December 13th 2024.
Welcome to the super safe withdrawal rate calculator! This tool is designed to help you estimate certainty-equivalent returns and the Merton share for your investment portfolio. These values can be used to determine ultraconservative safe withdrawal rates and the optimal allocation to stocks in your portfolio. Let's take a closer look at how this calculator works and how you can use it to personalize your own super safe withdrawal rate.
To get started, simply click on the "Calculate" button to see example calculations using historical averages. Alternatively, you can follow the instructions below the calculator to make your own personalized calculations. Please note that the initial default inputs use U.S. historical real average returns and volatility, with one simplification. While the historical volatility of intermediate US treasury bonds is typically 5 percent, we have set this input to 0 to match the typical textbook treatment.
The calculator steps through three calculations to estimate your super safe withdrawal rate. First, it takes the average geometric returns expected from equities and risk-free assets and adjusts them to approximate arithmetic mean returns. Then, it estimates the equity premium and calculates the certainty-equivalent returns and resulting Merton "equity allocation" shares for a standard set of risk tolerances.
If you want to calculate a personalized super safe withdrawal rate, simply replace the default annual average "geometric mean" returns for equities and risk-free bonds with your own forecasted returns. You should also estimate the volatility, or standard deviation, for both asset classes. If you don't have these estimates, don't worry - major investment services regularly provide this information.
A simple line chart is also included to show how Merton shares and certainty-equivalent returns work. The blue line represents the average expected arithmetic returns for portfolios using a variety of stock allocations, ranging from 0% to 100%. The dashed grey lines show the 25th and 75th percentile returns, giving an indication of portfolio risks. The green line represents the certainty-equivalent returns, or CERs, and shows the utility that the investor can expect at different stock allocations. The line flattens as the allocation to stocks increases, indicating a diminishing marginal utility. Essentially, this means that while larger returns can be achieved by allocating more to stocks, the risks also increase. The green line reflects a good estimate of the utility, as it uses the standard utility function that economists believe does a good job. The main takeaway for non-economists is that while allocating more to stocks can result in larger returns, it also comes with higher risks, and the utility essentially tops out at the Merton share.
It's worth noting that using the historical default numbers, the Merton share formula suggests a 62.5% allocation to stocks, which is very close to the orthodox 60% stocks and 40% bonds asset allocation. Furthermore, the certainty-equivalent return per the formula is approximately 3.56%, which is interestingly close to the canonical 4% safe withdrawal rate. However, it's important to personalize your relative risk aversion when using this calculator, as it assumes a constant relative risk aversion of 1, 2, 3, 4, or 5. These values are like standard "shoe sizes" for risk aversion, with most people falling in the 2-3 range. A risk aversion of 1 may indicate someone who is comfortable with a leveraged portfolio, while a risk aversion of 4 or 5 may suggest a lower allocation to US equities, perhaps around 10-15%.
So, can you use certainty-equivalent returns as a "safer" safe withdrawal rate? The answer is not straightforward, as it depends on individual circumstances. On one hand, using CERs can provide a good safe withdrawal rate number that considers the risks of a particular portfolio and addresses periods of lower expected returns. This makes it almost guaranteed not to fail for investors with long retirements who want to preserve their wealth. However, in some situations, using the CER as a super safe withdrawal rate may not make sense. For example, it may suggest a very low withdrawal rate for investors who limit their equity investments to US stocks, or it may result in a retiree not spending much of their nest egg and restricting their spending.
In conclusion, the super safe withdrawal rate calculator is a useful tool for understanding the Merton share and certainty-equivalent returns in relation to your investment portfolio. It can also help you think about diversifying away from US stocks and more objectively assessing your portfolio risks. However, it should be used with caution and personalized to your specific risk aversion and investment goals. For further reading, we recommend our related resources on the Merton Share Estimator, Retirement Plan B, and Monte Carlo Safe Withdrawal Rates.
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