We talk quite a bit around here about philosophy, literature, long walks; the idea is to discuss different ways of seeing the world, points of view that expand our horizons and allow us to incrementally break out of the Jail that our minds fit themselves into over time. Once in a while, we also talk about personal finance—for one of the things that keeps many people too distracted to stop and see things differently is a constant pursuit of money and consumption of stuff that it can buy. The earlier manifesto laid out one alternative approach to money, whose punch line is this: money shouldn’t be used to buy stuff, it should be used to buy freedom. In fact, my wife and I originally created the term Jailbreak to refer to finances: breaking out of the rat race that held our time and best mental cycles behind bars. It evolved into what it is today as we reflected on how the relationship with money is only one part of an issue that pervades our larger lives.

So I, being an engineer, love to play with the numbers that relate to financial Jailbreak: how much money do we need to save to retire early, how much passive income do we need to live, and just where would it go? I’m not alone; many of my fellows on the internet discuss these things on forums and blogs of their own, analyzing early retirement scenarios until they are blue in the fingers. Today’s post fills a gap that I haven’t seen addressed anywhere else: the relationship of the Safe Withdrawal Rate (SWR) to the Price/Earnings (PE) ratio of the stock market.

The slow dance of SWR and PE

What is the SWR?

A quick background, for those not intimately familiar with the subject: start with the assumption that you have a truckload of money saved for retirement, and you want to know how much of that money you can spend every year and not run out before your retirement ends. Assume, also, that your money is invested in stocks and bonds that earn passive income, but whose prices fluctuate with the market. The answer to how much you can spend each year is impossible to know ahead of time, because nobody knows how the stock market will perform during your retirement. On the other hand, it’s simple to calculate for hypothetical retirements that occurred in the past. So if, for example, you pretend to have retired in 1955, all of the data exists to calculate the percentage of your money you can withdraw every year, adjusted for inflation: your SWR.

The calculation of the SWR was done first by William Bengen, and then by the Trinity Study; Wade Pfau has updated and summarized the arguments. The findings are summarized in Figure 1.

Safe Withdrawal Rates
Figure 1. Safe Withdrawal Rates as a function of retirement year.

The history of a whole movement can be summed up as follows: in all of recorded US market history, the Safe Withdrawal Rate has never been below 4%. So if you have a cool $1M invested, you can spend $40,000 annually, adjusted for inflation, over the course of your 30-year retirement, and never in history would your strategy have failed. The 4% SWR has become the dominant rule of thumb throughout the personal finance and retirement planning spheres. No matter where you turn, you will find a discussion. See Mr. Money Mustache, Go Curry Cracker, jlcollinsnh, and more.

What is the PE ratio?

Buying a share of stock (Apple, IBM, Johnson & Johnson…) is buying a small piece of a company, and, in theory, the rights to a share of the profits (the earnings) of that company. There’s a large academic literature out there about how to value shares of company stock…what is a reasonable price? One measure that usually comes up is the PE ratio, which is, as its name implies, the ratio of the stock’s price to the company’s earnings per share. A stock with a PE ratio of 10, for example, is priced at 10 times the company’s earnings per share. Another way of looking at that is to invert the ratio: the earnings are 1/10 = 10% of the stock’s price, and you can think of that as, roughly, the return on your investment. You won’t actually get paid 10% for owning the stock, though; the company may pay dividends (say, 2%), the stock’s price may grow a bit, and the may invest the rest of the earnings in growing the business or developing new products. Since you own (a part of) the company, the benefits of all those activities accrue to you, in cash payments or in the prospect of future growth.

So what are people willing to pay for when buying stocks? They’re willing to pay, as it turns out, anything from 5 to 100 times the earnings per share; seen another way, they’re willing to accept returns of somewhere between 20% down to 1%, depending on their mood. But generally, the number is somewhere between 10 and 25, with a mean of about 15. (Technical note: I’m going to use the Shiller PE ratio, which replaces the current-year earnings with the average of the past 10 years of earnings, to produce a smoother result. Some people argue that the Shiller ratio more accurately reflects valuations.) Historical values of the PE ratio are shown in Figure 2.

Shiller PE ratios
Figure 2. Stock market valuations over the years. From multpl.com

What goes up, must come down. When the PE ratio gets too high, what generally follows is a stock market crash. The crashes of ’29, ’01, and ’08 are all apparent. Currently, the PE ratio is 25; that implies that investors, generally speaking, are willing to accept a 4% return on their money. And since the historical average is around 15, there is some likelihood that the price of stocks will fall from their current ‘lofty’ levels to more normal valuations—and that the owners of stocks will lose money in the process.

