Future returns and their impact on SWRs

Today I wanted to talk about the forecasting of future returns and more importantly what implications future returns have for SWRs (Safe Withdrawal Rates). As I showed in my last post, the first 10 year period real return in retirement is the best predictor of SWRs for 30 year retirement periods. Thus by creating a model for returns for the next 10 years based on where assets are priced today we can get a better idea as to the applicability of the traditional 4% SWR for future retirees.

There’s a been lot of discussion over the last couple of years in the financial blogosphere about future equity returns. Most of the that discussion is centered around US equity markets being over valued and therefore leading to very poor returns going forward, for anywhere from the next 5 years to the next 20 years. The analysis goes something like this; you take historical valuation figures based on different parameters such as Shiller PE, MarketCap to GDP, Q ratio and see what the historical forward returns where for different levels of starting valuation. Then you compare that history to today’s valuation level and make a statistical forecast for future returns. It’s more complicated than it sounds but that is essence of what the process is to arrive at return forecasts. The best summary of these types of analyses I’ve found anywhere is this post from GestaltU. There is a lot of gory detail (or awesome detail for folks like me) in the post and associated caveats but here is the punch line that we need to consider.

Butler forecasted returns oct 2014

Not so pretty right? The most probable compounded US equity returns for the next 10 years is about -1%. This could imply a rethinking of the 4% SWR. This being a statistical analysis there is a potential range of outcomes. I wanted to get a feel for what those range of outcomes were in the past with specific years attached to it – after all, this is based on historical data anyway. Sometimes the human brain needs context and a story behind the data to derive a better understanding. I went to my handy dandy data base of historical stock returns that I use for my SWR analyses and added the Shiller PE (CAPE) data to it, as well as bond returns, 60/40 portfolio returns and inflation. At the end of the day we care about total portfolio returns, not just equity returns. I then sorted all 10 year period returns starting in 1929 by CAPE range. Below is the summary. Highlighted is the CAPE range of the US equity market today, greater than 25.

Ten year historical returns by CAPE range oct 2014

The data in the table pretty much agrees with the GestaltU data. Forward stock returns from high valuation markets are low. Stock returns pretty much go up with decreasing starting valuation as expected. A couple of interesting things to note in the table are that bonds returns are highest at both high starting equity valuations and low starting equity valuations. Also, inflation increases as starting equity valuation decreases. This is not the place to delve into the reasons why but the important point is that these effects are all important to and affect what we care about which is total real portfolio return. The portfolio returns also decrease directly with increasing equity valuation but note that the absolute numbers are not as bad. A 2.85% avg portfolio real return from the highest valuation tier is a lot better than a -1% stock only return that starts freaking investors out. Now recall that the first 10 yr period return for the worst case retiree in history, which defined the 4% SWR rule, was -1.26% real per year for a 60/40 portfolio. So, this simple look into the details tells me that the 4% SWR rule is probably still OK. But could some of the future periods be worse than any other period in history? Yes. I think for more insight here we need to look into even more detail at the historical data. Below I break out all the 10 year periods with CAPE ratios greater than 20. The table is sorted by CAPE ratio from highest (most expensive) to lowest (cheapest).

Detailed Ten year historical returns by CAPE oct 2014

Along with CAPE I also added the yield of the 10 year note at the start of the period. For example, in the begging of 2000 the CAPE ratio was over 42 and the 10 yr yield was 5.11%. Note that indeed the 10 year period starting 1966 started from a high valuation, although not in the top tier, and produces almost the lowest total portfolio return with both negative real stock returns and bond returns! Now, could it be worse than 1966 in the future thereby forcing a lowering of the 4% SWR? To look at that I highlighted all the past years in yellow that could be called similar to today, with high equity valuations and low bond yields. Looking at the data and thinking about the story behind those periods makes me think that 1937 could be a similar parallel for today. Beginning of 1937 was about 8 years after the Great Depression. Today we stand at close to 7 years after the Great Recession. Maybe? Who knows but worth a think. The data is the data though – high equity valuations and low bond yields is what we face.

You could even say that there is no precedent for where we are today with CAPE ratios of over 25 and bond yields below 2.5%. And that could imply that the 4% rule may fail going forward. Definitely a possibility. But I think the important point is that it would take more than weak first 10 year equity returns to kill the 4% SWR. It would take a similar but even worse brew than the 1966 period which combined high starting equity valuations, with rising bond yields, and rapidly rising inflation.

If that was where we ended it would indeed be a worrying picture. And then maybe the best recommendation would be to reset expectations to a lower SWR. But the problem with the all the above is that we have taken a very narrow view of the brave new investing world we live in. The entire discussion above and in most of the blogosphere is solely focused on US equity markets. There are other markets out there with better valuations. Most of the discussion around the potential failure of the 4% SWR assumes a US large cap stock and US intermediate government bond only allocation. There are better asset allocation methods out there. There are portfolio strategies that seek to enhance return and minimize risk which also help maintain SWRs. There are better retirement withdrawal and spending models that help combat poor early returns in retirement. Before we go off concluding that a 4% SWR won’t cut it anymore we need to look at all of these and what impact they have on SWR. I’ve done that in many previous posts but I plan to recap and summarize most of that work in future posts.

In summary, future US equity returns are probably going to be lower than in the past due to today’s high valuations. But that is only part of the story when it comes to determining SWRs. Despite these headwinds I think that with the combination of better asset allocations, better portfolio strategies, and better spending and withdrawal models the 4% SWR can continue to serve retirees well into the future.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.

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4 thoughts on “Future returns and their impact on SWRs

  1. Really appreciate all the analysis. The technical aspects of your research are outside of my current comfort zone but you do a great job of distilling the meaning out of the results. Combine the current market drop with your less than stellar predictions for the future it looks like our retirement timing couldn’t be much worse:-) Fortunately, you have introduced tools that at least give us a better than average chance at doing at least as well as the predictions. Glad we are poised for an RV lifestyle that is less expensive than our current one.

    1. Hi John, I think its important to be prudent yet flexible. Even taking these predictions as inevitable fact does not mean that a great retirement under the 4% rule is out the window. As I said in the post, it just takes the use of better tools and methods. Sure its not 1982 where valuations were ultra low and 30 years later we had a huge legacy to pass on or give away. But we don’t control these things. We can still have a highly successful retirement even under the current conditions. And if things turn out better than predicted, we can adjust and take advantage of the improved situation.


  2. How would adding more int’l market into a Quantitive system change things , would a 1966 retirement portfolio look deferent for
    Someone in the US. Vs. (Somewhere else in the world ) maybe you could rotate to the market in the world that is working ?

    1. John, adding international equities to a portfolio increases risk adjusted returns and SWRs. At least this is what the data tells from the early 1970s. Unfortunately there is no good, cheaply accessible, international equity data going back to 1966 or further. All modern diversified portfolios and quant systems, except the Permanent Portfolio, include allocations to international equities.


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