October 12, 2022
As promised in the “Building a Better CAPE Ratio” post last week, here’s an update on how I like to use the CAPE ratio calculations in the context of my Safe Withdrawal Rate Research. I have studied CAPE-based withdrawal rates in the past (see Part 11, Part 18, Part 24, Part 25) and what I like about this approach is that we get guidance in setting the initial and then also subsequent withdrawal rates based on economic fundamentals. That’s a lot more scientific than the unconditional, naive 4% Rule. In today’s post, I want to specifically address a few recurring questions I’ve been getting about the CAPE and safe withdrawal rates:
- Can a retiree factor in supplemental cash flows like Social Security, pensions, etc. when calculating a dynamic CAPE-based withdrawal rate, just like you’d do in the SWR simulation tool Google Sheet (see Part 28 for more details)? Likewise, is it possible to raise the CAPE-based withdrawal rate if the retiree is happy with (partially) depleting the portfolio? You bet! I will show you how to implement those adjustments in the CAPE calculations. Most importantly, I updated my SWR Simulation Google Sheet to do all the messy calculations for you!
- With the recent market downturn, how much can we raise our CAPE-based dynamic withdrawal rate when we take into account the slightly better-looking equity valuations? Absolutely! It looks like, the 4% Rule might work again! Depending on your personal circumstances you might even be able to push the withdrawal rate to way above 4%, closer to 5%!
- What are the pros and cons of using a 100% equity portfolio and setting the withdrawal rate equal to the CAPE yield?
Let’s take a look…
CAPE primer
Because I haven’t specifically written about CAPE ratios and their application to safe withdrawal rates in a while, let me just get everybody up to speed again on why and how CAPE ratios matter for retirees. Even if you don’t pursue a dynamic CAPE-based safe withdrawal rate, but prefer to use the standard Trinity Study-style calculations with a fixed withdrawal amount (though adjusted for inflation), CAPE ratios should matter for setting that withdrawal amount and percentage. Here’s again a chart from an earlier post to drive home this point. All the historical failures of the 4% Rule have occurred when the CAPE earnings yield (= one divided by the Shiller CAPE Ratio) was under 5%, i.e., when the CAPE Ratio was above 20. So it would be way too conservative to use a 4% Rule when the CAPE Ratio is in the low teens. But a 4% Rule might be way too aggressive conditional on facing a high CAPE ratio because the conditional failure probability is much higher than the (unconditional) failure probability you’d get from a Trinity Study.
Because of the great relevance of this CAPE ratio to retirement success, I dedicate a portion of the main results table of my SWR Google Sheet (see Part 28 for the link and explanation) to the different valuation regimes, please see the screenshot of the table below. It’s the failure probabilities for different withdrawal rates (ranging from 3.25% to 5.25%) over the entire sample, but also conditional on equity valuations. For example, a 4% WR might seem somewhat safe with an 11.62% failure rate. But this disguises the fact that we encountered failures in 37% of the retirement cohorts when the initial CAPE ratio was elevated, at above 20. The failure rate rises even further, to 43.2% when both the CAPE was above 20 and the S&P 500 index stood at an all-time high at the commencement of retirement. (and I should note that this is the baseline scenario with a 60-year horizon, 25% final value target, and modest supplemental flows later in retirement coming from Social Security and a pension)
I also like to highlight the extreme sensitivity of failure rates as a function of the withdrawal rate. And the sensitivity is more extreme if equity valuations are elevated. For example, shifting withdrawal rates from 3.50% to 3.75% and then 4.00%, when the CAPE is below 20, the failure rates go from essentially 0% to 1.7% and then 5%. But when the CAPE was above 20, the failure rates go from 2% to 24% and then over 37%. So, to everybody who’s making fun of my blog for calculating withdrawal rates with precision behind the decimal point, I laugh straight back at you for not understanding the simple finance wisdom that small changes in your financial strategy will amount to a huge difference after 60 years of compounding!
So, how can you use the new CAPE ratio in the traditional SWR worksheet? Simple, at the bottom of the parameters section you can toggle back and forth between the old, traditional Shiller CAPE and the new adjusted CAPE ratio. Use option 1 (=old) or 2 (=new) respectively. The new default setting is 2, for the new adjusted Shiller CAPE.
CAPE-based Dynamic Safe Withdrawal Rates – a primer
Just to get everyone back to speed on dynamic withdrawal rates, here’s a quick primer on the CAPE-based SWR rules. In the most basic setup, we calculate our withdrawal rate as
WR = intercept + slope / CAPENotice that our setup also encompasses, as a special case, another popular withdrawal rate rule: the Bogleheads variable percentage withdrawal (VPW) rule, if we set the slope to zero and fix the withdrawal amount to a certain percentage of the portfolio. But of course, we do want equity valuations to have an impact because economic fundamentals should matter. There are three neat features of using a withdrawal rate contingent on equity valuations:
First, we find an initial withdrawal amount that’s calibrated to be consistent with equity valuations. Second, our subsequent withdrawal amounts will adjust to changing portfolio values but also equity valuations. That’s a great improvement over the naive Bogleheads rule that uses a fixed withdrawal rate (though adjusted for retirement horizon). With a variable withdrawal rate, your withdrawal amounts will be significantly less volatile than the portfolio value. The portfolio may be down 20%, but the withdrawal amount is only down by, say, 10% because you also adjust the percentage withdrawal rate to reflect the better-looking CAPE ratio after an equity market correction.
And third, our CAPE approach satisfies Bellman’s Principle of Optimality. It implies that subsequent retirement planning decisions are following an optimal path, as though the retiree had simply re-retired under the new prevailing conditions. This Bellman Principle is violated in the naive Trinity-style fixed withdrawal amount calculations, and that always bothers me! But if you’re not a math geek, please ignore this one point! 🙂
If you’re familiar with my Google Sheet (see Part 28 for the most recent comprehensive guide to the sheet), you can enter supplemental cash flows to be taken into account in the traditional safe withdrawal rate simulations. But not in the CAPE-based simulations. As you might recall, I set up a separate tab where you can enter your future supplemental cash flows, like Social Security, pensions, home sales or purchases, anticipated nursing home expenses, etc. Until now, the CAPE-based rule is calibrated to target capital preservation and it ignores all supplemental cash flows. A reader asked me a while ago how he would factor in those supplemental flows. I had some ideas on how to “hack” my Google sheet, and I implemented those in the latest Google Sheet. This brings me to the next point…
Factor in supplemental cash flows and (partial or complete) asset depletion
So, here’s how to calculate that new CAPE-based withdrawal rate:
Step 1: CAPE Rule basics
We still calculate an initial CAPE-based safe withdrawal rate, assuming no additional cash flows and capital preservation. In this case, I use a CAPE of 27 and the following CAPE parameters: intercept=1.75% and the slope of 0.50, as I recommended in previous posts, e.g., in Part 18. So, the SWR calibrated for capital preservation and no additional cash flows would be…
WR = 0.0175 + 0.5 / 27 = 0.036In other words, the initial CAPE-based SWR is 3.60%.
Step 2: Supplemental Cash Flows
Enter the supplemental cash flows as you would always do in the Google Sheet, namely in the tab “Cash Flow Assist”. Notice that there are columns for cash flows that are already inflation-adjusted (e.g., Social Security, most government pensions, etc.) as well as cash flows that are in nominal dollars (e.g., most corporate pensions). For example, as the baseline scenario in that Google Sheet, we have a retired couple where one spouse expects $2,000 in Social Security in month 301 (25 years into retirement) and the other spouse expects $800 in month 313. Furthermore, to account for higher health expenses we model a negative cash flow of $1,000 starting in month 361, and $2,000 starting in month 481. There’s also a corporate pension worth $300 a month starting in month 133 (year 11), but it’s not CPI-adjusted. You’d also enter your current portfolio value here, $3,000,000 in this case.
Calculate the present value of all supplemental cash flows, using the initial CAPE-based withdrawal rate as a discount rate. Add this discounted value to the initial (financial-only) net worth. And of course, you don’t have to do that by hand, the Google Sheet does it for you! In this case, the portfolio was worth $3,000,000 and the supplemental cash flows add another $189,499 to that net worth.
Step 3: Factor in the (partial) asset depletion.
