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May 14, 2009

Calculator How much of your retirement account can you afford to withdraw each year without having to worry too much about whether you'll run out of money before you're dead?

The old rule of thumb that gets tossed around by investment advisors is that you should withdraw roughly 3.0% of the total amount in your retirement fund in any given year, with the downside being that this amount may not provide for the kind of retirement you may have envisioned. Newer research suggests that withdrawing anywhere from 4.0% to 6.0% of your retirement account balance can be safely sustained for a prolonged period of time, but the higher your rate of withdrawal, the less likely your retirement will last as long as you might.

Another factor that greatly affects your effective safe withdrawal rate is how your investments are allocated within your retirement account. As we've seen in the past two years (2007-2009), having a significant portion of your retirement portfolio invested in stocks can greatly affect the total value of your retirement account, as the stock market can gain or lose a substantial amount of value in relatively short periods of time. For instance, an individual retiring in late 2007, when stock valuations were high, would have seen a substantial reduction in the value of their retirement portfolio. Meanwhile, an individual retiring in early 2009, with stocks at much lower valuations, might very well see their retirement portfolio grow as stocks rebound in value.

In both cases, we would expect the relative valuation of stocks to have an effect upon how much either investor should feel comfortable withdrawing from their retirement portfolio. If stocks have relatively high valuations, then a hypothetical retiree might need to significantly lower the amount they might withdraw from their retirement account, since it would be more likely to lose value in the near future. Likewise, at relatively low stock valuations, our retiree could comfortably withdraw a higher percentage of their account, with the reasonable expectation that stock prices would increase in value.

The question then is to determine how highly or lowly stocks are being valued when the retiree withdraws money from their retirement account, and to then work out how that might affect the percentage that the retiree could safely withdraw and still be able to have their retirement funds through their retirement.

Retirement Risk Evaluator Tool One of the neater concepts we've been intrigued by that addresses the effect of relative stock valuations upon a retiree's safe withdrawal rate is a tool developed by Rob Bennett and John Walter Russell, whose work in predicting future trends in stock returns based upon their relative valuation we've reviewed previously.

The valuation measure used in their Retirement Risk Evaluator tool is the Price-to-Average Inflation-Adjusted 10 Year Earnings Ratio (P/E10), which was originally developed by Robert Shiller, who makes this stock market data available in spreadsheet form on his web site. [Note: This is very much not the same as the Price-to-Earnings (or P/E) Ratio that you can easily find or calculate!]

A retiree looking to determine how much of their retirement account to withdraw would need to enter the most current P/E10 ratio into the tool, then account for how much of their retirement account is represented by the stock market, the rate of return of a Treasury Inflation Protected Security (or TIPS, a risk-free T-bill whose yield is adjusted for inflation), and finally, the percentage of the current value of the retirement account that the retiree would want to ensure is available in 30 years.

The tool's interface is slightly clunky and dated in appearance (the same criticisms we had of the design of the Stock Price Predictor tool), and with four scenarios to enter, we believe a bit overkill, since we would expect most users would mainly consider a side-by-side comparison of just two scenarios.

On the plus side, the tool provides a neat execution and the graph function provides a really nice touch in visualizing the safe (the white bar), mostly safe (green), okay (blue), risky (yellow) and almost certain to fail (red) rates of withdrawal that Russell and Bennett's tool calculates, which is based on their regression analysis of historic stock valuation data.

Going with the default data provided, we see that a retiree's safe withdrawal rate drops significantly at times when stocks have relatively high valuations, and increases significantly at times when valuations are low.

The only caveat we would have with using the tool is that given how fast valuations can change in the stock market, retirees would need to monitor the relative valuation of stock prices frequently to adjust how much they might consider withdrawing if they based their decisions of how much to withdraw purely on the results they obtain using the tool. Alternatively, investors might just simply opt to withdraw a relatively low percentage of their portfolio each year, say around 3.0 to 4.0%, and just tweak that amount occasionally depending upon where stock market valuations go.


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