The peak withdrawal amount in the worst case sequence increased from \$3900+ to \$5400+.
5) The maximum balance decreased from \$259329 to \$200355.

We can characterize these results by the following observations:
1) Increasing the slope term increases the spread of the data.
2) At today's valuations, increasing the slope term decreases the initial withdrawal amount.
3) In the past and under worst case conditions, increasing the slope term increased the initial amount withdrawn.
4) In the past and under worst case conditions, increasing the slope term increased the peak amount withdrawn.
5) In the past and under worst case conditions, increasing the slope term decreased the minimum amount withdrawn.
6) In the past, increasing the slope term reduced the maximum balance found within the sequences.

With 50% stocks, increasing the slope term from 0.25 to 1.0 caused the following changes:
1) Today's initial withdrawal rate decreased from 3.3% to 2.4%.
2) The initial withdrawal amount in the worst case sequence increased from \$3838 to \$4566.
3) The peak withdrawal amount in the worst case sequence increased from \$4300+ to \$6100+.
4) The minimum amount in the worst case sequence decreased from \$3365 to \$1908.
5) The maximum balance decreased from \$155096 to \$134412.

The previous observations still apply.

The most important observation is that increasing the slope term from 0.25 to 1.0 increases the spread in withdrawal amounts too much. The minimum balances under worst case conditions are too low.

In spite of this, some people will prefer the larger slope term. Historically, it has increased withdrawal amounts in the early years at the expense of withdrawal amounts in the later years. At today's valuations, however, the initial amount withdrawn actually decreases. [This is a side effect of a wider standard deviation combined with using a lower confidence limit. Using the lower confidence limit comes from the requirement for safety.]

Stock allocations

With a slope of 0.25, increasing the stock allocation from 50% to 80% caused the following changes:
1) Today's initial withdrawal rate decreased from 3.3% to 2.9%.
2) The minimum amount in the worst case sequence decreased from \$3365 to \$3183.
3) The initial withdrawal amount in the worst case sequence decreased from \$3838 to \$3625.
4) The peak withdrawal amount in the worst case sequence decreased from \$4300+ to \$3900+.
5) The maximum balance increased from \$155096 to \$259329.

We can characterize these results by the following observations:
1) At today's valuations, increasing the stock allocation decreases the initial withdrawal amount.
2) In the past and under worst case conditions, increasing the stock allocation decreased the initial amount withdrawn.
3) In the past and under worst case conditions, increasing the stock allocation decreased the peak amount withdrawn.
4) In the past and under worst case conditions, increasing the stock allocation decreased the minimum amount withdrawn.
5) In the past, increasing the stock allocation increased the maximum balance found within the sequences.

With a slope of 1.0, increasing the stock allocation from 50% to 80% caused the following changes:
1) Today's initial withdrawal rate decreased from 2.4% to 2.1%.
2) The initial withdrawal amount in the worst case sequence increased from \$4566 to \$4770.
3) The peak withdrawal amount in the worst case sequence decreased from \$6100+ to \$5400+.
4) The minimum amount in the worst case sequence decreased from \$1908 to \$1792.
5) The maximum balance increased from \$134412 to \$200355.

With a slope term of 0.25 or 1.0, the previous observations apply except for the initial amounts withdrawn.

We can characterize these results by the following observations when the slope term equals 1.0:
1) At today's valuations, increasing the stock allocation decreases the initial withdrawal amount.
2) In the past and under worst case conditions, increasing the stock allocation increased the initial amount withdrawn.
3) In the past and under worst case conditions, increasing the stock allocation decreased the peak amount withdrawn.
4) In the past and under worst case conditions, increasing the stock allocation decreased the minimum amount withdrawn.
5) In the past, increasing the stock allocation increased the maximum balance found within the sequences.

Varying the stock allocation changes the spread in withdrawal amounts in the worst case sequence by only a little. In contrast, the maximum balances changed considerably.

At today's valuations, the initial amount withdrawn actually decreases as the stock allocation increases. This has varied in the past. It is a side effect of different standard deviations combined with using a lower confidence limit. [Requirements for safety cause us to use the lower confidence limit.]