Partial asset depletion is already modeled in my standard SWR package. In the baseline example, the couple has a 60-year (720-month) horizon and they like to leave a bequest worth 25% of the initial portfolio value, i.e., $750,000. You already entered those parameters on the main parameters page, together with all the other parameters, like portfolio weights, see the screenshot below:
In the context of the CAPE-based WR calculations, we can now compute the target withdrawal amounts through the Excel (or Google Sheets) PMT function, calculating the level of monthly payments to deplete a total net worth of $3,189,499 down to $750,000 over 720 months assuming an average return equal to the initial CAPE-based SWR. I get $10,368 or an annualized 4.15% withdrawal rate relative to the initial portfolio value of $3,000,000. That’s pretty awesome because we’ve just made the 4% Rule sustainable again!
So, enter your parameters and see how much you can raise your CAPE-based safe withdrawal rate. And please share your results in the comments section if you like!
With the new CAPE, the 4% Rule looks even better!
So it looks like even with those still-lofty Shiller CAPE stock valuations of about 27, this couple can use a withdrawal rate of more than 4%, despite their long horizon. If we use the new adjusted CAPE of just about 21 (as of 10/11/2022), we can even increase the withdrawal rate to 4.13% (basic) and 4.57% (factoring in the additional cash flows and the asset drawdown).
A small caveat here: This CAPE-based dynamic withdrawal rate is not a one-time, set-it-and-forget-it kind of deal. The CAPE-based withdrawal amounts are still subject to portfolio risk over time. If the market were to tank another 20% you’ll certainly start reducing your withdrawals as well. But the nice feature of the CAPE-based withdrawal amounts is that even if your portfolio drops you may not have to reduce your withdrawals one-for-one by the same percentage. That’s because a further drop in the equity market will also make equity valuations more attractive and thus raise the CAPE-based withdrawal rate again. Let me cook up the following experiment to showcase this.
Imagine we start with that same scenario, a 60-year horizon, a $3m initial portfolio, a $750k bequest target, and the moderate cash flows described earlier. The CAPE stands at 21.00. We end up with an “initial” CAPE-based of 4.13% (ignoring supplemental flows, targeting capital preservation) and an adjusted monthly spending target of $11,427, or 4.57% p.a., relative to the $3,000,000 initial portfolio.
Now assume that the 75/25% portfolio takes a 20% hit in the stock portfolio and a 10% drop in the bond portfolio, which translates into a 17.5% drop in the overall portfolio. For simplicity, I also assume that this drop happens all at once. What would that do to the SWR calculations? First, the paper portfolio is down to $2,475,000. But the CAPE ratio also drops to 17.60. We would drop the monthly withdrawals to $10,299. But that’s only a 9.9% drop even though the portfolio is down by 17.5%.
So, there’s this nice offsetting effect that cushions the drop in the portfolio. Also, notice that because the drop in the portfolio happened instantaneously we slightly overstate the drop in the withdrawal amount. If the 17.5% drop in the portfolio had happened over the next several months, the target withdrawal amount would have been slightly higher because a) we would have already slightly shortened the remaining retirement horizon and b) we’d be increasing the present value of the future positive supplemental cash flows.
Even in the static withdrawal simulations, 4% and even 4.5%+ may work again!
How about the traditional Trinity-style simulations? Well, the rationale for higher withdrawal rates today, as in October 2022, is that since the market has already dropped by quite a bit, it would seem overly conservative to calibrate today’s withdrawal rate to the 1929 or 1968 market peak. Do I really believe that after a 23% or so drop in nominal terms and even a 28% drop in real terms, the stock market will now tag on another Great Depression-sized drop? Highly unlikely. What’s more realistic and reasonable is to calibrate the current (October 2022) withdrawal rate to historical situations that were equally beaten down from their respective recent stock market peaks. That’s easy to get from my spreadsheet! In the Main Results tab, there’s a table that lists the fail-safe consumption rates as a function of the equity drawdown. Turns out, that after a 20% drop, we already make the 4% Rule viable again. And in the real drop between 25% and 30% region, we’re already up at 4.17 and 4.38%, respectively. So, in light of the recent drop, we can be a little bit more aggressive.
Notice that this calculation used the 60-year horizon. Using a traditional 30-yer horizon, we can easily push that conditional rate up to above 4.5%, even close to 5%! Go ahead and play around with your own parameters. You’ll be surprised! The 4% Rule, maybe even the 5% Rule may be alive and well!
Can I use a 100% equity portfolio and set the withdrawal rate to the CAPE yield?
This is a question I’ve been thinking about for a while and then recently it came up again in the comments section and in a newsletter/blog post that I subscribe to. Today’s blog post is a great excuse to write about this idea!
The rationale against a 100% equity portfolio is that it would be far too volatile for the average retiree. But Victor Haghani (Elm Partners Management) made this important point in his excellent and thought-provoking post “A Sheep in Wolf’s Clothing“: Maybe we shouldn’t focus so much on the portfolio volatility. If we withdraw the 10-year rolling EPS from an equity portfolio then the earnings volatility rather than the portfolio volatility impacts our retirement happiness. And the annualized standard deviation of earnings was only 7%, much lower than the volatility of the stock market.
So, I wanted to check how a CAPE-based withdrawal rate with a slope of 1.0 and intercept of 0% would look in practice. Right now, with a CAPE of about 21, that would translate into a withdrawal rate of 4.76%, and that’s before the adjustments for supplemental flows and partial depletion of the portfolio, which could easily lift the rate to above 5%.
In any case, I first set the equity weight to 100% and all other asset classes to 0% in the main tab:
Next, how do we evaluate a CAPE-based strategy? The CAPE-related tab helps us simulate how this simple CAPE-based rule would have performed over time (without supplemental flows though!). In fact, we can study how the withdrawal rates and withdrawal amounts would have behaved over the 1871-2022 period, see the screenshot below. The results are not that promising. There were a few cohorts that would have suffered massive declines in their retirement spending. Above all, the cohort that retired right before the 1907 banking panic and then went from one disaster to another, WW1, the Depression of 1920-1921, and then the Great Depression. They eventually had to cut their withdrawals by more than 81% over a 30-year horizon. Tightening the belt doesn’t start to describe that. We’re now entering “eating cat food in retirement” territory.
In fact, even the 1929 cohort saw a drawdown of 44+% of withdrawals during their retirement, though the final withdrawal amount recovered and even surpassed the initial 1929 amount by 2.26%. The 1965-69 and 1970s cohorts also got hammered if they had applied this rule. The good news is that the cohorts that retired around the dot-com and Global Financial Crisis peaks both fared really well.
What causes the precipitous fall in the portfolio value and the withdrawal amounts during those two episodes? Very simple: The CAPE ratio dropped deep into the single digits, and that caused withdrawal rates of almost 20%. Even if the stock market eventually recovered again, the portfolio minus the withdrawals had taken such a severe hit that the retiree suffered massive declines in purchasing power. Sequence of Return Risk!
Bummer! Suddenly, the prescription from Victor Haghani’s article doesn’t sound so attractive anymore. Sure, the volatility of annual changes in withdrawals is low, around 4-6%, but that’s of little help if the trend is down 3.5-5.0% on average every year and 60-80% over a 30-year horizon.
So, unfortunately, the CAPE-based rule WR=1/CAPE doesn’t work so well in practice during the very deep bear markets in the 1920s, 30s, and 70s. But during the 2000s you would have fared very well, thanks in part to an extremely low initial withdrawal rate of only 2.37 at the peak in 2000. What also helped you is that the CAPE didn’t even drop below 10. The low point around the Global Financial Crisis was about 11 (based on month-end index data). The CAPE stayed below 15 for only 9 months in 2008-2009. So, there was never any risk of severely depleting your 100% equity portfolio. If we believe this pattern repeats in the current bear market you might get away with a 100% equity portfolio and this CAPE rule.
If you’re uncomfortable and worried about a sharp drop in withdrawals again, you could choose a rule slightly more cautious. For example, pick an intercept of -0.25% instead 0% and a slope of only 0.9 instead 1.0. I also added a feature of capping the CAPE withdrawal rate. An upper limit of 10% seems to work pretty well in the simulations. So, we’d limit the extreme drawdowns in the early periods, while also maintaining pretty solid initial withdrawal rates in today’s environment: 4.04% as the raw withdrawal rate and 4.49% when taking into account the supplemental flows and partial asset depletion.
Side note: A TIPS ladder approach
This side note has nothing to do with the CAPE, but I just wanted to mention how today’s improved bond valuations also improve our safe withdrawal math. Specifically, here’s another approach to make the 4% Rule work again: Invest in a ladder of TIPS (=inflation-protected government bonds) because real yields on TIPS have now reached levels that would easily sustain a perfectly risk-free retirement income stream, albeit only for 30 years. A quick look at the TIPS term structure on 10/11/2022 (via Bloomberg) tells me that the entire real yield term structure is now between 1.5% and 2% again.
