The Story Behind the Numbers

Too often, I see numbers in isolation. Too often, someone identifies 4.0% as The Number without any explanation whatsoever. There needs to be more.

There needs to be an explanation as to how to reach The Number.

The original 4.0% was never The Number. It was only an illusion. The odds of success, starting from today’s valuations, were only 50%-50%.

We have now pushed Safe Withdrawal Rates much higher. They are well above 5.0% (of today’s balance plus inflation) for a 30-year retirement that begins ten years from now. Starting today, we can count on 4.8% (of today’s balance plus inflation) for a retirement that extends far into the distant future. Even at 5.4% (of today’s original balance plus inflation), our actual odds of success equal those of the original portfolios at 4.0% (plus inflation).

The Actual Numbers

Early studies neglected valuations. It was an attempt to avoid the issues that always surround statistical estimates.

The attempt failed. Valuations are critically important.

Many who state that The Number is 4.0% cling to an outdated understanding of what is involved. They suppose that a portfolio of stocks and commercial paper delivers a 30-year Safe Withdrawal Rate of 4.0% (plus inflation). They are wrong. Today, at today’s valuations, a portfolio that is 80% stocks and 20% commercial paper (rebalanced annually) delivers a Safe Withdrawal Rate of 2.5%. At 4.0%, the odds of reaching year 30 are 50%-50%. Similarly, at today’s valuations, a portfolio that is 50% stocks and 50% commercial paper (rebalanced annually) delivers a Safe Withdrawal Rate of 3.0%. At 4.0%, the odds of reaching year 30 safely are almost identical, almost exactly 50%-50%.

Using 2% TIPS improves matters greatly. A portfolio with 80% stocks and 20% TIPS at a 2% interest rate, rebalanced annually, has a 30-year Safe Withdrawal Rate of 3.0% (plus inflation) and its odds of reaching year 30 are 50%-50% at a withdrawal rate of 4.1% (plus inflation). A portfolio with 50% stocks and 50% TIPS at a 2% interest rate, rebalanced annually, does better. It has a 30-year Safe Withdrawal Rate of 3.6% (plus inflation). Its odds of reaching year 30 are 50%-50% at a withdrawal rate of 4.4% (plus inflation).

Recovering 4.0%

Our first task was to recover The Number of 4.0%. Previously, 4.0% was only an illusion. We sought to make it a reality.

TIPS (Treasury Inflation Protected Securities) restored 4.0%. In fact, a TIPS-only baseline portfolio, consisting of 2.0% TIPS, provides 4.0% (plus inflation) safely for 35 years before depleting principal. It provides 4.5% (plus inflation) for 30 years.

Recovering the Upside

A TIPS-only portfolio draws down principal. We need stocks if we want our portfolios to grow. We need stocks if we want to extend portfolio lifetimes.

Switching allocations restores the upside potential. If we switch optimally, our 30-year Safe Withdrawal Rate climbs to 4.4% with a portfolio of stocks and 2% TIPS. Our odds are 50-50% that we could withdraw 5.1% (plus inflation) for 30 years or more. A more reasonable alternative, that constrains stock and TIPS allocations to 25% to 75%, allows us to withdraw 4.1% safely for 30 years. Its odds are 50%-50% that we could withdraw 4.8% (plus inflation) for 30 years or more.

Even allowing for uncertainty regarding the details of an optimal switching algorithm going forward, we have restored The Number. The 30-year Safe Withdrawal Rate exceeds 4.0% (plus inflation). We have restored the upside potential.

Intermediate-Term Timing

Stock market timing is exceedingly difficult in the short-term. Year-to-year fluctuations dominate. Year-to-year fluctuations are huge.

Stock market timing is difficult in the long-term (beyond 30 years). The variation of annualized returns narrows sharply, even faster than the 1/(the square root of the number of years) associated with purely (independent) random behavior.

Between the very short-term and the very long-term lies an area with a reasonable amount of predictability. The intermediate-term of ten to twenty years is the most important for most investors, especially for retirees.

Intermediate-term timing is a simple notion. The stock market is great at normal valuations. It is even better when valuations are low. The stock market is not nearly so attractive when valuations are high.

Intermediate-term timing is a reasonable notion. Markets fluctuate. Stocks will not remain forever on a new, permanent plateau with prices far exceeding those of the past. A glance at the Dividend Discount Model (and its variants) shows us why. Stocks aren’t always worth buying. Stocks don’t always possess an upside potential good enough to justify the downside risk.

Bigger Numbers

For those approaching retirement, I recommend that you read my If You Don’t Want to Wait series of articles. Today’s one-half million dollars can allow you to withdraw $40000 (plus inflation) annually for 30 years, starting within a decade. I have grouped this series together in my Notes through November 29, 2005.

Notes through November 29, 2005

I have focused my latest dividend-based research on those who would like to retire today. I have grouped my findings together in the Dividends section under the heading Dividend-Based Design Example.

Dividends Section

Follow the steps in my Dividend-Based Design Outline article from that group. Notice that I used the most conservative estimate (6.9%) of future dividend yields from high quality, high dividend companies. The actual range was from 6.9% to 10.4%. Using 6.9%, I found that you could withdraw 4.8% (plus inflation), safely and perpetually, from dividends alone. You start by withdrawing 4.8% (plus inflation) from a 2% TIPS-only portfolio until yields grow to 6.9% among the high quality, high dividend paying companies.

If you base your planning on an 8.65% future dividend yield (the average of 6.9% and 10.4%, which is reasonable), you can withdraw 5.4% (plus inflation) indefinitely. The TIPS-only portfolio would still have 62.9% of its principal at year 10. You would anticipate buying an income stream of dividends equal to 8.65%*0.629 = 5.4% (of your original balance plus inflation). It would be safe. It would continue long into the distant future.

Have fun.

John Walter Russell
January 26, 2006