Interactions and other effects

If we restrict ourselves to looking only at today's valuations and initial withdrawal amounts, we find no interaction between the slope term and the stock allocation.

That is, with a slope term of 0.25, changing the stock allocation from 50% to 80% changes the initial amount withdrawn from 3.3% to 2.9%, a decrease of 0.4%. With a slope term of 1.0, changing the stock allocation from 50% to 80% changes the initial amount withdrawn from 2.4% to 2.1%, a decrease of 0.3%.

Other comparisons show a little bit more variation, but not much more.

I have already pointed out that there is an interaction between the valuations of today versus the past that change the initial withdrawal amounts. It occurs because safety demands our use of the lower confidence limit. This introduces the effects of scatter (and standard deviations) into the comparisons.

Excursion

With 50% stocks and a slope term of 0.25, changing the offset from minus 2.5% to minus 5.0% caused the following changes:
1) Today's initial withdrawal rate decreased from 3.3% to 2.9%.
2) The minimum amount in the worst case sequence increased from \$3365 to \$3479.
3) The initial withdrawal amount in the worst case sequence decreased from \$3838 to \$3550.
4) The peak withdrawal amount in the worst case sequence decreased from \$4300+ to \$4200+.
5) The maximum balance increased from \$155096 to \$165721.

The excursion reduced the variation of withdrawal amounts for the worst case sequence. In that sense, it is similar to increasing the TIPS allocation. It has reduced today's initial withdrawal amount. In this sense, it is similar to decreasing the TIPS allocation.

Baseline Comparisons

With a 50% stock allocation and a non-varying withdrawal amount, the safe withdrawal rate is 3.4% at today's valuations. With a slope term of 0.25, the safe withdrawal rate is 3.3%. With a slope term of 1.0, the safe withdrawal rate is 2.4%.

With an 80% stock allocation and a non-varying withdrawal amount, the safe withdrawal rate is 2.7% at today's valuations. With a slope term of 0.25, the safe withdrawal rate is 2.9%. With a slope term of 1.0, the safe withdrawal rate is 2.1%.

In both cases, I have understated the baseline's performance since it includes expenses of 0.20%, which are not included in the other portfolios.

An alternative baseline

These data shout at us to abandon stocks entirely at today's valuations. A portfolio consisting entirely of inflation-matched cash equivalents produces a safe withdrawal rate of 3.33% for 30 years. A portfolio consisting entirely of 2% TIPS produces 4.46% safe withdrawal rate for 30 years (subject only to minor idealizations).

If we were to withdraw 3.4% annually from a portfolio consisting entirely of 2% TIPS, we would end up with \$43000 (plus inflation, based on an initial balance of \$100000) at the end of 30 years.

I used the formulas from the following post in the 3% SWR for 56 Years thread dated Monday, Oct 13, 2003:
http://nofeeboards.com/boards/viewtopic ... 536#p12536

Summary

This new algorithm is the kind of thing that an actual retiree is likely to do. He is likely to cut back his withdrawal amount when the outlook for stocks looks bad. He is likely to increase his withdrawal amount when the outlook for stocks looks good.

This approach differs from Gummy's Sensible Withdrawal Rate strategy. This approach depends upon the future prospects for stocks. Gummy's approach depends upon the actual recent performance of stocks.

I expect many retirees to combine the two. They will implement Gummy's Sensible Withdrawal Rate strategy with minor modifications based upon the future prospects of the stock market. That is, if they are convinced that the overall stock market is likely to underperform during the next decade, they are likely to reduce withdrawals below what the Sensible Withdrawal Rate strategy would allow during good years.

We keep coming back to the frustratingly consistent story, however, that tells us to abandon stocks in favor of TIPS at today's valuations. Favorable outcomes are still possible with high stock allocations, but they are not likely.

Alternative choices include careful selection of stocks and other investments that differ significantly from the S&P500 as a whole.

Of course, there is a problem with 2% TIPS. They no longer exist. The issue is whether a person can actually construct a good equivalent portfolio. There is a requirement to be able to handle emergency cash needs. There is another requirement to match inflation. There is an additional requirement to produce sufficient income (above any return of capital that might distort the numbers).

Have fun.

John R.

