Withdrawal Rate Rule #1: Your Portfolio Will Deliver A Higher Withdrawal Rate When The Market Has A Low Price to Earnings Ratio
A price to earnings ratio (P/E ratio) is a tool that can be used to estimate the future long-term returns (15+ year cycles) of the stock market. Please note: it is not very useful in predicting short term stock market returns.
For a retiree, it can be used in determining the right starting withdrawal rate; an amount that could safely be withdrawn each year, with the ability for subsequent year’s withdrawals to increase with inflation.
- When the price to earnings ratio of the stock market (S&P 500) is below 12, safe withdrawal rates range from 5.7% to 10.6% depending on the time period studied.
- When the stock market’s price to earnings ratio is in the range of 12 – 20, safe withdrawal rates range from 4.8% to 8.3%, depending on the time period studied.
- When the price to earnings ratio of the stock market is above 20, safe withdrawal rates range from 4.4% to 6.1% depending on the time period studied.
The point to remember, if you retire when the stock market has a low price to earnings ratio, your portfolio will likely support more income over your lifetime than someone with the same amount who retired when the market had a high price to earnings ratio.
A detailed study on price to earnings ratios and safe withdrawal rates was published by Michael Kitces in his newsletter The Kitces Report in the May 2008 issue.