If we apply a weighted average of, say, 1.8% real return over the next 30 years, we can generate a real safe withdrawal amount of $42,633 per $1m of capital, using the Excel PMT function. So, a safe withdrawal rate (with depletion over 30 years) would stand at 4.26% again:
=PMT(0.018,30,-1000000,0,1)That’s significantly better than I Bonds. They currently yield 0% real, giving you only a 3.33% safe withdrawal rate with depletion. And you can’t even move $1m all at once into I bonds due to the $10,000 per person/entity per year limit.
Conclusion
In the post last week, I introduced a few adjustments to the Shiller CAPE and they seem to shift the CAPE into a slightly more reasonable range. And sure, the market is still a bit overvalued. But chances are that we can push the CAPE-based withdrawal rate to 4% and above. Even higher when we take into account partial asset depletion and supplemental cash flows later in retirement. As someone in the comments pointed out, this is a bit of a “hollow victory” because you can apply a higher withdrawal rate but everybody’s portfolio is down since January 2022. Granted, but I still see folks applying 3% and even sub-3% withdrawal rates in today’s market. Relax, everybody, the risk of another bad market event on top of the current drawdown is low!
Likewise, with the adjusted CAPE quite close to dropping below 20 and the S&P 500 dropping more than 25% in real terms since the beginning of the year, I am also ready to announce that even in the traditional static SWR calculations, we should now safely move the withdrawal rate to 4% and above. Well, you heard it here first; the 4% Rule works again! And with a little bit of flexibility and a generous pension and Social Security benefits later in retirement, you can certainly go crazy and justify 4.5% or higher!
It’s great that we finally have more reasonable valuations and higher rates in the mix. Savers can finally get some return.
I’m always intrigued by the SWR for a market like Japan, or other failed countries, since there is no SWR (or at least so low it is irrelevant). The reason it is intriguing is because it’s a particular situation and that has nothing to do with the CAPE ratio and fails 100% of the time. Do you just hold thumbs we never see a Japan scenario in the US markets, or are there any indications/similarities in the overall market (ie. MMT plus high CAPE and people borrowing against assets to buy more equities) that would give you pause that we might see something similar in the US?
I might be wrong, but I’m an eternal optimist.
I don’t see a repeat of the Japanese scenario. There will be too much backlash against bad economic policy (Nixon+Carter) to bring a pro-business predicent (Reagan) back to power.
The Japan comparison often comes up in these discussions. Recently, I read an article stating that at the time of the ATH of the Nikkei, the majority of the (largest) constituents of the Japanese index were corporations (many of which were banks), which operated mostly locally, with very little international exposure. According to the author of that article, these circumstances made the Japanese stock market more vulnerable at the time, and, more importantly, also makes that the Japan situation of back then cannot / should not be projected onto the US (or even the European stock market) of today.
Yes, and the CAPE in Japan was much higher than in the US today. So, I don’t see that that happening here. But I can also understand that folks are worried about the US getting past its prime.
1. CAPE in Japan reached mad heights of like 100 before eventually falling to more normal levels.
2. Japan isn’t necessarily a failed market for a Japanese investor who DCA’d (YCA’d?) into the market over a decades-long career.
It could have been a failed market for a Japanese investor who either piled in most of their NW as a lump sum close to the top, or worked only a very short career a few years prior to the peak and retired mostly on appreciation rather than contributions. (given the relative cultures, such an investor was more likely to be American nationality than Japanese)
3. A while ago I did a monte carlo simulation for Japan and found that 1/CAPE (1%) DID work even at the market peak and even given the subsequent poor performance. I think 2% did as well but don’t quote me on that. This is allowing asset depletion.
All excellent points. The CAPE of ~100 is a huge difference with today’s market.
And the CAPE-based rule works pretty well in the US at the 200 market peak. I’m glad you confirmed that the same is true for Japan at its peak. Thanks for doing that important research! 🙂
I dug up the simulations I ran.
What I found is that a 60/40 equity/bond portfolio had a 2.5% SWR at the Nikkei peak. I think that was US bonds not Japanese bonds as I couldn’t find a free Japanese bond total return series.
One reason why bonds did so well for a Japanese investor is that Japan had ~0% inflation during much of the period the period the Nikkei was down.
I re-ran the script I made for 100% Japanese equities and SWR at the market peak is 1.55%, which is a bit better than 1/CAPE.
Nice! Thanks for confimring!
This is the general problem with a lot of the international comparisons of SWRs: Japan now had 2 episodes of bad SWRs due to getting wiped out in WW2 and during the lost decades. Much of Europe in WW2. But I cross my fingers that US investors will fare much better..
Excellent work. Thank you. I am currently using an annually calculated SWR with 0% failure and 50% capital preservation which has so far worked okay but does leave me exposed to potentially dramatic income volatility. I will populate your updated spreadsheet and see how this works. I had been playing with the CAPE based approach and am tempted to move in this direction.
Do you think the return assumptions for the next ten years look reasonable? I need to update mine but they are sitting at cynical levels currently 🙂
Stocks for next 10Y 3.40%
Stocks after that 4.90%
Bonds for next 10Y -1.00%
Bonds after that 1.30%
Cash for next 10Y -4.20%
Cash after that 0.60%
The return assumption used there are simply used to fill in the back-end returns of the 1960s and 70s retirement cohorts. There is relatively little impact on SWRs computed with the sheet.
I believe that cash returns will be higher than that near term. Inflation will come down over the next 1-2 years. 10-year average is now maybe 2.3-2.5%. My nominal cash cash curve over ten years is now about 3.6%,, so +1.3% real return.
Likewise bonds:; the 10Y yield is way above the inflation forecast. So, will get a positive expected return with bonds.
A great news amid this endless storm of bad news lately ! 4% rocks!
Yay! Of course, the 4% is applied to a slightly diminished portfolio. But still good news! 🙂
There’s only one problem with this. Although 4% is NOW possible, I bet no portfolio was imune to this 25% drop in the stock AND BOND market alike so 4% of your current net worth is probably equivalent to 3% of your old, pre-drop, net worth so in the end it really didn’t change anything
Good point. I thought I made this point in the chart about the offsetting effect. But I also added 3 more sentences in the conclusion to emphasize your point again.
I suppose “it really didn’t change anything” was the point. If you were ready to retire in January 2022, but got the nominal value of your portfolio walloped during the year, then you are not actually all that less prepared to retire because the SWR is higher now than it was then. Maybe no need to resign oneself to 3-5 more years of work.
That’s a good way to put it. No need for today’s FIRE enthusiasts to target 33x when 25x works with today’s data.
Great work as always. Can you explain why cell D7 in ‘Parameters & Main Results’ is ‘WR’ and not ‘CR’? I’m confused because the table is titled ‘Failure Probabilities of different initial consumption rates’. Thanks!
It’s semantics. I changed a lot of the lingo from withdrawal rate to consumption rate, but probably missed a few.
We can still use both because people are more familiar with the WR and SWR term.
But we should acknowledge that in the light of supplemental flows you may withdrawal more or less than what you budget/consume in retirement.
Can you talk more about TIPS in the current market ? It seems someone with a high percentage of stocks in their portfolio and a retirement window in the next 5 years (Me), would do well to start loading up on these type of bonds. The way I see it is you’d lock in a decent guaranteed real yield and if rates were to start rising in the future wouldn’t their underlying price rise as well if you needed to sell ?
I have written about pre-retirement glidepaths (Part 43). And indeed, it’s not a bad idea to shift into bonds over the last few years before retirement.
But your second conclusion is incorrect. TIPS would lose in value if real yields rise. ust like nominal bonds lose value of the nominal yield rises. The whole point is that real yields would drop if there’s a recession right around your retirement date, so then the TIPS would rise in value and serve as a diversifier.
Can you explain the use of the PMT function in the CAPE-based rule sheet? Even with $0 PV of future cash flows, the target withdrawal is well above the safe withdrawal rate.
From the toolbox:
===
CAPE Rule Parameters
a (intercept) 1.75%
b (slope) 0.50
Today’s CAPE 27.00
SWR (capital preservation) 3.60%
Horizon (M) 624
Final Value (%) 25%
Today’s Portfolio $3,000,000
PV of future flows $0
Desired FV $750,000
Target Withdrawal ($/month) $10,084
Target Withdrawal (% p.a.) 4.03%
===
I have (perhaps naively) always assumed the actual withdrawals I can make on a monthly basis would be SWR/12. Am I correct in understanding that one can actually withdraw the higher target withdrawal ($/month)?
