Safe withdrawal rate: Is 3 percent the new 4 percent?

(MoneyWatch) Being alive without sufficient assets to maintain a minimally acceptable lifestyle (which each person defines in their unique way) is an unthinkable outcome. That's why when planning for retirement, the most important question is: "How much can I plan on withdrawing from my portfolio without having a significant chance of outliving my assets?" The answer is generally expressed in terms of what is referred to as a safe withdrawal rate, or SWR -- the percentage of the portfolio you can withdraw the first year with future withdrawals adjusted for inflation.

Ever since the publication in 1998 of what has become known as the "Trinity Study," 4 percent became the conventional wisdom on safe withdrawal rates. That means a portfolio of $1 million dollars would support a first year withdrawal of $40,000, with the amount in subsequent years adjusted for inflation. However, there are several important issues related to the study that you should be aware of when considering what your withdrawal rate should be.

• How to treat Social Security, your home
• Spending from your portfolio in retirement
• Most common retirement planning mistakes

The first is that in retirement the order of returns can greatly impact the outcome. Bear markets in the early years have a large negative impact on the likelihood of success. The second point is that valuations matter a great deal. High current valuations (price-to-earnings ratios) on stocks and low real yields on bonds negatively impact the odds of success, requiring a more conservative SWR. Of course, the reverse is also true -- low valuations and high real yields can allow for a higher SWR.

The problem for today's investor is that current stock valuations and bond yields provide estimates of future real returns that are well below historical returns. First, we'll look at stocks. While the historical real return to stocks has been 6.8 percent (9.8 nominal return minus 3 percent inflation), most financial economists are forecasting real returns well below that.

While there is no generally agreed upon best metric for estimating future returns, the Shiller CAPE 10 (cyclically adjusted price-to-earnings ratio) is considered by many to be at least as good, if not better, than other metrics. It's currently at 23.9, well above its historical average. To forecast future real returns you begin by taking the earnings yield (the inverse of the Shiller PE ratio). Today, the earnings yield is about 4.2 percent. However, because the Shiller PE is based on the lagged 10-year earnings, we need to make an adjustment for the historical growth in real earnings, which is about 1.5 percent. To make that adjustment we then multiply the 4.2 percent earnings yield by 1.075 (.015 x 5), producing an estimated real return to stocks of about 4.5 percent, or 2.3 percent below the historical return.

Other methodologies come up with similar results, with most financial economists forecasting real future returns in the range of about 4 to 5 percent.

Turning to bonds, the picture is similar. Historically, intermediate to longer-term bonds have provided real returns in the range of about 2 to 2.5 percent. Today, real yields are much lower. For example the current yield on five- and 10-year Treasuries are currently about 1.7 and 2.9 percent, respectively. Subtracting the current consensus estimate for inflation from the Philadelphia Federal Reserve of 2.2 percent, we get estimated real returns of -0.5 percent and 0.7 percent, respectively. And the current yields on the same maturity TIPS are -0.1 percent and 0.8 percent, respectively.

Again, we see that future returns are likely to be below historical returns. The current low real yield on bonds has a very important implication as for most investors the bond allocation tends to increase as we approach and enter retirement.

While historical returns can provide insights, it's critical that investors not make the mistake of simply projecting the past into the future -- current valuation metrics must be used. In addition, we also have to address the issues of our very limited ability to estimate future returns and the fact that the order of returns matters a great deal. The way to do that is to use what is called a Monte Carlo Simulator (MCS).

Monte Carlo simulations require a set of assumptions regarding time horizon, initial investment, asset allocation, withdrawals, rate of inflation and, very importantly, the distribution of annual returns for the different asset classes. In Monte Carlo simulation programs, the expected final wealth distributions are determined by two numbers: 1) the average annual return (which should be based on current valuations/yields, not historic ones); 2) the standard deviation of the average annual return. The Monte Carlo simulator will randomly select a return for each year and calculate the wealth values over the expected retirement period. This process is repeated thousands of times in order to calculate the likelihood of possible outcomes.

MCS is an important tool as it helps investors determine both the right asset allocation and the right safe withdrawal rate. In fact, except for all but the wealthiest investors for whom any reasonable asset allocation and SWR will likely work, I don't know how you can make a prudent decision on these important issues without running an MCS.

There should be no doubt that current valuations and yields have changed the SWR. While each investor should run an MCS to determine the right asset allocation and SWR for there personal situation, it seems likely that the old SWR of 4 percent is at best now 3 percent. A recent report from Morningstar also supports this recommendation. That has significant implications for many investors. For those still in the labor force, among the considerations should be:

• Should I plan on working longer?
• Do I need to increase my savings rate and/or lower my spending goal?

Changes in these two areas can have dramatic impacts on the odds of not outliving your assets. Another way to improve your odds of success is to make sure you use only low-cost, passively managed funds to implement your plan. The costs of active management can be a significant drag on returns. Increasing your allocation to the higher expected returning asset class of small value stocks can improve your odds of success and an enjoyable retirement. (and allow for a lower stock allocation as well).