Mike
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Posts: 278
Joined: Sun Jul 06, 2003 4:00 am
Alternative choices include careful selection of stocks and other investments that differ significantly from the S&P500 as a whole.
Suggestions? I know you like high divvy stocks. Anything else?

peteyperson
**** Heavy Hitter
Posts: 525
Joined: Tue Nov 26, 2002 6:46 am
Mike wrote:
Alternative choices include careful selection of stocks and other investments that differ significantly from the S&P500 as a whole.
Suggestions? I know you like high divvy stocks. Anything else?
Hi Mike,

Timber is a separate asset class and yields 4-5%.

Global REITs yield up to 6%. Several new affordable global REIT funds are coming from Cohen & Steers and iShares.

Banks and Utilities.

Mature consumer product companies and healthcare yielding 2-3%. I would choose 2% over 3% as I would want those companies to retain enough earnings to still grow the business above inflation.

=--=

I would tend to opt for 30% in commercial real estate to get a high throughput on the yield. 1/3 of all wealth is in real estate globally anyway, so I don't see this as any bad thing. Replacement value goes up with increasing costs of materials and labor, so pretty good inflation hedge other than in markets that are overbuilt which overrides the RE fundamentals.

Timber is very different but useful for income purposes and timber long-term has appreciated 3-4% above inflation. I hope for 2% uplift over time but timber companies are getting smart at how to boost growth rates, cut less in cheap timber prices holding out for more demand with less supply and selling off/recycling land that has better uses for more productive timberland elsewhere. This can make up for years when timber doesn't appreciate and adds to returns. Overall I think timber will match inflation long-term and the harvest in the cash flow means you get a nice 4-5% real return from this. Quite tasty. If curious I would download the annual reports for the last couple of years from www.plumcreek.com. They do an excellent job in explaining to readers how they manage their 7.8m acres of timberland, how they extract extra value and so on.

Both these moves would boost a portfolio yield considerably. If you opted for large-cap index instead of active funds that use most of the dividend to pay their fees, then that would boost yields. Lower the cost, the higher the yields. Value indexing would give you typically a slightly higher yield as stocks are being bought at cheaper prices. Presently in the US that would add 0.2-0.3% to yields even after the slightly higher e/r from iShares when buying Russell 1000 Value, for instance.

I think one has to be aware of when one is sacrificing higher returns for greater income and the tax consequences of the higher income stream. Many higher dividend payers cannot grow faster than inflation leaving only the net dividend as your lifeline. This is unlikely to get close to the same 4% w/r rate if it was all capital gains sales. Depends on your tax situation but here in the UK dividends are taxable yearly but capital gains can be avoided or deferred until sale so higher income planning comes with considerable costs. It is also good to consider diversification of the income stream as companies can cut their dividends or you could experience a general lowering of payout ratios. Global diversification is therefore advisable on a more equal weighted basis than most Americans are comfortable with. 80/20 diverisfication won't do it. The advantage of the global REIT structure is that payouts are mandated rather than optional, so if these companies are still cash flow positive then some of that will have to be paid out. This is another reason why I like REITs and Timber REITs as a good chunk of the portfolio balanced globally. It is good insurance for the income stream.

The suggested move into REITs and Timber is done from the perspective that SWRs have typically been 4% substainable for at least 30 years. Both REITs and Timber should deliver this in both the income stream and their natural inflation-linked replacement value uplifts, so it is a no fuss solution to a decent chunk of the portfolio. Global diversification there reduces the bad real estate market worry. Returns net are less in REITs that many common stocks but I think they are a good place to be. I would prefer to have 25% in REITs and 50% in stocks than just 75% in stocks. They are different, have different characteristics and I don't view the former as a 75% stock allocation. It does not feel like that level of risk and the higher portfolio yield which may average 2-3% means I only need to worry about finding 1-2% w/r on the inflation-adjusted starting balance. This may allow you to preserve in place the highest returning, most volatile asset classes like ScV which are great performers long-term if you can hold on thru declines. So it is a balancing act!