And if there are future cashflows accounted for in the cash flow assist sheet, the actual withdrawal from one’s portfolio should be net of those cashflows when they start occurring?
As always, thank you so much for doing this “labor of love”, Big ERN!
The SWR is calibreated to preserve the capital and spending amount. If you start depleting capital you’d use the PMT function to calculate, the (higher) withdrawal to achieve the slow depletion of the assets.
And yes, with positive future cash flows, you assume that you reduce the withdrawals one-for-one. Hence, the higher WR.
I think you are correct to divide by 12.
(10084 * 12) / 3000000 = 0.040336
so close to 4.03%. Google Sheets probably formatted the value with fewer significant digits.
Never mind. I was confused…
Yes, 2 signficant digits seems all we need.
I probably just need to go back and understand better so ignore this question if you determine I didn’t do the work, but what column in the main results is for your updated CAPE (model 2) which is now updated more or less real time? The main output has large buckets like 20 which obviously will have huge variance (15 vs. 35 compared with 20 vs 21). I do get that the models are used within these two large buckets. Nice for learning and historical purposes… However, I assume there is a calculation for failure rates that is based specifically on the quasi-daily updated change in CAPE model #2? As you have mentioned before, precision matters and I’d like to be more specific. Again, ignore if it is there and I just need to find it!
Oh, found the new added sheet! Whoops.
No problem! 🙂
Thanks for clarifying consumption vs withdrawal again. As a reminder for others like me who are already receiving supplemental cash flows (thanks, early retirement!), you need to subtract your real supplemental cash flows in a month from SWR*PortValue to get your actual safe withdrawal rate.
Good point. No double-couting allowed! 🙂
What a great post. One of your best ever Big ERN which is saying something as all so good. But this one really fantastic. But could you please post a link to your toolbox as a xlsx Excel file? Would that be possible? As I thought google sheets allowed it so files can be opened and used in Excel? I ask as I would love to use your toolbox sheet but I do not have a google account nor do I really want one. Thank you.
Here’s a link:
https://docs.google.com/spreadsheets/d/1PV8D8ztgshAnUeVcJzsSv00M6MsWfJ1N/edit?usp=sharing&ouid=110384362952922098781&rtpof=true&sd=true
I can’t guarantee that I will be updating this as regularly as the Google Sheet, though.
Also notice that some charts don’t come through properly in MS Excel.
For all others: you can download from the Google Sheet:
Menu -> File -> Download -> Microsoft Excel (xlsx)
Hey Big Ern, thanks again for another ‘cut above’ contribution in our community.
1) For the TIPS ladder, do you mean allocating 25% of the bond allocation of a 75/25 into TIPS instead of towards a 10Y ETF?
2) So now we have lower risk through leverage + timing leverage + now… dynamic WR based on CAPE 😉
I imagine a leveraged treasury futures allocation (especially when retiring now, in Oct 2022) could drive up the SWR even further. Can a feature request be made for the future toolbox? 🙂 Though leveraged bonds probably would have been a disaster if starting in Jan 2022.
As for timing leverage, I’m living the experiment of using a margin loan during this >20% dd when I pulled the retirement trigger on Jan 1st 2022 🙈. So far so good! It definitely “feels” better than making withdrawals in a bear market!
Cheers,
Derek
TIPS: That section was just a side note and assumed a “safety-first” retiree with a 100% TIPS portfolio.
Good point about the leverage. There will come a time when the FED went too far and the 10y yield is massively attractive again. Now is not the time for leveraged bonds. Though, in an unleveraged portfolio, 4% for the 10y doesn’t sound to bad.
You can already simulate Treasury futures. Simply set the stocks+bonds at 100%+x and the cash allocation at -x%. You’d the approximate a 100% physicals portfolio plus an x% Treasury futures portion.
I have been wondering whether it adds or subtracts from the validity of the SWR output to consider a range of history that predates the federal reserve and for much of which the gold standard was in effect. It seems that many large structural changes have occurred in the global economy in the post-WWII period. This comment goes for the CAPE ratio as well. I understand reversion to the mean, but I also recognize that means shift. The temptation to use all the data available is strong, but predicting apples using oranges as the baseline is problematic.
Of course, it’s also problematic to only use data after a particular milestone such as the abandonment of the gold standard in 1971. Doing so would make early retirement look a lot easier because the retirement cohorts of the Great Depression and the late 1960s are our perennial problem children.
Also, the economic configuration has changed a lot in the past 45 years. The Fed didn’t receive its dual mandate until 1977, electronic markets didn’t appear until the 80’s, and QE/QT were not around until the GFC. The amount of data the Fed has to analyze has skyrocketed, along with its timeliness. The Fed now has a balance sheet bigger than most industrialized countries, and all this is relatively new.
Perhaps we allow for all the data because we can assume the US’s economic configuration will continue to change in the future. We probably won’t go back on the gold standard, but we might lose global reserve currency status. The dollar will be digitized in the next 20 years. A lot of what we call knowledge work today will be automated. A lot of consumer demand in the future will shift from things like cars and houses and toward information services. The population is expected to fall! Thus, the inclusion of Very Different Times from the past is one way to hedge variance from the Very Different Times of the future.
Very good point. We have to find a balance between being stuck with our history and not learning from history.
Yes, and we can certainly restict the analysis to post-1913. I’m still going to compute the whole thing for 1871, but we can certainly slice the date after that.
@BigERN A few months and a couple percentage points ago, I asked in the forum what fixed income yield you thought it would take to sustain a 4% WR because I figured yields were about to pop far above the long-term inflation rate.
Your answer was to use the RATE function in Excel to calculate a return that would fully deplete in the desired timeframe. For 30y inflation adjusted returns at a 4% WR, that comes to 1.31% real and for a 5% WR it’s 3.08% real.
Now my prediction has become reality, and I’m salivating over a lot of long-duration IG bonds and preferreds yielding 6-8% nominal at a time when both the forecasted and bond-market-expected 5 year future rates of inflation are in the 2-3% range. These yields could support my spending right now. I know inflation forecasts are notoriously unreliable, but there seems to be an opportunity to place a bet with limited downside here.
If the forecasts are wrong and inflation stays high, I would probably rather own these bonds instead of stocks, and at least the interest would offset some of my losses. If inflation falls as predicted, I’d have a portfolio with very high real yields (like 3-5% real yields) and less risk than stocks that could easily support a 5%+ initial SWR.
When the Fed cuts rates someday, my long-duration bonds would quickly appreciate, opening up the opportunity to wind down the bond tent and allocate back into stocks.
I wouldn’t know my initial SWR was very high until 2-5 years later, but I could retire a few years on the cash income while waiting to find out if I need to go back to work. That’s a game where I either win or get a paid vacation.
Anyone have thoughts on this strategy?
For the first time in a long time, fixed income is sexy again. We all have to kick off the rust and start pondering bonds, preferred stocks and even CDs. I find it exciting to consider that a risk free or low risk rate of return vehicle can cover our needs. I think there is an opportunity for that now and into the first part of next year. But what path to take? Maybe BigERN can add to his thoughts on this topics in a future episode.
I also think we are entering a period where excess is wrung out of the system, one where any one strategy could be caught in downdrafts (or updrafts). If you’re looking at fixed income being able to cover your SWR, as I am, I think it’s prudent to consider 2-3 strategies that provide some counter to each other as a volatility hedge. For me that is stocks (essentially funds I’ve had for so long that I can’t really sell them without a huge tax hit), fixed income (reading about the best vehicle(s)), tactical asset allocation (active once per month algorithm based trading) and cash. I think being nimble is the strategy over the next 5-10 years, less buy and hold.
Yes, though I wouldn’t necessarily call it “sexy” again. A stock/bond portfolio will likely get you the same WR, but some more upside, while fixed income still has to rely on guaranteed asset depletion.
But a good mix of stocks and FI is certainly very attractive now.
Yes, that sounds like a good strategy. The yields are now high enough to sustain a portfolio for 30 years at a very high initial SWR. The 4.26% (based on 1.8% real return( is the really conservative approach. With a little bit of credit risk, like in preferreds from high-quality borrowers and IG corporate bonds you can certainly reach 5%.It will also deplete the portfolio for sure, without upsaide. NSo this approach isn’t for everyone. And certainly not for folks with a 50+-year horizon.
