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Sequence-of-Returns Risk

CAPE-based withdrawal rules: valuation-driven spending

Pomegra Learn

How can market valuations guide retirement spending?

The Cyclically Adjusted Price-to-Earnings ratio (CAPE, also called the Shiller P/E) offers an unconventional approach to sequence risk: let the market's current valuation determine how much you withdraw. In expensive markets (high CAPE), reduce spending. In cheap markets (low CAPE), increase it. This is opposite to most retirees' instincts—they want to spend more in bull markets and pinch pennies in crashes—but the logic is sound: you're spending less when the portfolio must work harder to generate returns, and spending more when returns are cheapest.

Quick definition: A CAPE-based withdrawal rule adjusts annual spending based on the Shiller P/E (CAPE), a market valuation metric, with lower withdrawals when the market is overvalued and higher withdrawals when undervalued, directly offsetting sequence risk.

Key takeaways​

  • CAPE at 20–25 suggests normal valuations; above 30 suggests expensive market; below 15 suggests cheap market
  • A simple CAPE rule: withdraw 3.5% when CAPE is 30+, 4.5% when CAPE is 15–25, 5.5% when CAPE is below 15
  • This approach naturally withdraws less when future returns are expected to be lower (expensive market) and more when returns are expected to be higher (cheap market)
  • CAPE is an average; it misses timing, but it's far better than ignoring valuations entirely
  • The strategy requires accepting that your spending will vary year to year—sometimes 15–20% swings based on valuation changes

The CAPE fundamentals​

The Shiller P/E, developed by economist Robert Shiller, is the ratio of stock market price divided by the average earnings of the prior 10 years, adjusted for inflation. This 10-year average smooths out the distortions of a single exceptional or disastrous year.

Why does CAPE matter for retirement? Because it predicts future returns. A long-term study by Morningstar and others shows:

  • CAPE above 30: Expected real returns (inflation-adjusted) are around 1–3% over the next 10 years. Cheap and safe, but low reward.
  • CAPE 20–25: Expected real returns are around 4–6% over 10 years. Normal valuation, normal returns.
  • CAPE below 15: Expected real returns are around 7–9% over 10 years. Expensive from a valuation perspective, but return prospects are strong.

(As of the mid-2020s, CAPE was in the 30+ range, suggesting valuations had returned to expensive levels last seen in 1999–2000 and 2008–2009.)

A retiree who adjusts spending based on these expected returns avoids the trap of withdrawing a fixed percentage from an increasingly expensive portfolio, which guarantees poor outcomes if the market reverts to historical averages.

The mechanics of CAPE-based withdrawal​

A retiree with a $1 million portfolio and planned base spending of $45,000 (4.5% at normal valuations) would adjust as follows:

Year 1 (CAPE = 32, expensive market): Withdraw 3.5% = $35,000. Live on less because the market is pricey and future returns are expected to be low. This cut is temporary; it's not a lifestyle haircut, but a signal that the portfolio won't fund the base spending.

Year 2 (CAPE = 24, normal market): Withdraw 4.5% = $45,000. Back to baseline. The market has corrected slightly or earnings have improved, making valuations reasonable again.

Year 3 (CAPE = 14, cheap market): Withdraw 5.5% = $55,000. Increase spending. The market is trading near historical lows, future returns are expected to be high, and the portfolio can afford more withdrawals. Equities are cheap; the portfolio's long-term earning power is strong.

Over a cycle of three years, the retiree has withdrawn $35,000 + $45,000 + $55,000 = $135,000 from a portfolio whose expected average return over the cycle might be 4% (given the range of valuations). The flexible approach has let the retiree maintain purchasing power while respecting the market's signals.

Why CAPE beats fixed percentages in expensive markets​

The traditional 4% rule says: withdraw 4% of your portfolio annually, adjusted for inflation, forever. This works beautifully if the market starts at historical valuations (CAPE around 15–20) and ends there. But it breaks in bubbles.

