Systematic Relative Strength

We’ve written before that there is no guarantee that market returns going forward will look anything like the past. Things change. In an article in Advisor Perspectives, Wade Pfau discusses safe withdrawal rates in an international context.

Conventional wisdom states that, when it comes to retirement planning, the 4% “safe withdrawal rate” (SWR) rule is the platinum standard. That rule, dating back to William Bengen’s 1994 article in Journal of Financial Planning, says that a new retiree can safely withdraw 4% of their savings in the first year of retirement and adjust this amount for inflation in subsequent years. Bengen found that this strategy is safe in the sense that the strategy will not lead the retiree to exhaust all of his or her remaining assets for at least 30 years.

The 4% rule has been widely adopted by the popular press and financial planners as an appropriate general rule of thumb for retirees. Since Bengen’s paper, numerous researchers have developed strategies to allow retirees to safely exceed a 4% withdrawal rate. Though the SWR fluctuates a bit from study to study, depending on the dataset and assumptions used for its calculation, my own research suggests a safe withdrawal rate for the US of 4.02%. That was the highest amount that could be sustained in the worst-case retirement year. I find that using the Dimson, Marsh, Staunton Global Returns Data for 17 developed market countries since 1900.

The problem with SWR research based on historical data, however, is that most every study has been based on the same Ibbotson Associates dataset on US financial market returns since 1926. The time period covered by such data may have been a particularly fortuitous one for the United States that will produce dangerously overinflated SWRs if asset returns fail to be so stunning in the future.

Indeed, over the time period in question the US consistently enjoyed among the highest inflation-adjusted returns and lowest volatilities for stocks, bonds, bills and inflation.

From an international perspective, the US enjoyed a particularly favorable climate for asset returns in the twentieth century, and to the extent that the US may experience mean reversion in the current century, SWRs as presently calculated may no longer seem so safe.

The results have shown that from an international perspective, a 4% withdrawal rate has been problematic. The calculated SWR exceeds 4% in only three of the other 16 countries: Canada, Sweden, and Denmark. As for other countries, the most unfortunate retiree of all was a Japanese person retiring in 1940, whose maximum SWR was a miserably low 0.47% as high inflation and low real returns plagued Japan during and after the war. Six countries experienced withdrawal rates below 3%: Spain, Italy, Belgium, France, Germany, and Japan. In Italy, the 4% rule failed 62.5% of the time, and in Japan, such high withdrawals were sustainable for only three years in the worst-case scenario.

I’ve excerpted some of the important conclusions of the article and bolded a crucial point. The US markets dataset that has typically been used to calculate withdrawals included some very, very good markets. It seems to be more the historical exception rather than the rule. If we really do have low prospective returns to look forward to in the US—think about a Japan-type scenario—that 4% number is going to be too high.

What conclusions can we draw from all this?

• Save as much as you can. There’s no guarantee that US returns will be as high as they have been historically. You might need a cushion.
• If US returns are not as high as they have been historically, you are going to get killed buying a straight index fund of whatever variety.
• If US returns are not as high as they have been historically, you should strongly consider a more global, tactical investment policy. You’re going to have to grab returns wherever and whenever you can find them.
• Withdrawal concepts based on fecundity may be a better way to go, rather than a straight percentage withdrawal based on history unlikely to repeat.
• Markets simply give you the opportunity to compete; you are not entitled to a positive outcome. Earning even a “gentleman’s C” is difficult in the financial markets.