How the PE ratio affects the SWR

It’s pretty well known that returns from stocks trend lower at higher PE ratios. So, naturally, retirement planners (and early retirees) want to know: with the market inflated right now at PE = 25, what SWR should we be using to decide if we have enough savings to stop working? And how worried should we be if the market tanks?

Well, since the data is all out there, let’s see how it stacks up. I’ve already shown you the historical data above; now the easy part is to plot the two data sets against each other. That’s what I did in Figure 3.

SWR vs Shiller PE
Figure 3. Historical safe withdrawal rate vs historical Shiller PE ratio.

It is amazing just how nicely all the data lines up; the trend is really very clear. But first, a couple notes on the chart:

  • The red dots are the years 1928, 1929, and 1930—which anyone will agree were among the most pathological years of the market. I left out those three points when doing curve fits, to make things prettier. Anyway, since those three dots give a very rosy picture (> 5% SWR at elevated PE), leaving them out only serves to make the conclusions more conservative.
  • The solid green line is a power-law curve fit to the data—the “average”, if you will.
  • The dashed green line is my eyeball fit to the lower bounds of the data—the “worst case scenario”.

The takeaway here is really quite clear: the higher the PE ratio is, the lower your assumed SWR should be in your retirement planning. At present-day PE of about 25, the SWR is about 4%, which corresponds to the worst-case SWR in Bergen’s work. On the other hand, if you retire in several years, and the PE ratio has by that time fallen to, say, 15, (either because prices have fallen or earnings have risen) then your SWR is really more like 5%. And if you retire at the bottom of a market crash, when the PE is 10…you should be able to enjoy a SWR of 6%–7%, because the recoveries after crashes tend to be pretty robust.

Psychologically, this is hugely counterintuitive! A booming market makes people feel rich and spendy; a market crash makes them feel vulnerable and frugal. But history is clear: the best time to retire is at the bottom of a crash, if you still have the money to do it.

Now of course, at market bottom when PE is low, your portfolio has presumably also been battered and your higher SWR on a smaller stash will still equate to a smaller absolute dollar amount. But it’s not quite as bad as you might think. Why? Because the rise in SWR cushions the fall in portfolio value. That effectively means this: if your portfolio value falls 20% in a market correction just before your retire, the dollar value of your withdrawal will not fall by 20%; it will only fall by 7%–8%. Figure 4 lays this out explicitly.

Drops and Spending
Figure 4. The impact of portfolio value drops on yearly retirement spending. The dashed and solid lines correspond to the dashed and solid lines in Figure 3.

As a rule of thumb: if your portfolio drops by x%, you will always be safe by dropping your planned spending by x/2 %. To make this concrete, here’s a scenario that may well be completely realistic:

  • You have, again, a cool $1M invested in the stock market today, where the PE ratio is 25. You plan on using a 4% SWR, in accordance with Figure 3, when you retire in December of this year. That will give you $40,000 per year to live on. You figure you need $35,000, so you have a small cushion.
  • In November, the stock market ‘corrects’, losing 40% of its value. Your $1M has become $600,000. Your 4% SWR now says you have only $24,000 per year to live on if you retire in December…which is not enough.
  • But now, since the stock market tends to recover robustly after a crash, you re-figure your SWR based on the new PE ratio (which is now 40% off its high of 25, and so is 15) and find that it’s now 5.5% (using the average) or 5% (using the worst case). So your actual dollar withdrawal available is now somewhere between $30,000 and $33,000…not quite the $35,000 you needed, but way closer than $24,000. Now, you just have to exercise some flexibility to make your spending match your new SWR, and your retirement, though dented a little, is saved.

In this scenario, you lost $400,000 in market value, but your available spending only fell about $7,000 per year (not $16,000, as a rigid 4% SWR would dictate). The market’s history tells us that disasters just aren’t quite as bad as they seem.

Epilogue

Received wisdom is both a fantastic shortcut to understanding the world and a dark woolen blanket covering your eyes—that is, it can work for you, or work against you. In this case, the 4% SWR rule of thumb gives you a quick answer to whether you are in the ballpark of being able to retire on your savings. But applied rigidly, it can also be misleading, and many of the personal finance bloggers out there have opined that, due to their own conservatism using the 4% rule, they worked too long and have more money than they really need. On the other hand, by understanding where the SWR comes from in the first place, and what factors influence it, we can make the concept work for us to make the world’s uncertainty seem a little less daunting. And that, in turn, frees up some of our mental cycles from worrying, and lets us pursue other things—things leading further toward our Jailbreak.

