Tuesday, March 16, 2021

How to Account for High Stock Prices in Retirement Spending

I have a spreadsheet that calculates how much I can spend each month during my retirement.  However, lately I’ve felt that I really should back off somewhat from this amount because stock prices are so high.  After all, it doesn’t make sense to spend lavishly now and cut way back after a stock market crash.  Here I describe what I’ve done to account for high stock prices.

My spreadsheet estimates my safe monthly after-tax spending amount, rising with inflation, that would consume all my savings by age 100.  It assumes that total stock returns are 4% above inflation each year, before taxes and other portfolio expenses.  The spreadsheet calculates this spending amount daily as I age and my portfolio level changes (not that I need to check it this often).  I chose a 4% real stock return because it is a little lower than the historical long-term average.  This provides a modest buffer in case future returns are below the historical average.

Although I’m able to reduce my spending by quite a bit if stocks crash, I’ve had the feeling lately that my planning may be too optimistic.  This left me not fully trusting my spending figure, which defeats its purpose.

The question was what I should do about this situation.  Some people are calling for a market crash and are selling their stocks.  I don’t engage in this type of market timing.  I’m not going to change the way I invest; I just want a more realistic idea of how much I can safely spend each month.

As I write this, Robert Shiller’s well-known Cyclically-Adjusted Price-Earnings (CAPE) ratio sits at about 35.  The only time since the 1870s when it’s been higher was around the year 2000 dot-com boom when it reached about 45.

What if I assume that the CAPE will decline from today’s level to, say, 20 by the time I’m 100?  This is a decline of about 43%.  For a 50-year old, this works out to about 1.1% per year (1.4% for a 60-year old).  It seems reasonable to reduce my expectation for stock returns by this calculated annual amount. This gives a steadier spending level if the CAPE comes back to earth.

Now my spreadsheet grabs the current CAPE value from a table online and calculates the annual decline that reduces the CAPE to 20 by the time I’m 100.  It then reduces the 4% real return I expect from stocks by this CAPE adjustment amount.   (If the current CAPE goes below 20, I don’t add an amount to the 4% return.)  I was surprised to discover that this change reduced my spending level by less than I expected.

This change has two positive effects.  The first is that it should make the calculated spending level in my spreadsheet less volatile.  If stocks crash, my reduced portfolio size lowers my spending level, but it also gives higher assumed future returns (because the CAPE adjustment will be lower), which raises the spending level.  My spending level will still drop after a stock market crash, just not by as much as before I changed my spreadsheet.  

More importantly, the second positive effect of this change is that I trust that I can safely spend the amount indicated on my spreadsheet.  I’ve eliminated that nagging feeling that high stock prices invalidate my calculations.

This is the biggest change I’ve made in some time to my financial plans in retirement.  I won’t predict it’s the last, but I’m feeling good right now about trusting my spreadsheet to have me spending the right amount.

9 comments:

  1. Sounds like an interesting approach.

    As an Excel addict myself, I implore you to please share your spreadsheet. :) I guess it would take some time to "make ready for public consumption" but my favorite times are playing with other's tools, seeing what I might use for myself, etc.

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    Replies
    1. Anonymous,

      I've tried several times to remove personal information from my spreadsheet and make it generic enough to be useful to others, but without success so far. I have some ideas for doing that to just parts of the spreadsheet, but I haven't done that yet.

      Delete
    2. +1 for seeing a public version of your spreadsheet. I know it would be a tonne of work, though.

      I will put out a big thanks to you for originally talking about the script you added years ago to email out re-balance alerts... That inadvertently set me off on a Google Apps Script adventure that continues to this day :)

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    3. Hi Sebastien,

      I originally got the idea for using scripts to send emails from a reader -- one of the many benefits of writing this blog.

      Delete
  2. What about the Canadian Market?

    Currently the CAPE10 is 21.1 and the median figure is 19.4. Does your spreadsheet account for that?

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    Replies
    1. Anonymous,

      My stock mix is 30% Canada, 45% U.S., and 25% international. So, there is some logic to blending CAPE figures. So far, I've only used the U.S. figure to test the idea. I'm still deciding what to do about Canada and international CAPE figures.

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    2. As of the end of 2020, the web site below says the Canadian CAPE10 is 22.82:

      https://siblisresearch.com/data/cape-ratios-by-country/

      Based on the increase in Canadian stock prices since then, it would seem the Canadian CAPE10 is a little under 25. Are there other more authoritative sources for more recent Canadian CAPE10 values?

      Delete
  3. Hi Michael, stocks do appear expensive based on the CAPE measure. As an alternate approach, did you consider increasing your bond allocation during periods of expensive stock prices?

    Btw, thank you for your site. It’s probably my favourite financial blog.

    ReplyDelete
    Replies
    1. Hi Jim,

      Glad you like the site. Bond prices are very high too, so it's hard to justify shifting into bonds. I don't believe I can out-trade the pros who control much of the market. So, I stick to my allocations based on my age.

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