Agreed that this is one of your best columns ever. You’re delivering sunny news in a gloomy environment, which is welcome of course. But more importantly you’ve adjusted the best available SWR tool (Shiller CAPE) for taxes and buybacks and lagging data and then made computation of personal SWR readily accessible. One can intuit that a market correction results in a higher SWR, but your tool quantifies it. A terrific service. Thank you.
Thanks for the kind words! Glad you likes the last two posts! 🙂
I’m curious what you are using Custom1 and Custom2 for in the Stock/Bond return tab. Ultimately, I’m looking for a way to incorporate REITs into the asset allocation. Do you have a recommendation for this? I can’t tell you how important this spreadsheet has been for me over the last few years. Thanks for continuing to develop and support it.
↓↓↓↓ … this … my household completely agrees.
I can’t tell you how important this spreadsheet has been for me over the last few years. Thanks for continuing to develop and support it.
Thanks for the feedback! Keeps me going here! 🙂
It’s up to you.
I’ve run this with some custom series, so for example an active stock/bond/cash strategy with a momentum signal (Custom1) and a valuation signal (Custom2) and then see how much better we can do than the plain old static weights.
Great analysis! Have you considered modeling a risk parity portfolio instead of a 75/25 portfolio, maybe Dalio’s all season portfolio or golden butterfly portfolio?
In Part 34, I simluated three alt portfolio flavors:
https://earlyretirementnow.com/2020/01/08/gold-hedge-against-sequence-risk-swr-series-part-34/
Permanent Portfolio
Ray Dalio All-Weather
Golden Butterfly
They all sucked in historical simulations, especially the permanent and Ray Dalio Risk Parity portfolios. The Golden Butterfly did pretty well, but only because Small-Cap Value stocks outperformed so much. There’s no guarantee that they will in the future.
Hi ERN! Is the ‘capital preservation’ withdrawal rate assuming capital preservation in real terms vs nominal?
As always here, unless otherwise stated, I’m always speaking in “real” terms.
Thanks ERN!
Tremendous work, as always. This is exactly the type of analysis I have been waiting for over the last several months. Thank you.
Is the “new” Big-ERN-adjusted CAPE Ratio something that you plan on periodically calculating and publishing? And if so, where?
Unless I’m wrong, it doesn’t appear that the “Today’s CAPE” cell in the spreadsheet is dynamic, or self-updating.
Thanks again!
I update the adjusted CAPE essentially daily. Or at least as often as I run my little Python code. See the previous post (https://earlyretirementnow.com/2022/10/05/building-a-better-cape-ratio/) for the link to the CSV file on my Google Drive.
Might want to put this link in the spreadsheet itself.
Added the link. Thanks for the suggestion! 🙂
ERN/Karsten, I echo what has been said here regarding the importance and value of what you’re doing for my household as well. I’m definitely going to be putting your CAPE based algorithm work for us, but not sure whether to use the original or your new adjusted CAPE. Even above in your first example you used the traditional CAPE and then later in the post modified it.
How confident are you in the use of your new CAPE as a predictor of future yield? I’m assuming from your writings that you are setting your own personal SWR using your CAPE based formula. Are you using the old or new CAPE?
Sorry, meant to reply earlier.
The CAPE is a reliable predictor of future real equity returns. (I assume that’s what you mean by “yield”). It’s not perfect but likely the best indicator we have as ordinary retail investors.
I’ve been lucky enough to see my portfolio grow but my spending stayed the same, so I actually withdraw a lot less than what a CAPE-based rule would offer. But if I had to I’d use the “new” CAPE 2.0. That’s why I constructed it! 😉
I went back and reread “Building a Better CAPE Ratio”. I understand the rationale for making the changes and have trust that you’ve implemented them correctly. Here’s what I’m missing to have more confidence in it.. I don’t see any back testing of the CAEY it produces to validate that it is a more accurate predictor. Has that been done? If not, is there a reason you feel it’s not needed? I’d be happy to roll up my sleeves if it is work you have just not done yet.
Jason
Yes, there’s a minor improvment in the fit. I didn’t report this in the post.
But keep in mind that because the CAPE.1 and CAPE.2 are so highly correlated, there’s can’t be much of a difference. But the difference goes in the right direction, i.e., the R^2 and (HAC, heteroscedasticity and autocorrelation robust) t-stat is better for CAPE.2
Great read. I am using a similar principle I believe by using the ABW method for withdrawal and getting the expected return from the asset allocation interactive website for the next 10 years. For my specific portfolio, the website was giving me a 2.75% real return last year and I am getting 3.70% right now. So even with a reduced portfolio due to the bear market, my withdrawals didn’t changed that much.
Regarding using the NPV of future benefits like social security, is using the CAPE method not too optimistic? The NPV could be considered close to an extra cash amount as it will follow as best the inflation. In this case, the portfolio allocation should reflect an higher cash amount hence smaller expected return than with the current portfolio allocation entered in the spreadsheet.
If you believe that the future cash flows should be discounted with a lower real rate (closer to cash) then my calculations are too pessimistic, because I’m discounting at the higher rate, no?
I am confused. There has been a 20-20% decline in the stock market but the CAPE ratio is still above 20. So is your advice to use the SCR of the column reflecting the drawdown in the S&P or the one that reflects the current adjusted CAPE which as above >20?
You use a combination. According to the new measure, we’re at a CAPE of 21. Still elevated. But I find it unlikely that we tag on another Great Depression from here.
Also, keep in mind that the cutoff of 20 is not that sharp. It’s not like 21 means run for the hills and 19 means hunky-dory lala-land. We’re right at the edge where historically the 4% Rule worked pretty well hen measured by CAPE and we’re well above 4% when measured by the drawdown.
I may be missing something but I’m trying to understand the Target Withdrawal versus the cash flow assist inputs.
For expenses I input after-tax dollars I’m paying the bills with but the Portfolio Today input is a before-tax dollar figure. It appears to me were mixing apples and oranges.
I’m wondering if the Portfolio Today input should be reduced for taxes, e.g., a 20% reduction or ?
Thanks.
The withdrawals are pre-tax. Since I don’t don’t know everybody’s tax rate, all my analysis is pre-tax. So, safe consumption rate is slightly imprecise. You still have to pay the tax bill before consuming.
Great post. Can you comment on the difference in using individual bonds/ TIPS as portfolio diversifiers vs. bond *funds*? I always relied on the latter and they seem to work as intended currently, as bond prices go down interest rates paid by the fund rise over time, and the TIPS funds cushion inflation as designed. It’s also clear they are somewhat of a different animal though. I would not know how to build a bond ladder with a fund, for example. Are there some common misconceptions or practical implications that we personal finance hobbyists tend to be missing as we use bonds vs. bond funds in a portfolio?
Trading individual bonds is still an arcane and untransparent and potentially expensive process at most brokers. Most private investors are better off with bond index funds. The expense ratios are pretty low at Fidelity, Schwab, and Vanguard.
One exception would be preferred shares. Many of them are liquid and exchange-traded and you can save the sometimes high expense ratios of preferred ETFs (e.g. 0.45% p.a. for PFF).
>> Most private investors are better off with bond index funds
Lord, when has this been true for the last couple of years??
When? If by the last couple of years you mean two years, my statement has been true for the entire two years. My statement was about the relative performance of active bond picking vs. bond index funds. Not the awful total return of bonds over the last 2 years.
Yes, couple means two.
Your post was
>> Most private investors are better off with bond index funds
which I queried. Now it seems you meant something else ?
vgit, bnd, bsv, ftbfx are all well down (I could list others similar, of course), -8% to -17%, for the last 2y, stockcharts shows, while stip is up like 3.5%.
I was referring to the individual bonds vs. ETFs. Staying in the same asset class, simply replicating the ETF with the underlying individual bonds. My point was that it’s cumbersome. It’s best to stick with ETFs
Yes, you can also diversify with different bond flavors, like long-erm TIPS (also lost a lot this year because real yields rallied). Short-term TIPS did better because they have less real-yield duration. But the suggestions is the same: You’re better off with TIPS ETFs rather than getting into the weeds and buying the individual underlying TIPS.
But how do you build a TIPS ladder using ETFs since the TIPS never mature? Wouldn’t you need to buy actual TIPS to construct the ladder? Maybe I am misunderstanding?
TIPS do mature.
