The 4% Rule Works Again! An Update on Dynamic Withdrawal Rates based on the Shiller CAPE – SWR Series Part 54
October 12, 2022
As promised in the “Building a Better CAPE Ratio” post last week, here’s an update on how I like to use the CAPE ratio calculations in the context of my Safe Withdrawal Rate Research. I have studied CAPE-based withdrawal rates in the past (see Part 11, Part 18, Part 24, Part 25) and what I like about this approach is that we get guidance in setting the initial and then also subsequent withdrawal rates based on economic fundamentals. That’s a lot more scientific than the unconditional, naive 4% Rule. In today’s post, I want to specifically address a few recurring questions I’ve been getting about the CAPE and safe withdrawal rates:
- Can a retiree factor in supplemental cash flows like Social Security, pensions, etc. when calculating a dynamic CAPE-based withdrawal rate, just like you’d do in the SWR simulation tool Google Sheet (see Part 28 for more details)? Likewise, is it possible to raise the CAPE-based withdrawal rate if the retiree is happy with (partially) depleting the portfolio? You bet! I will show you how to implement those adjustments in the CAPE calculations. Most importantly, I updated my SWR Simulation Google Sheet to do all the messy calculations for you!
- With the recent market downturn, how much can we raise our CAPE-based dynamic withdrawal rate when we take into account the slightly better-looking equity valuations? Absolutely! It looks like, the 4% Rule might work again! Depending on your personal circumstances you might even be able to push the withdrawal rate to way above 4%, closer to 5%!
- What are the pros and cons of using a 100% equity portfolio and setting the withdrawal rate equal to the CAPE yield?
Let’s take a look…
Because I haven’t specifically written about CAPE ratios and their application to safe withdrawal rates in a while, let me just get everybody up to speed again on why and how CAPE ratios matter for retirees. Even if you don’t pursue a dynamic CAPE-based safe withdrawal rate, but prefer to use the standard Trinity Study-style calculations with a fixed withdrawal amount (though adjusted for inflation), CAPE ratios should matter for setting that withdrawal amount and percentage. Here’s again a chart from an earlier post to drive home this point. All the historical failures of the 4% Rule have occurred when the CAPE earnings yield (= one divided by the Shiller CAPE Ratio) was under 5%, i.e., when the CAPE Ratio was above 20. So it would be way too conservative to use a 4% Rule when the CAPE Ratio is in the low teens. But a 4% Rule might be way too aggressive conditional on facing a high CAPE ratio because the conditional failure probability is much higher than the (unconditional) failure probability you’d get from a Trinity Study.
CAPE-based Dynamic Safe Withdrawal Rates – a primer
Just to get everyone back to speed on dynamic withdrawal rates, here’s a quick primer on the CAPE-based SWR rules. In the most basic setup, we calculate our withdrawal rate as
WR = intercept + slope / CAPE
Notice that our setup also encompasses, as a special case, another popular withdrawal rate rule: the Bogleheads variable percentage withdrawal (VPW) rule, if we set the slope to zero and fix the withdrawal amount to a certain percentage of the portfolio. But of course, we do want equity valuations to have an impact because economic fundamentals should matter. There are three neat features of using a withdrawal rate contingent on equity valuations:
First, we find an initial withdrawal amount that’s calibrated to be consistent with equity valuations. Second, our subsequent withdrawal amounts will adjust to changing portfolio values but also equity valuations. That’s a great improvement over the naive Bogleheads rule that uses a fixed withdrawal rate (though adjusted for retirement horizon). With a variable withdrawal rate, your withdrawal amounts will be significantly less volatile than the portfolio value. The portfolio may be down 20%, but the withdrawal amount is only down by, say, 10% because you also adjust the percentage withdrawal rate to reflect the better-looking CAPE ratio after an equity market correction.