Imagine a retiree at the top of the 2000 tech bubble, when CAPE was 44. A 4% withdrawal meant withdrawing from a portfolio valued at 44× earnings. Equities then corrected 50%, and earnings fell. The portfolio never recovered that buying power because the retiree had been withdrawing from a bubble-level valuation. A CAPE-based rule would have said: "Withdraw 2.5% instead," sparing the portfolio.

The flip side: a retiree who retired in March 2009, when CAPE was 13, faced cheap valuations and high expected returns. A 4% rule meant withdrawing from cheap assets just when they were most valuable. A CAPE-based rule would have said: "Withdraw 6–7% instead," because the portfolio was poised for strong returns.

Over time, the CAPE-adjusted retiree withdraws less in bubbles and more in crashes, compounding to a much higher portfolio value at age 90.

Calculating CAPE in practice​

CAPE is published free by Robert Shiller at his Yale website and is updated monthly. A retiree can simply plug the current CAPE into a spreadsheet with their base spending and the CAPE-based withdrawal schedule, then calculate the year's withdrawal.

Alternatively, a more sophisticated approach uses historical CAPE percentile rankings:

  • CAPE in the top 25% of historical values (expensive): withdraw 3.5%.
  • CAPE in the 25–75% range (normal): withdraw 4.5%.
  • CAPE in the bottom 25% of historical values (cheap): withdraw 5.5%.

This approach is less dependent on absolute CAPE numbers and more on relative valuation. It's useful because CAPE can change its meaning as investor behavior or accounting standards shift over decades.

CAPE-based withdrawal vs. flexible spending​

CAPE-based withdrawal is not the same as flexible spending. Flexible spending says: "Cut spending 15% if the portfolio is down 40% from peak." CAPE-based withdrawal says: "Adjust spending based on market valuation, regardless of whether the portfolio is up or down."

They can be combined. A retiree might use a CAPE-based rule for the base withdrawal (e.g., 4.5% at normal valuations) and then layer on flexible spending rules on top: "If portfolio is also down 30% from peak, cut an additional 5%."

The advantage of CAPE over pure flexible spending is that it's market-focused rather than portfolio-focused. A retiree who ignores CAPE is taking on sequence risk without a compensating return. A retiree who ignores portfolio depth (using flexible spending) is at least respecting the portfolio's health.

Real-world examples​

The 2000 retiree: A retiree who quit the workforce in early 2000 when CAPE was 44 faced the worst possible sequence outcome: expensive valuations and 10 years of subpar returns. A 4% withdrawal rule meant withdrawing $40,000 from a $1 million portfolio valued at 44× earnings (implying $22.7M in aggregate market earnings supporting the stock value). That same portfolio in 2009, with CAPE at 13 (and market down 50% from 2000), had earnings support of $76.9M but was valued at only $500,000 in the account. A CAPE-based rule in 2000 would have said: "Withdraw 2.5% = $25,000," preserving capital. By 2009, the portfolio would have been <$750K instead of <$500K, and the retiree would have been better positioned for the 2010–2020 recovery.

The 2009 retiree: The opposite case. A retiree in March 2009, when CAPE was 13, faced cheap valuations and a decade of strong returns ahead. A 4% withdrawal rule meant withdrawing $40,000 from a portfolio poised to grow 7–9% annually. A CAPE-based rule would have said: "Withdraw 6% = $60,000," because the portfolio's expected earning power was high. Over 10 years, the CAPE-adjusted retiree would have withdrawn $550,000+ while the fixed-rate retiree withdrew $440,000, and both portfolios would have grown substantially—but the CAPE-adjusted retiree would have enjoyed a materially higher lifestyle.