Being 54 now, 100% equities; still working W2 job; I would like to retire by 57, but – I see opportunity here to pad my accounts from age 54-59.5 in both equities and bonds. The TIPS ladder seems I may be too late to start something like that… So, I’m considering just vanguard bond funds in my ROTH IRA for the remaining working years (not sure which I should choose, and ROTH would continue without withdrawals until my 70’s. My thought is I would start with my traditional IRA on withdrawals, since this will be taxed as regular income…
I’m stuck I think; I see this recession/bear market as more opportunity to boost my taxable account with more equities (VTI specifically). This would leave me no time for buying bonds until I retire… but – given we may be in this recession/bear market for a bit – it may benefit me to keep pushing into equities while the market is down.
My gut tells me (not math) that between age 54 to 59 – I may see some reasonable returns…
Any thoughts on my random thoughts?
Steve (NWOutlier)
I don’t think it’s too late for a TIPS ladder. TIPS yields are now reasonable again, close to 2% real.
Also, if we go through a nasty recession in 2023, maybe 2023-2024, maybe it’s not a bad idea to pad the equities through the trough. If valuations aren’t too bad, maybe you don’t need too much in bonds once you retire.
Hi ERN, Thanks for this post.
In the past, I suggested a variation of the fixed withdrawal method, see here:
https://earlyretirementnow.com/2018/08/29/google-sheet-updates-swr-series-part-28/comment-page-2/#comment-18750
Out of curiosity, does this method satisfy the Bellman principle?
No, that also violates the Bellman principle. For two reasons: 1) due to the max() operator and 2) assuming a flat profile going forward at any juncture, against better knowledge that you will not follow a flat profile over time.
And I should ay, that just because some strategy violates the Bellman principle it’s not a dealbreaker. I’ve seen examples where the non-BP solution comes close enough to the fully BP-optimized version.
Is the CAPE method withdrawal rate variable (changes with changes in future CAPE) or is it the fixed withdrawal rate you can retire with under today’s CAPE ratio?
The CAPE rule means that you apply varying CAPE-SWRs to a varying portfolio level. Thus, the withdrawal amounts will likely vary quite a bit.
As always a great analysis and original thoughts!
Do you have any thoughts on the effect of exchange rates for investors abroad? This issue has recently become a great risk with historically low Euro valuations against the Dollar. The hit we took on our portfolio has been largely offset by the Euro tanking over the same period. This makes the porfolio look not quite as bad now but poses a great risk looking forward – the risk being that the Euro valuation normalizes again (of course nobody knows if/when that would happen). As a remedy one could shift the investments to Euro markets but then I would look at a very different data set (returns!) than those used for your SWR calculations/simulations.
Thanks for all your great work!
FX is notoriously unpredictable. But that said, the Euro will likely depreciate some more considering how far the ECB is behind with rate hikes.
For US investors, it’s best to use FX-hedged funds for non-US equity investments. For non-US investors, it means that it’s best to diversify and keep enough in USD-denominated US stocks.
What success rate do you target for your SWR calculations in the CAPE spreadsheet?
Also, is the “target withdrawal” on the CAPE spreadsheet an SWR tied to a specific failure probability or is it just the average withdrawal to make the final portfolio value equal your target (with no particular failure/success rate in mind)?
There’s no failure per se in the CAPE-based rules. You can never run out of money but you can slowly erode the purchasing power of your withdrawals.
So, I target the withdrawals to roughly move sideways to up. I don’t want to see a downward trend.
Hi Karsten,
Big fan. I’ve followed you since your 2nd/3rd post in your SWR series, but this is my first time commenting. This post and, most especially your previous post, are two I’ve been waiting years to see you write about – and you have not disappointed! When you have a chance, I’d certainly love to get your thoughts on the below questions:
1. 100% Equities and Optimal Intercepts/Slopes: In Part 18 (and others) of your SWR series, you ran a few simulations (for an 80:20 equity:bond allocation, rebalanced monthly), where you suggested using a 1.5 (and possibly a 1.75) intercept, and, most importantly, a 0.5 slope, was likely to be the sweet spot. However, in this post, you gave an example for using a -0.25% intercept and 0.9 slope. Was that intended to be a truly random example or was there more to it? I am wondering if you have some thoughts on whether a different intercept and slope value should be used for different portfolio allocation mixes? Strictly speaking, I am confident your short answer would be “yes”, but I do recall (years ago) you replying to someone’s comment inquiring about your intercept and slope values for bonds and you replying that (paraphrasing here): “there appeared to be little significance in playing with bond intercepts and slopes when equities comprised >=70% of one’s portfolio”…for me personally, I am 100% equities (mostly VTI), so am especially curious where you lean (and why) with regards to the “sweet spot” intercept and slope value for a 100:0 portfolio. I’m planning on using a 1.75 (maybe 1.5) intercept and 0.5 slope, and will experiment more with your Google Sheet to see how comfortable I feel with it (especially given your newly adjusted CAPE metrics) when the day comes that I choose to retire, but I would genuinely like to know what you think that sweet spot value would be. FWIW, I achieved FI 2 years ago (when I was 32), but continue to work (as I enjoy it) and save >50% of my pre-tax income (and invest it in VTI). I also am naturally happy spending very little (2% of my net worth covers all of my needs and wants, including planned travel and unfortunately high medical expenses). Ironically, I found that once I achieved FI (and found the courage to change both employers and fields of employment, as part of my “One More Year” syndrome/strategy), I doubled my income, halved my work hours, and 10x’d my life enjoyment – so now I genuinely don’t wish to stop working, haha. 🙂 I credit some of this success to you for giving me the confidence to evaluate these finance topics more objectively, so I just wanted to share my abridged story with you, along with my heartfelt “thank you!!”
2. Using Your Google Sheet: For someone interested in using your Google Sheet for planning their real monthly drawdowns, and not just using it for simulation purposes, what guidance, tips, or warnings might you have to share (aside from re-reading your entire SWR series)? Personally, I’ve been planning to take my own crack at adjusting the CAPE (just as you have, though you clearly have done better than I ever would have). In light of this, I’m inclined to maintain a copy of your Google Sheet in my own Google Drive, so that I can update it monthly/quarterly for CAPE-adjusted withdrawals for practical withdrawal calculations. However, it dawns on me that my copy is likely to go stale without your python script’s near-daily output-ed results. In light of this, what should someone about to RE for 50-60 years do? After all, it’s unwise to plan on your continuing to update this Google Sheet daily for that many more years – though selfishly, I certainly would enjoy that! 😀
Thanks!
1: I still believe that a slope of 0.5 is the sweet spot. I simply tried to study the suggestion of withdrawing the CAPE earnings (as suggested by Victor Haghani). To show that it’s not really that useful. Hence the adjustment to b=0.9 and a=-0.25.
2: I intend to keep the Google Sheet running. The average user doesn’t need the regular return updates for the returns. But I occasionally add some other features. Most recently, I added the 30-year Treasury returns.
But even in the worst case, you can use an older stale version to study how your personal situation would have worked in a repeat of the 1929 scenario. Nothing will change there. OK, maybe the SWR will change a little bit for the 1968 cohort (for a 60-year horizon, some new returns are coming in until 2028) but the returns at the end of a 60-year horizon have essentially zero impact on a 60-year SWR.
1. Ah, I understand now – thanks for clarifying!
2. Couple follow-up questions on what you wrote here.
2.A. Your intention of updating the Google Sheet for the next 60 years with the latest CAPE values and (what will eventually become) historical data is awesome. And not surprising, as you initially set out on this journey for your own planning purposes. And it makes sense that, when the day comes that you do stop performing updates, the sheet will still hold value in real everyday planning – it just would lack the “new” historical data. However, I think some guidance/input on the Google Sheet concerning how to generate the (future) “Today’s Cape” cell value would be very helpful for people (perhaps as part of a new sub-sheet on “Helpful Tips”, else a blog post). Especially when it comes to your Adjusted CAPE calculations. The difference between the two values can be quite significant.
2.A.i. Example: Per the “Stocks/Bonds Returns” sub-sheet, for the year 2021, the general CAPE monthly mean is 36.92 (rounded to 2nd decimal) and the adjusted CAPE monthly mean is 28.52. When looking at the calculated SWR (capital preservation) for both CAPE values, I derive 3.5% and 3.1%, respectively. That’s a 0.4% difference, which is pretty sizable. Especially when considering that choosing between a 100% and 0% capital preservation approach has relatively less impact (in all the scenarios that I ran) in determining one’s SWR.
2.B. For someone planning 60 years of withdrawals, is it best to input 60 or 30 years? The rationale here being there are more 30 year cohorts to draw higher confidence of results from. Conceivably one could do back-to-back 30 year plans, such that the first half inputs a “Final Value Target” of 100%, and the second half inputs their truly desired “Final Value Target” (i.e. 20%) for end of life.
