Saturday, May 26, 2012

Reality Check on Retirement Planning Assumptions


Before reading the May 12th issue of the Economist, I was flipping through the pages of the May 19th issue and saw that Peter David, the Lexington columnist and Washington bureau chief, had died in a car accident the previous week in Virginia after having given a talk at the Charlottesville Committee on Foreign Relations. It’s a real reminder about the frailty of life and how we should cherish every day.

And this meant that the May 12th Lexington column would be his last. I think with his final paragraph, he left the stage on a fine note:

Charles Dickens said of the United States that if its citizens were to be believed America ‘always is depressed, and always is stagnated, and always is at an alarming crisis, and never was otherwise.’ On a variety of objective measures, it is in an awful mess right now. And yet America of all countries still has plenty of grounds to hope for a better future, despite its underperforming politics, and no matter who triumphs in November.

I do believe this is true. 

But nonetheless, when it comes to retirement planning, we need to keep in mind two very important facts: (1) bond yields are currently at extremely low levels, and (2) the equity premium earned by stocks in U.S. history was abnormally high and we should plan for a more reasonable premium in the future. 

We have got to use capital market expectations that are linked to reality. That means we can’t use historical averages to guide simulations, and it means that the Trinity study and its brethren are of no particular use.

The historical data averages used to guide most withdrawal rate studies are shown in Table 1:

Table 1
Summary Statistics for U.S. Real Returns Data, 1926 – 2010




Correlation Coefficients

Arithmetic
Means
Geometric Means
Standard Deviations
Stocks
Bonds
Inflation
Stocks
8.70%
6.62%
20.39%
1
0.1
-0.2
Bonds
2.52%
2.28%
6.84%
0.1
1
-0.6
Inflation
3.07%
2.99%
4.18%
-0.2
-0.6
1
Equity Premium
6.18%





Source: Own calculations from Stocks, Bonds, Bills, and Inflation data provided by Morningstar and Ibbotson Associates. The U.S. S&P 500 index represents the stock market, intermediate-term U.S. government bonds represent the bond market, and bills are U.S. 30-day Treasury bills.

I’m now trying to finalize a set of assumptions to use in my new research. Table 3 shows my current planned assumptions, though I do encourage and request any feedback you may have about these as I don’t fancy myself to be much of a market forecaster:

Table 3
Assumptions for Real Asset Returns




Correlation Coefficients

Arithmetic
Mean
Geometric Mean
Standard Deviation
Stocks
Bonds
Inflation
Stocks
5.1%
3.1%
20.0%
1
0.1
-0.2
Bonds
0.3%
0.1%
7.0%
0.1
1
-0.6
Inflation
2.1%
2.0%
4.2%
-0.2
-0.6
1
Equity Premium
4.8%





Note: Standard deviations and correlation coefficients are based on Stocks, Bonds, Bills, and Inflation data provided by Morningstar and Ibbotson Associates, in which the U.S. S&P 500 index represents the stock market and intermediate-term U.S. government bonds represent the bond market. The arithmetic mean for bond returns is calibrated to recent TIPS yields. The arithmetic mean for inflation is based on the breakeven inflation rate implied by TIPS and Treasury yields. The arithmetic mean for stock returns is calibrated to allow an equity premium of 4.8% above the bond return, which is the equity premium for a GDP-weighted portfolio of 19 developed market countries between 1900 and 2010 from the Dimson, Marsh, and Staunton Global Returns Dataset provided by Morningstar and Ibbotson Associates.

With these assumptions, failure rates for the 4% rule are quite shocking. With 50% stocks, the 4% rule can be expected to fail 47% of the time. Retirees are pushed toward 100% stocks to minimize failure, and even that failure rate is 39%. Is this too pessimistic?