Designing a 45-Year Retirement

Here is an example of how you can use my 15-Year and 30-Year calculators back-to-back.

How about a 4.5% (plus inflation) withdrawal rate?

Calculators

I used Super SVTVR Calculator L and 15-Year Calculator A. Both are available to download from my Yahoo Briefcase. They are in the Big Project folder.

The highest level of safety corresponds to a probability of success of 95% or better. The reasonable level of safety corresponds to a probability of success of 80% or better. I use the term “Likely Success” to describe conditions with a probability of success greater than 50%.

Yahoo Briefcase

Why 15 then 30?

Normally, I would recommend using the 30-year SVTVR Calculator L first because of data spread. This did not work out.

I brought up SVTVR L. I entered today’s P/E10 of 26, a TIPS interest rate of 2.0% (currently, it is 2.2%) and a final balance of zero. I looked at portfolios A, B, 0% stocks (and 100% TIPS) and 100% stocks. The Safe Withdrawal Rates were 4.2%, 4.4%, 4.5% (read this TIPS-only value from cell Q20) and 2.3%, respectively. Trying stock allocations of 20%, 50% and 80% produced Safe Withdrawal Rates of 3.9%, 3.7% and 3.1%.

The Reasonably Safe rates for portfolios A, B, 100% stocks, 20% stocks, 50% stocks and 80% stocks were 4.6%, 4.8%, 3.2%, 4.2%, 4.1% and 3.7%. [Only one rate is relevant with a TIPS-only portfolio.]

All of these withdrawal rates are for Year 30 balance of zero.

Extending these portfolio lifetimes to 45 years at a 4.5% withdrawal rate requires an unacceptable level of risk.

Success

Now I shift gears. I start with the Year 15 Calculator A. I shift allocations later, when stock valuations improve.

Research into demographics forecasts a stock market bottom in the next 10 to 15 years. The most likely year is 2018.

It is reasonable to assume that stock valuations will return to the normal level (around 13.5) or, consistent with history, fall to bargain levels (P/E10 below 8).

Step 1.

We start from today’s valuations (P/E10=26), a 2% TIPS interest rate and a Year 15 balance of 50%. The Safe Withdrawal Rates for portfolio A, B, 0% stocks (100% TIPS) and 20% stocks are 3.7%, 4.2%, 4.9% and 4.0%, respectively. Stock allocations of 50%, 80% and 100% have Safe Withdrawal Rates of 3.1%, 1.7% and 0.9%.

The Reasonably Safe rates for portfolios A, B, 100% stocks, 20% stocks, 50% stocks and 80% stocks were 4.4%, 4.8%, 2.3%, 4.3%, 3.8% and 2.9%. [Only one rate is relevant with a TIPS-only portfolio.]

Step 2.

We start with a TIPS-only portfolio during the first fifteen years. I varied the calculator’s Year 15 balance. Withdrawing 4.5% (plus inflation) annually for fifteen years from a 2% TIPS portfolio leaves us with a final balance of 57%.

Step 3.

If we have 57% of the initial balance, we must increase our withdrawal rate to 4.5%/0.57 = 7.9% to maintain the same withdrawal amount.

I looked at P/E10=8. I left the TIPS interest rate at 2%. I set the final balance to zero. The Safe Withdrawal Rates for portfolios A, B, 100% stocks, 20% stocks, 50% stocks and 80% stocks are 7.8%, 7.5%, 10.0%, 5.3%, 7.3% and 9.1%, respectively. The Reasonably Safe rates are 8.1%, 7.9%, 10.9%, 5.6%, 7.7% and 9.7%, respectively.

Compared with our 7.9% requirement, portfolio A comes very close. Both the 80% and 100% stock portfolios succeed at the highest level of safety. At the Reasonably Safe level, portfolios A, B, 80% stocks and 100% stocks all succeed, while 50% stocks comes close.

Excursions for Added Safety

Step 4.

Next, I investigated a pessimistic extreme, where P/E10=14 at Year 15. I left the TIPS interest rate at 2%. I set the final balance at 0%.

The Safe Withdrawal Rates for portfolios A, B, 100% stocks, 20% stocks, 50% stocks and 80% stocks are 5.6%, 5.6%, 5.2%, 4.5%, 5.0% and 5.4%, respectively. The Reasonably Safe rates are 5.9%, 6.0%, 6.1%, 4.7%, 5.4% and 6.0%, respectively.

All of these fall below our 7.9% requirement at year 15.

Step 5.

I continued by looking at P/E10=11 in Year 15, halfway between 8 and 14. This is pessimistic, but not terribly so. I left the TIPS interest rate at 2%. I left the final balance at 0%.