Granted, accounting for the present value of future cash flows would be a bit more complicated for 30+30 years than 60 years.
2.C. I had noticed some of your recent additions (i.e. 30 year treasury returns and World Ex-US Equities) – really awesome to see those! Love the work that you do.
3. Google Sheet Errors: FYI, noticed a couple errors, which you may wish to correct.
3.A. Mislabeling: The “CAPE-based Rule” sub-sheet has Columns A (Year) and B (Month). However, their contents are reversed, such that months are shown under column A and years are shown under Column B.
3.B. CAPE-SWR Calculation: When calculating CAPE-based SWRs, portfolio diversification is not accounted for. This might not be so much an error as a potentially missing disclaimer, as I believe you’ve premised your work here on CAPE for US equities. For instance, the same SWR is calculated whether someone has 100% equities, 100% bonds, 100% cash, or 100% gold.
2.A: You can always get the CAPE value from some other source.
2.A.i: Yes, it can make a big difference. That’s one of the reasons i derived this new measure.
2.B: You should still use the 60y window. When using a less-than-100% final value, none of the “back-to-bacl_ window calculations make any sense.
3.A: Fixed that.
3.B: I use the portfolio as specified in the main tab. You should only use the CAPE-based SWR when the majority of your portfolio is in stocks. It doesn’t make any sense to use the CAPE-SWR when the portfolio is 100% gold.
great
Lets say someone determined a 3% rate as safe during January 2022. Now the market dropped by 25% (assumption). Then the SWR has to increase to 4% (=3% / 0,75). Anything else would contradict the initital assumption of a 3% SWR. No Cape etc needed.
You still need the CAPE. If the CAPE is low you don’t even have to worry about another 25% drop and you can just use the 4% Rule (or maybe even higher) right from the beginning.
True, but once your personal SWR has been determined you should stick to it. If the initial SWR was according to CAPE 4%, then you can increase to 5,33% after a 25% drop regardless the CAPE.
“once your personal SWR has been determined you should stick to it. ”
I prefer to adjust my plan as time goes on. Effectively, re-retire every year. Or month. Or day.
Love the update!
Did you ever re-optimize the coefficients (a, b, c, d) in “CAPE robust” from part 18 using your new cape ratio metric?
I’d be curious if anything changed since the original coefficients were calculated based on the raw cape ratio.
There isn’t any single optimal set of parameters because people have different objectives. So, I built that tab in the Google Sheet where people can play with the a, b parameters and see how certain portfolio stats change (30-year average consumption, drawdowns, volatile, etc.). If someone wants to build a “utility function” over some of those and then use a solver to maximize that U, go ahead. I find that a step too far, though. 🙂
Thanks for all the interesting SWR series posts. I have read several of the posts, especially this last one, and more than once and have gained a level of clarity each time.
I have two separate questions I want to make darn sure on. I will post them separately. For background I am 61, so “not so early retirement”, — but eased into at 50% FTE since global pandemic. I will be getting fairly close to max for social security when I claim it, my wife is more modest amounts, around $2400/month at age 67. I entered the numbers in to the google sheet and came up with this ( I have “X’d out” the exact dollar amounts, for privacy reasons, let me know if this is not ok):
CAPE Rule Parameters
a (intercept) 1.50%
b (slope) 0.50
WR Cap 10%
Today’s CAPE 29.26
SWR (capital preservation) 3.21%
Horizon (M) 420
Final Value (%) 25%
Today’s Portfolio XXXXX
PV of future flows $XXXXXX
Desired FV $XXXXXX
Target Withdrawal ($/month) $XXXXX
Target Withdrawal (% p.a.) 5.19%
Could this be right, 5.19%? This makes the target withdrawal amount more than I ever spent (or even took home after taxes) during my working years. The explanation I can come up with for this very pleasant surprise is that due to our relatively advanced age for “early retirement” and the amount of social security we will be getting.
I hope you understand why I am doing this double check, it is not something I want to find out 10 years from now I erred on …. not a big fan of eating cat food, I dont even like the smell :). Thanks for all you do.
Hi Karsten,
I posted the above after I struggled for it for several days, then the moment I posted I realized I should just copy the spread sheet and remove the SS amounts (but left in medical expenses) and came up with this:
CAPE Rule Parameters
a (intercept) 1.50%
b (slope) 0.50
WR Cap 10%
Today’s CAPE 29.26
SWR (capital preservation) 3.21%
Horizon (M) 420
Final Value (%) 25%
Today’s Portfolio XXXXXX
PV of future flows XXXXXX
Desired FV XXXXXXX
Target Withdrawal ($/month) $XXXXX
Target Withdrawal (% p.a.) 4.17%
A full percentage point difference in withdraw or 25% more that can be withdrawn. This really points out the value of the cash flow assist tab in planning. Please let me know if I am off on this, Im still averse to making a critical error. At was a very good exercise to work through, the very compulsive could make different screens to determine when to take SS.
Big difference. That’s why it’s important to factor in your personal parameters…
Depending on the PV of the cash flows, yeah, that’s possible.
Using your parameters and setting all the cash flows to 0, I get 4.33% alone from the CAPE-based rule. For a $3m portfolio you only need another $600k in PV of cash flows and you’re at 5.27%.
Do you have any plans to take look at SWR’s for historical levered portfolios instead of assuming 0 leverage and only asset allocations between 0 and 100%?
Is it possible that a leverage portfolio could have a higher SWR than all of the unlevered estimates provided in the series?
Yes. I already did. See parts 49 and 52.
Also, you can use the SWR to study leveraged portfolios with a constant. Simply set the % weights and use a negative weight for cash to get back to a sum of 100%.
I am pretty new to retirement planning so please let me know if I’m talking rubbish, but I was looking at your blog from here in the UK. I was just wondering how the CAPE tab on your sheet would handle situations where there are relatively much higher supplemental flows which will start a good number of years after retirement?
To be clear, I am talking about a scenario where after about 12 years, guaranteed income streams will cover around 80% or more of the required spending, but the first decade relies on the fund only.
I have a pretty sizable defined benefit pension which will start at about 10 years after I hope to retire and then further benefits a couple of years later. When I put this into your CAPE model and into the CAPE tab, it is showing an opening withdrawal of more than 10% – significantly higher than any other approach I’ve tested.
If I then cut the fund by 10% and reduce the periods by a year, the withdrawal only went down slightly (and went up in % terms).
If I was to draw out 10% for 10 years, I am pretty sure I will have a very high risk of my fund running out before my other income streams kick in. I suspect your model will make large adjustments to deal with this which is one of the things you were trying to avoid.
The issue here I guess is that in your approach of back calculating everything from the end and in particular adding the PV of all future flows to the current value, ignores the risk of the fund running out or being heavily depleted before large future income streams kick in – if I programmed a complete edge case where I was going to inherit a huge sum 40 years later, this would illustrate it even furher I think.
So I guess my question is, how do you think this approach will cope with “bridging” scenarios where someone has some big income streams coming and the fund that they have is being partially or mainly used to bridge the gap and allow them to retire early?
From reading your blogs I’m well aware that this is not the main case that your model is trying to deal with.
That’s what I’d expect: If you have a 10-year bridge you would expect a SWR in the high single digit % or even >10%.
“If I then cut the fund by 10% and reduce the periods by a year, the withdrawal only went down slightly”
Again, that’s what I’d expect.
I am still a bit puzzled but this – I am struggling to see how the way you model the supplemental flows of income into (and out of) the “cash flow assist” sheet and I cannot see how this is a valid approach (unless I don’t understand how to use the sheet).
It appears that you are calculating the present value of the future flows and applying that to the opening balance. However, to me this cannot be right because you might run out of cash before those additional pensions kick in later on. I would think that the timing of those flows matters (and also the way they are being treated in those years when they don’t yet exist).
I can see this for example if I keep reducing the value of my starting portfolio in the sheet – I get to the point where your sheet tells me that I can withdraw more money than the entire 100% in the first month, and the month year and so on, so this method definitely breaks with extreme edge cases.
If I eradicate all my additional income flows then of course everything works fine.
In all of personal finance, common sense has to be applied. One can devise an example where my approach would give you slightly odd results.
Example: your portfolio is $1. Not $1m, but one dollar and zero cents. Your pension starts in 2 years and is worth $100,000 p.a.
You don’t need my sheet to figure out what to do. Ignore that $1 portfolio. You will likely live on credit for two years (get a HELOC on your primary residence, for example) and pay back the loan over time when your pension kicks in. Use some NPV calculations, and you’ll likely get a safe consumption rate of $80k-$90k, depending on interest rates, life expectancy, borrowing limits, etc.
