Should You Retire in a Bear Market or in a Bull Market?

Must-Know Number One: Pay Attention to Starting Conditions

Christine Benz: Starting conditions at the outset of our retirement can give us a little bit of a clue as to how the market might behave, at least over the first 10 years of our retirement. And this is another slide I love because it depicts two different sequences of returns. So, on the left-hand side of the slide is the actual sequence of returns that a retiree cutting out of work in the early 1970s would have had. And I mentioned earlier on, it was a bad market environment, so bad equity returns, bad bond returns due to rising interest rates and high inflation for a good part of that period. So, someone with a $500,000 portfolio using a 5% withdrawal rate over that specific very difficult time horizon early on in retirement would have spent through his or her portfolio within 20 years. And that’s what we think of as a retirement fail. Because typically when you embark on retirement, if you’re, say, in your mid-60s, you want to be sure that your portfolio lasts 25 or 30 years at a minimum. So, to have spent through your funds within 20 years is a retirement failure. It’s not something that we’d want to emulate, obviously.

The right-hand side of the screen shows the sequence of returns exactly flipped, where the great returns we had for a good part of the 1980s and in the early 1990s occurred at the beginning of that 20-year time horizon. So, assuming the same $500,000 portfolio, the same 50% stock, 50% bond mix, the same 5% withdrawal rate, that person at the end of that 20-year period would have not only met his or her distribution needs—so the person would have taken the cash flows from the portfolio and spent those—but the portfolio would have also grown very nicely during that time horizon. And again, luck of the draw. We’re assuming a much more fortuitous sequence of events where you have a good bond market, a good stock market, fairly low inflation—all of those factors redound to the benefit of being able to take more from the plan.

Gauging Withdrawal Conditions

This goes back to that slide I already showed you—that the right withdrawal rate really depends on the specific time period and the specific confluence of market events in play during that drawdown period. So, if we’re thinking about our own retirements, I think it’s helpful to put a little bit of a dashboard together, where we’re looking at some of these key variables and making some assessments about whether we think things might work in our favor or things might work against us. So, the ideal conditions for starting withdrawals would be that you’d come into retirement with low equity valuations, so stocks are cheap, and during your retirement, you’re able to sell them off to meet your cash flow needs and you’re able to sell them at ever-higher prices. So, low equity valuations would be a good thing to come into retirement with. Decent cash and bond yields are another huge plus. That’s something that retirees did not have in the previous decade. It’s looking a lot more favorable, thanks to rising interest rates, that people will have that safe footing in safe securities with a higher yield. And finally, low inflation is another big plus. If you can come into retirement with the sense that inflation is pretty low and there are no clear catalysts for it going higher, that definitely is beneficial to the plan, and it can help improve starting safe withdrawal amounts.

So, the flip side is also true. Poor conditions for starting portfolio withdrawals would be that stocks are expensive at the outset of retirement, that cash and bond yields are very, very low and that inflation is high. And the reason high inflation early on in retirement—and I’ll hit on this a little later on—the reason why that’s such a negative is that high inflation reduces the purchasing power of our portfolio cash flows. So, even if we are able to get a higher yield from our portfolio, if we’re having to haircut those yields by inflation, that cuts into our actual spending. So, high inflation is certainly a negative as we think about starting conditions for retirement withdrawals.

2022: A Harbinger of Better Things?

The good news for people who are thinking about retirement right now or perhaps for those who have just retired is that 2022, even though it was a painful market in many respects, does foretell better things for new retirees. So, we had stock prices fall. We had bond prices fall at the same time, largely because of rising interest rates. Just a handful of categories managed to perform well last year—commodities, and that yellow line in my slide, is the one that did manage to buck the trends—but if you had a fairly vanilla portfolio, you probably saw losses in your portfolio last year. It wasn’t a comfortable year. It wasn’t an easy year. But the good news is the fact that we have depressed stock prices and certainly, bond yields coming up due to depressed bond prices, that conspires to make market conditions more attractive for new retirees today.

Equity Valuations Are Improving

This is a look at our price/fair value graph that our analysts put together based on their bottom-up research for the individual companies that they cover. And I’ll just explain what we’re looking at here in case you’re not familiar with this graph, and this is part of the Morningstar Investor website. This is an aggregated price/fair value for all of the companies in our global coverage universe. When our analysts are tasked with covering individual companies, we ask them to come up with what they think is a fair value for that company based on their own discounted cash flow analysis. So, to use a simple example, if a company is trading at $80 and our analyst thinks it should be worth $100, the price/fair value would be 0.8. On the other hand, if the share price were $120 and the analyst thinks it should be worth $100, well, then, the price/fair value would be 1.2. So, this is the aggregated price/fair values for all of the companies in that global coverage universe, and what you can see is that this bounces around a little bit, that there are various points in time where the market looks expensive to our analysts. So, for a good part of 2021, for example, you can see that our analysts thought, again, based on that bottom-up research, that stocks were looking frothy. But then, when the market sold off in 2022, you can see that the analysts thought that stocks looked a lot more reasonable at that time.