The Safe Withdrawal Rates for portfolios A, B, 100% stocks, 20% stocks, 50% stocks and 80% stocks are 6.4%, 6.3%, 6.9%, 4.8%, 5.8% and 6.8%, respectively. The Reasonably Safe rates are 6.7%, 6.7%, 7.8%, 5.0%, 6.2% and 7.4%, respectively.

By switching to 100% stocks, we come very close to our 7.9% requirement with a reasonable level of safety. To maintain the highest level of safety throughout the second period, which lasts 30 years, we must reduce our withdrawal rate to 3.9% after Year 15 (since 4.5%*[6.9/7.9]=3.9%).

Step 6.

This time, I reduced withdrawals to 4.2% during the first 15 years. Once again, we choose an all-TIPS portfolio. Once again, I assumed that the TIPS interest rate is 2%.

At the end of 15 years, our portfolio still has 62% of its original buying power. Our new requirement, which maintains a constant withdrawal amount (after adjusting for inflation), is a withdrawal rate of 4.2%/0.62 = 6.8%.

Once again, we cannot meet the requirement for the second period if the Year 15 level of P/E10 equals 14. But we can meet it at the highest level of safety when P/E10=11 if we allocate 80% or 100% to stocks.

We can meet our requirement for the second period with a reasonable level of safety when P/E10=12 with 80% and 100% stock allocations. Similarly, we can meet our requirement at the 50% level of safety when P/E10=13 with 80% and 100% stock allocations.

Excursions for More Time

Can we reach 60 years with a 4% withdrawal rate? Let’s try 15 years with TIPS-only portfolio, followed by 30 years with a high stock allocation, followed by 15 years at various starting valuations.

At the end of 15 years, our portfolio still has 65% of its original buying power. Our new requirement, which maintains a constant withdrawal amount (after adjusting for inflation) is a rate of 4.0%/0.65 = 6.2%.

This is very easy if P/E10=11 at Year 15. I left the TIPS interest rate at 2%. I varied final balances. With 80% stocks, we can meet our requirement (to withdraw 6.2% of the Year 15 balance) for 30 years and still end up with 75% of the Year 15 balance. (This is 75%*0.65=48.75% of the original balance). With 100% stocks, we double the Year 15 balance.

If we want a TIPS-only portfolio to suffice during the final 15 years, we need about 78% of the Year 15 balance, which is 51% of the starting balance.

With P/E10=12 at Year 15 and 100% stocks, we reach 78% of the Year 15 balance with a level of safety only slightly less than that of the Safe Withdrawal Rate. With P/E10=13 at Year 15 and 100% stocks, we reach 78% of the Year 15 balance with a probability of success between 50% and 80%.

Excursion: Less Time

Much of our concern over P/E10 stems from our need to withdraw from a TIPS-only portfolio for 15 years. This should be enough time for valuations to hit bottom, but it is unreasonable to think that stocks will continue above normal levels of P/E10=13 or 14 until then. Let us assume that stocks return to normal valuations in Year 10.

If we withdraw 4.5% (plus inflation) annually from 2% TIPS, we have 73% of our original balance at Year 10. Our required withdrawal rate to maintain a constant withdrawal amount becomes 4.5%/0.73=6.2% of the Year 10 balance.

Looking at our previous P/E10=14 results, we come very close while being Reasonably Safe if we switch to high stock allocations (with 100% stocks being best) at Year 10. If P/E10 drops to 12, we reach the highest level of safety by switching to a high stock allocation at Year 10.

Accomplishments

We have learned what it takes to withdraw 4.5% (plus inflation) of a portfolio’s initial balance for 45 years. We start with a TIPS-only portfolio for the first 10 to 15 years. We convert to a high stock allocation when P/E10 falls to 8. Even if we switch to stocks at P/E10=11, we maintain a reasonable level of safety. The probability of making it through the entire 45 years is better than 80%.

There are risks if P/E10 drops only to 12 or 13 by Year 15. The odds of success are always better than 50%-50%.

You don’t have to be fatalistic. You can start easing into stocks as soon as valuations return to their normal range. There is quite a bit of tolerance. If P/E10 drops to 14 by Year 10, you can switch to a high stock allocation and have better than an 80% probability of making it to year 40.

The simplest approach, cutting back, can help in times of stress. It is not nearly as effective as taking advantages of bargains when they occur.

As a matter of comparison: The 45-Year TIPS-only baseline withdrawal rate with 2% TIPS is 3.4%. By using my most recent calculators, I have increased the withdrawal amount by 32%.

Have fun.

John Walter Russell
August 22, 2006