Finance

Do not toil to acquire wealth; be discerning enough to desist. —Proverbs 23:4

Jailbreak is an elusive state. Usually, our day-to-day lives provide us with distractions aplenty, each one in its insidious way keeping us from a quiet consideration not only of how to achieve Jailbreak, but also of even what Jailbreak means to us. Sometimes, we self-distract with mental junk food; other times, we sit in analysis paralysis over some decision. At my worst, all of my distractions will pile onto me just before bed, and I will lie awake in interminable distraction…which not only accomplishes nothing, but ensures that the next day I will be exhausted and unable to consider anything, much less difficult-to-grasp topics.

But let’s face it: among the distractions, both the imposed and the self-imposed, few are as all-consuming as money. Most of us spend eight hours a day—half of our waking hours, five-sevenths of the days of the week, working at jobs in order to bring in money. In the best case, we’ll spend as little as only one extra hour preparing ourselves to do this…dressing, commuting, etc. Because we spend so much time and energy working to bring in money, we also spend a good bit of time “decompressing” at the end of the day. And for the ambitious, the notion of a 40-hour work week is laughable; the reading of career-oriented books, attendance at “networking” events, and planning a career trajectory all combine to turn free time into “quasi-work” time. All told, the pursuit of a paycheck, though necessary and good, can consume virtually all of one’s time and mental energy, in one way or another.

Some people live for this. The adrenaline rush of job performance is a reward in itself. The feeling of power and success that comes from moving up an organization’s ladder, or the heady glee that comes from leapfrogging the ladder altogether by jumping between companies, or the self-reliance that comes from the entrepreneurial push to create a new personalized job, all can provide a sense of meaning and purpose. A lucky few also find the work that they love doing so much that they would do it for free…and the paycheck is just a way to make sure they don’t have to do anything else.

Whether that’s you—or whether you are the polar opposite, and hate laboring in your personal coal-mine—one question we all face is: what do we do with this money that we earn? Some things are given. We acquire food, shelter, and clothing, and provide the same for those who depend on us. We provision some security services: e.g., health insurance. And we go on to get some convenience and entertainment: cars, cell phones, televisions, more clothes, food in restaurants. We all have our own lists. And we all choose to draw the line somewhere: this I will buy; that I will not buy.

One thing that too few people buy is one of the most important things that can be bought. Freedom. The problem is that you can’t find it in any store. If you go looking in stores or online or in advertisements, you will only find clothes, and restaurants, and electronic gadgets, and cars, and cable packages. No freedom anywhere. Nobody makes money off of freedom…except you. So nobody is going to try to convince you to buy freedom…except you.

Money can’t buy you love…never more true words were spoken. Can money really buy freedom? Yes, and no. Money can’t buy freedom from your inner demons. It can’t buy freedom from your past. Too many celebrities and lottery winners end up broke and in rehab because they think they are buying their way to happiness with their enormous riches. No, money can only buy you freedom from one thing: itself. Fortunately, since so much of our lives revolve around the earning and spending of money, money’s limited power to free us from itself is actually exceedingly powerful.

To understand how money can buy freedom, first understand how it can buy imprisonment. For $700, you can buy a new iPhone and pay $70 per month for a service plan. For $1,000 down, you can buy a new SUV and pay only $400 per month for it over the next five years. For $5,000 down, you can buy a beautiful motorboat and pay another $400 per month for it over 10 years. For $50,000 down, you can buy a nice suburban house and pay $2,000 per month for the next 30 years…and taxes, maintenance, and HOA fees in perpetuity. And for absolutely free, you can sign up for cable TV, magazine subscriptions, streaming video services, club memberships, warranties, service plans, and insurance to cover loss, theft, and destruction of all the things you have already bought.  You can get house cleaners and landscapers for your nice house; good dry cleaning for your nice suits; stabling for the horse that you can’t keep in the back yard. Go a little further, and you can also engage a pilot to fly your pretty new executive jet. And you can always sign up for credit cards or revolving credit lines to cover anything you can’t quite pay for…at the cost of 20% annually.

Having money allows you to acquire things; those things require money to maintain, upgrade, or replace. The more money you have, the more things you can buy; the more things you buy, the more you commit yourself to spending. It need not be said that the more you commit to spending, the more you must work to earn what you have in effect already spent. And—violà—you have bought your way into a comfortable, middle-class Jail. There will be no leaving unless you serve out your sentence—30 years at 3.7%—or you go bankrupt. One way you walk out into the daylight, gray-haired and grateful to finally be out. The other way is just a transfer to a place far worse.