And for the record, if you have no HELOC option, you might live off unsecured credit (credit cards), in which case you might have to tighten the belt and live off much less than 80-90k.
Nobody in their right mind would use my sheet and claim, “ooohhh, look at this, this is wrong because $80k per year is an SWR of 8000000% of the portfolio!!!”
A simple starting point to think about this problem is to just assume your portfolio only keeps up with inflation.
In this case, you’d need 1 unit of living expenses for the first 10 years of retirement then 0.2 units of expenses for say, 20 years beyond that so 1*10+0.2*20 = 14 years of living expenses needed or 7% SWR.
From this starting point you can play with the more complicated SWR scenarios by experimenting with different equity allocations, but with front heavy withdrawals like yours it can be hard to beat a zero yield inflation linked bond ladder due to SORR risk.
Well this was kind of my starting point – if I look at whether for example a fund of 500K would keep up with inflation if I took out 10% per year over 10 years, other tools like CFiresim for example would report a significant failure rate there.
Bottom line I guess is that I am using several different tools and spreadsheets of which this is one to compare different scenarios to prepare for retirement – I take the point that you have to keep in mind the assumptions and methodology of the sheet and you cannot just assume you can retire with $1 if you have a big inheritance coming in 30 years from now or whatever.
However as far as I can tell tracing through the formulas in this sheet (and please correct me if I’m wrong as I’m no spreadsheet genius), the approach amalgamates the current estimated value of future cash flows and then applies a blanket adjustment to each row of the historical data based on this. Would I be right in assessing that this means the estimated present value of those flows is effectively treated as if it’s invested funds using the mix on the parameters sheet, when actually it’s only supposed to grow with inflation? This will probably be a bit of a wash in most situations over a decade or so and it won’t make much difference in the grand scheme of things.
Bottom line – this spreadsheet will not automatically warn you if you have a portfolio size where you might in some scenarios run out of money before your DB pension arrives. Of course you would be assessing this during the time anyway and I take the point that you have to apply common sense to the situation.
I guess you can also mitigate this by analysing your intended bridging period as a discrete event using this sheet or other methods.
You’re confused about a few things here.
1: Like cfiresim, my regular toolkit will generate a warning that a portfolio will generate a high risk of running out of money if withdrawing money at a 10% rate over ten years.
2: The punchline of a CAPE-based rule (as opposed to a fixed withdrawal amount adjusted for CPI) is that you never run out of money, but you may have to cut down your annual spending if the market doesn’t cooperate. Failure of a CAPE rule is not in the form of running out of money but in running out of purchasing power. Please read my relevant SWR Series post to understand that.
3: Using a two-stage method with stage 1 up to the pension and stage 2 after the pension starts, as you suggest, is a very naive and mathematically inferior method. What if the stage 1 withdrawal amount is $100,000 and the pension is only $50,000? Wouldn’t you want to spend a little bit less during the first 10 years and then keep a bit more money to generate a permanent retirement benefit of, say, $85,000? How would you split your money into bucket 1 (to spend down over the next 10 years) and bucket 2 (permanent bucket)? Well, my spreadsheet here helps you decide to make that calculation. How would cfiresim help you if you have $1m now and a $50k/year starting in year 10?
But again: if you like cfiresim so much more, please use that tool. Please don’t use my tool. Like most of my readers, I prefer my toolkit because it makes much more sense than cfiresim in many, many ways. But I can’t please everyone.
Thanks for the reply and no problem. I didn’t wish to imply that your tool is somehow wrong or not as good as one or others, so sorry if it came across that way.
I think you model is great and I don’t think cfiresim is better – I just like to use several different tools and compare the results as a kind of sense check. If different ones give different results for the same input values then I look into the reasons to see if it makes sense.
Your analysis certain provides a lot of other useful information that cfiresim and also some others I have tried don’t give you. My gut feel is to use several different tools including yours and then decide when to retire and how much spending to take out in the first years.
Noted. I just wanted to reiterate that for fixed spending with CPI adjustment, my tool and cfiresim perform similar calculations if there are supplemental flows: adjust the spending by the supplemental flows, i.e., the withdrawals are reduced by the pension, Social Security, etc.
It’s more complicated when using the CAPE-rule spending: run two different cfiresim scenarios, one with and one without supplemental income at a future date. cfiresim will give you the same spending in the early years. That’s nonsense. You should find a way to spread the future income and to smooth the future income starting in year 0. I’m not saying that my approach is the best. It’s the best I could find. If you know a better approach, please let me know. The cfiresim approach of ignoring the future cash flows in Year 0 is certainly the worst possible assumption.
PS: also note that cfiresim has no feature to simulate CAPE-based rules with a planned drawdown, the way I model it. So, for example, in cfiresim, if you have only 10 years left the tool will still only assume a WR based on the CAPE but calibrated to asset preservation. Way too low, considering that you can also draw down part of the principal .
Hi Big ERN! Checking in after a long time. Though I no longer blog, I’ve always enjoyed your insightful comments on my past articles. I believe they are still there on my old website though it has changed hands 4 years ago.
With this article, I believe you have outdone yourself (if that is even possible!). I have always been a huge fan of your work and have been using the 1.5% + 0.5/CAPE formula in my SWR calculations. Even back then, you recommended 1.75% but I have stayed with a lower intercept for higher safety factor. Now, with the CAPE adjustment and your recommended intercept, SWR is “giddily” up in my case by about 0.75%, or up 23% in withdrawal amounts! In a year of double digit portfolio decline, this is a soothing balm indeed. I am still staying with 75%+ equity allocation (and deploying cash periodically at these levels into equities). Just wanted to drop in a comment to say Hi from an old fellow blogger and long-time fan. Best wishes, TFR
Hi Mr. 10!Rocks. Good to hear from you again! Thanks for the update, and I’m so happy to hear you’re still finding value in my little blog project here. All the best!
Karsten
In the case of someone with substantial international equity exposure (say 40% non-US equities) where the CAPE ratios are much lower at the moment, would it make sense to use a reduced CAPE ratio in the Google Sheet. See https://indices.cib.barclays/IM/21/en/indices/static/historic-cape.app.
Yeah, I knew about that link. But thanks for sharing.
I don’t have any of the underlying data for that Barclay’s database. So, I will not construct any adjusted CAPEs for those markets. Maybe Barclays will adopt my method one day?! 🙂
Big ERN. Quick question: I’ve been using the supplemental ‘cash flow translational tool’ from SWR 17 since you first published it. Does all the work contained in Toolbox 2.0v supplant the SWR 17 data, i.e. can I use the Toolbox calculations exclusively? Thanks.
Yes, good point. You should use the new SWR sheet and get more precise estimates than with the rough figures from Part 17!
I’ve been trying to decide whether to use the static SWR from the main sheet, or a CAPE-based rate. I like the idea of “re-retiring” every year, since you have more data, a shorter horizon, and possibly a better idea of future cash flows, and should end up with a better answer. This would imply leaning towards a dynamic SWR, but in order to decide I’ve been trying to come up with an intuitive reason why the CAPE-based SWR is so much higher (in my case, tens of thousands of dollars per year).
One thing I’ve come up with is that the static SWR is designed to be a set-it-and-forget-it value, so to insure success it must necessarily be lower.
However, I’m also wondering about specifying the desired final value. With a static SWR, and say a final value of 10%, it seems like the vast majority of outcomes will be turn out to leave you (or your heirs) with significantly more than 10%. If I specify 10% final value with a CAPE-based rule, however, it feels like you’re much more likely to end up with just that. Does this make sense?
If you follow the CAPE-based rule and adjust the SWR meticulously with the PMT function to exactly target the final value, you will indeed hit that. But you also likely take out a lot of money toward the end. So, instead of overaccumulation with a high probability, you overconsume with a high probability, especially as you get closer to the end.
This is great as always. Thanks Karsten. One suggestion – I believe that your CAPE calculations do not factor in expense ratios when coming up with the new CAPE-SWR (like your standard SWR calculation does). How would you modify the CAPE-SWR to account for this? Even better, would it be possible to update your spreadsheet so that it automatically takes the expense ratio from the Parameters & Main Results tab into account when calculating the CAPE SWR?
You could subtract the E.R. from the SWR calculated with the WR = a+b * CAEY
Also notice that in my SWR sheet in the appropriate tab, I use the net of expense ratio returns. So, if you calibrate your CAPE-based SWR that way you did indeed take into account the expense ratio.