So, when we look at price/fair values for that global coverage universe today, you can see that the typical company is trading at about a 10% discount to fair value. That’s a better condition for starting retirement withdrawals than would have been the case even a year ago or a year-and-a-half ago when valuations were higher.

Undervaluation Across the Morningstar Style Box

The good news is that we see this undervaluation across the style box. It’s not just concentrated in a single area, although you can see on this slide that our analysts are finding the cheapest stocks in the small-cap rung of the style box. But generally speaking, this is broadly dispersed undervaluation, that even large company stocks, whether value or growth, look inexpensive to our analyst team. So, that’s a good news story.

And Across the Globe

Another good news story, and this is one that we’ve been beating the drum on a little bit for the past few years, is that the undervaluation does appear to be not just in the U.S. but across the globe. In fact, there are other major markets where our analysts’ price/fair values are a little bit more attractive than in the U.S., than in North America today. So, that’s good food for thought. If you haven’t rebalanced your portfolio or haven’t been wanting to give much attention to any international holdings in your portfolio, this suggests that you might consider doing so simply because of relatively attractive valuations in non-U.S. stocks.

Bond Yields Are Also Looking Much Better

Another factor that bodes well for new retirees, and I hit on this earlier, is just the fact that we’ve seen yields come very far in a very short period of time. So, these are 10-year bond yields across geographies, and you can see that most major geographies have moved higher in terms of their yields. U.S. has led the way, but other countries have certainly been raising interest rates to combat inflation as well. Even Japan, which is that bottom line there, it has been raising interest rates very recently, which is a relatively new phenomenon for Japan. All of this redounds to the benefit of bondholders. If we have higher yields on offer, when we’re embarking on retirement, that portends well for the starting safe withdrawal rate. So, this is a good news story in many respects, even though we had a difficult market environment for 2022 for bonds, that it sets bond investors up with better conditions than they would have had a-year-and-half ago because we know that there’s a very tight relationship between bond yields, starting bond yields, and subsequent bond returns over the next decade.

Outlook for Stocks, Bonds Have Improved

This is a slide that is a compilation of the various capital markets’ forecasts that I try to put together at the beginning of every year, and sometimes within periods of market disruption, I’ll gather the capital markets forecast from various firms, including our team at Morningstar Investment Management, as well as other firms outside of Morningstar—BlackRock, Vanguard, and so on. In my latest rundown of capital markets forecasts, what I found were much better equity return prospects and certainly fixed-income return prospects than was the case when I did the same exercise at the beginning of 2022. Back in 2022, most firms were expecting bond returns to be in the 2% range. Equity return expectations were also much lower. So, this is just another reinforcement that the starting conditions for retirees embarking on retirement today look a lot better than they did even a couple of years ago.

One thing I would point out on this slide is that the capital markets forecast for both developed-markets equities and emerging-markets equities look a lot better than is the case for U.S. equities. This has been a consistent theme in these capital markets forecasts. It really hasn’t changed. Even though we did have a selloff in the U.S. equity market in 2022, global markets generally sold off as well. So, the valuation advantage for non-U.S. stocks is still there despite 2022. Again, if you haven’t rebalanced, might be a consideration to do so whether you’re retiring or many years from retirement.

Better Expected Stock/Bond Returns Lift Starting Safe Withdrawal Rate

The good news is when we have better market conditions, better expected stock and bond returns, that lifts what is a safe starting withdrawal amount.

So, when we did our research on starting safe withdrawal amounts in the 2020-2021 period, our conclusion was that a 3.3% starting safe withdrawal rate had a 90% probability of success with a balanced portfolio over a 30-year time horizon. When we revisited the research last year, so at Sept. 30, 2022, we came up with a better number, a 3.8% starting safe withdrawal rate, in large part because market conditions have improved along the lines of what I just discussed.

Before we go any further, I just want to underscore the assumptions that we use in coming up with these calculations. So first of all, we’re using a fixed real withdrawal system. So, we’re assuming, to use my base case, we’re assuming that someone is withdrawing 3.8% from that portfolio in year one of retirement and then they’re inflation-adjusting that dollar amount thereafter. So, to use that 3.8% number with a $1 million portfolio, that would mean $38,000 in year one of retirement and then assuming a 3% inflation rate, you get to take $39,000 and change in year two. So, the idea is that the retiree wants more or less a paycheck equivalent, kind of a fixed level of real spending throughout the retirement time horizon. That may or may not be what the retiree wants, but that’s the base case that we used, and that’s very much the convention when we talk about starting safe withdrawal rates. We used a balanced portfolio, and again, we used a 90% success rate. We targeted a 90% chance of not running out of funds over the time horizon.

So, this is a good news story that starting safe withdrawal rates are higher. But the bad news story, and I think I have to address it, is the fact that investors saw their portfolios decline last year. So, 3.8%, yes, it’s a higher number, but your portfolio balance very likely is down a little bit. So, it may be roughly the same, maybe even a little bit less than would have been the case with that 3.3% on a higher portfolio balance.

Watch “5 Must-Knows About In-Retirement Spending” for the full webcast from Christine Benz.