It doesn’t have to be this way. It is too often this way, but it doesn’t have to be. The path away from this Jail—toward financial Jailbreak—is probably the world’s worst-kept secret, but it is so rarely trod. It has been featured in books: The Millionaire Next Door comes to mind. It is in Thoreau. It’s in the Bible. There have been no shortage of people who, in the course of history, have pointed out that stuff doesn’t make you happy, that debt is ruinous, and that making yourself feel rich by spending like you are rich will just make you poor.

In the context of Jailbreak, money distracts. It distracts when you earn it—especially if you are working a job you would rather not be working, but regardless, if you are dependent upon the money, you are never truly working on your own terms. It distracts when you spend it—you have to spend a lot of time figuring out what you want to buy and then buying it. And it distracts in its aftermath: you have to maintain your stuff, you have to service any debt, and you need to worry about whether you will be able to do any of it.

Thoreau said—and I agree with him on this, though I don’t agree with him on everything—“A man is rich in proportion to the number of things which he can afford to let alone.” I can attest to this from personal experience. When I was in graduate school, I was the only one among my friends who didn’t own a car. They told me that I should get one—we all made pretty good stipends, after all (it’s good to be an engineer). But in truth, I saw no need. I lived just off campus, where the most extensive libraries I had ever seen housed almost any book I could ever think want. The university symphony played almost monthly in the concert hall. I walked across the beautiful forest-and-castle campus to my lab every day. I occasionally had the grocery store deliver groceries, or I would walk to the nearer (but dearer) organic-foods store for small supplies. All my needs were easily met without a car, and I could not see at all why I would want to spend the time to 1) find a car, 2) buy the car, 3) register and insure the car, and 4) maintain the car. Perhaps there were some other things I might have done occasionally if I had a car. But I can say with certainty that my life was simpler without one, and I read more books and took more advantage of the university’s resources. Life was also cheaper. Based on that single decision to not buy a car, I was able to pay off all my remaining undergraduate student loans by the time I finished graduate school.

If you need to watch the latest TV shows, or all the college football games, you not only have to devote $70+ per month to your cable subscription, but you need to devote several hours per week to watching it all. If you need to be a wine connoisseur, you not only have to devote a few hundred dollars per bottle to your collection, but you have to spend time finding and acquiring the wines, and devote space and electricity to the climate-controlled wine cellar. If you need to have the latest electronic gadgets, you not only have to walk the $700 iPhone upgrade treadmill, but you should really be reading the industry news to make sure you know what features you’re really after and what you can brag about when showing off your newest model.

Do you see? Not only does all of this stuff cost money…it costs you your attention and your time, three times over, once when you earn the money, once when you spend the money, and once when you use and maintain the stuff. With all your time taken up in the pursuit of stuff, where will you find the time to Jailbreak?

So what do you do instead? How can money, rather than being a distraction, help you achieve Jailbreak? I suggest that getting to the answer looks something like this:

  • Choose something you want and have but could do without (cable TV, new electronics, new leased cars…).
  • Get rid of it.
  • Stop and enjoy your new free time. Consider what else you might get rid of to create even more free time.
  • Invest the money you’re now saving in paying down debt or in income-producing assets (stocks, bonds…)
  • Stop and enjoy the mental freedom of knowing your debt burden is permanently smaller, and growing smaller by the month. Or that your passive income stream is permanently larger, and growing by the month.
  • Repeat.

There are a ton of specifics to get into on this topic: what should you eliminate? How should you invest the money that you save? Just how much of a standard middle-class lifestyle can you get rid of and still enjoy a decent quality of life? (Or is that even a good question?) We’ll discuss some of these things here in the future. But they have been talked about an incredible amount in the personal-finance blogosphere already. Some of my favorite blogs on the topic are Mr. Money Mustache, Go Curry Cracker! and jlcollinsnh. For loads of specifics, these are invaluable resources.

To wrap up, then: just how does all of this talk equate to money buying freedom? The simple answer is: money first buys you freedom when you can have it, and not feel compelled to spend it. It buys you more freedom when you can choose to buy things that give you back more money (investments). It will buy you a final dose of freedom when the investments that you have bought produce enough money to cover those things that you still feel compelled to buy. And that is complete financial Jailbreak. You have redeemed a huge chunk of your life from the pursuit of money and the stuff it buys—and are now free to pursue Jailbreak in the rest of your life.

Finance