Both asset classes seem far better than owning stocks that payout so much and are so large that one questions if they can grow even with inflation. This likely will only give you their yields if you're lucky and so are a poor substitute to REITs/Timber. Fees are also terrifically low with Plum Creek (PCL) and Rayonier (RYN) available to be purchased and held long-term and REITs available via incredible cheap VIPER now. One can also choose whether to own only the largest, most liquid US REITs (Cohen & Steers Realty ETF) or broader Vanguard REIT Viper which hasn't done as well over the last 5 years.

I think REITs and Timber are terrific no-hassle investments for the FIREd investor. Years ago it was no so easy and simple to have 1/3 of your holdings in real estate and benefit. I recall that Shakespeare himself owned several rental apartments and bought some farm futures for 30 years of output when he was in his 40s. This continued to do well for his benefactors after his death. That was several hundred years ago and real estate is still a good investment most of the time! Timber has been a good investment for over a century. Mark Twain bought timber with his brothers but it was all in one place and burnt down! With the advent of companies like Plum Creek and Rayonier one can benefit from far better diversification today! So I differ from the typical advice on real estate to have a 5-10% allocation. Today endowments and pension funds are starting to increase their allocations gradually after being scared off running like a herd into the last overbuilding mania in real estate following the 1966-1981 market decline scared them out of stocks.

Petey

Mike
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Posts: 278
Joined: Sun Jul 06, 2003 4:00 am
Thanks Petey. What global real estate and timber mutual funds do you recommend? Are global REITS and timber reasonably priced now? US REITS seem a bit pricey to me, but I don't know about global REITS or timber.

peteyperson
**** Heavy Hitter
Posts: 525
Joined: Tue Nov 26, 2002 6:46 am
Mike wrote:Thanks Petey. What global real estate and timber mutual funds do you recommend? Are global REITS and timber reasonably priced now? US REITS seem a bit pricey to me, but I don't know about global REITS or timber.
Hi Mike,

This my own personal take, Mike, so you have to do your own research and not rely on what I say for investment decisions. That said..

Timber is a separate asset class. It works differently. As I mentioned, to get a feel of this read the Plum Creek annual report if you have the time. It is short and simple. Many lump timber in with REITs but that is a mistake. Most endowments place them either separately or within an natural resources allocation - not real estate allocation - to give you some idea. Timber is a commodity so is very different. There are few securities so no mutual funds. PCL and RYN in the US and TimberWest in Canada are the best options. PCL is overpriced at present. M* put fair value at \$28. It is \$36. RYN looks less overpriced. TimberWest looks the cheapest of the bunch. Yields are 4%, 4.7% & 6.7% last time I looked. I would be a buyer of TimberWest at these prices but poss. not Plum Creek unless I would buying for isolation from mainsteam equities and found comfort in the decent livable yield. It is not a great growth investment, not gonna shoot to the moon. It is a good inflation + 4% type investment which suits people living off investments very well indeed. However in these days whether everything is overpriced, it is a decent conservative equity position to hold I feel.

US REITs are presently up to 35% overpriced. A few are 10% overpriced according to M*. Foreign REITs were 20-30% underpriced 3 years ago and those discounts have mostly closed. Most are available at NAV today which represents a fair deal. There are couple of expensive global funds - Alpine International Real Estate is one which has done well in the past 5 years - 20% annualised - because of 10% fundamental int'l RE returns, closing of NAV discount and US dollar movements. Split was 10% RE returns, 7% valuation uplight & 3% currency movement as best as I can tell. I would wait until Cohen & Steers launch their global fund. iShares are looking into this area too so may launch something in the coming months. Cohen & Steers have an e/r of 1/2% and iShares may be cheaper. The former are aiming at higher income yields and less capital growth which may not suit the accumulator but suit someone in distribution phase well. Yields circa 5% 25% in US, 25% in Australia which payout the highest percentage of cash flow. See http://www.cohenandsteers.com/ for link on home page to info.

British Land, available as an ADR I think, is the largest UK RE company and has a discount of 20% to NAV. That is the largest obvious one. They own \$15Bn of quality assets. Google them for more info. Not a bad idea to look up various int'l companies to get an idea what you might choose to own, rather than just buying an int'l real estate fund and not really knowing much about it.

Those would be my suggestions.

Petey

Mike
*** Veteran
Posts: 278
Joined: Sun Jul 06, 2003 4:00 am
Thank you Petey, I shall ponder these asset classes.