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…
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 / CAPE
Notice 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 = 0.036
In 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:
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.
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!