Common mistakes​

Treating CAPE as a market-timing tool. CAPE predicts long-term returns (7–10 year average), not short-term market moves. A retiree might see CAPE at 35 and think, "The market will crash next month." It might not. CAPE at 35 means the market is expensive and will likely return 2–4% over the next decade, not that it will crash soon. Don't use CAPE to avoid equities; use it to adjust withdrawals.

Overfitting withdrawal rules to CAPE. The relationship between CAPE and returns is real but loose. A CAPE of 28 might imply 3–4% returns, but could be 2% or 5% depending on other factors (interest rates, profit margins, investor sentiment). Don't assume CAPE-based rules are precise. Use them as a signal, not a formula.

Ignoring CAPE entirely. The flip side: some retirees say, "CAPE is too complicated," and stick to fixed 4% rules even when CAPE suggests a different withdrawal. Ignoring market valuation is costly. A simple CAPE-based rule (3.5% when expensive, 4.5% when normal, 5.5% when cheap) is easy to implement and materially improves outcomes.

Not adjusting for dividend yield. CAPE is price-to-earnings. A high-dividend-yield market (3%+ from dividends alone) can support higher withdrawals because you're getting cash returns independent of capital appreciation. Some CAPE-based rules add the dividend yield to the withdrawal rate (e.g., 4.5% from CAPE-based rule + 2.5% dividend yield = 7% total withdrawal). This is defensible but can be aggressive. Be conservative.

Withdrawing below historical CAPE baseline. If CAPE is at 20 (historical average), a withdrawal of 4.5% is right. Some retirees get nervous and withdraw only 3.5%, "just to be safe." Over time, this compounds to over-saving in retirement—a subtle form of lifestyle deprivation. If CAPE is average, your withdrawal rule should be average too.

FAQ​

What if CAPE changes dramatically from year to year?​

It does. CAPE can move from 20 to 28 in a year if equities surge, or from 28 to 18 if equities crash. Your withdrawal will vary correspondingly. If this variability makes you uncomfortable, use a 2–3 year average of CAPE instead of the current month's value to smooth out swings.

Is CAPE only for US stocks?​

Shiller published CAPE for the S&P 500 (US large-cap). Some researchers have extended CAPE methodology to other markets (developed international, emerging markets), but the data is less reliable. If your portfolio includes international exposure, you might use CAPE only for the US portion and a fixed rule for the rest.

What if I'm using a low withdrawal rate already (3%)?​

CAPE-based withdrawal still applies. If CAPE is expensive, stay at 3%. If CAPE is cheap, consider 4.5–5%. You're still getting the benefit of valuation-based flexibility, just at a lower absolute level of spending.

How often should I recalculate my withdrawal?​

Annually. CAPE is published monthly, but most retirees adjust their withdrawal only once per year (often in January or on their birthday). Quarterly or monthly adjustment is possible but adds complexity without much benefit.

What if CAPE suggests I increase spending but the market just crashed?​

Possible. In a crash, CAPE might fall from 25 to 18 (cheap), but the portfolio might also fall 30%. A CAPE-based rule says increase your withdrawal rate percentage, but your portfolio value is lower, so the absolute dollar amount might not increase. Model this carefully. A CAPE of 18 and portfolio down 30% might mean the same annual dollar withdrawal as CAPE of 25 and portfolio at peak. CAPE is a percentage rule, not an absolute dollar rule.

Can I use CAPE with a bucket strategy?​

Yes. Use CAPE to size the annual withdrawal from the bond bucket. If CAPE is expensive, withdraw less; if cheap, withdraw more. The bucket sizes (2 years in cash, 5 years in bonds, rest in equities) stay the same; only the dollar amount drawn varies.

What valuation metrics are better than CAPE?​

CAPE is not perfect, but it's the most widely used and researched. Alternatives include price-to-book (P/B), price-to-sales (P/S), and dividend-yield-based metrics. None is demonstrably better than CAPE over long periods. Stick with CAPE for consistency and because it has decades of research backing.

Summary​

CAPE-based withdrawal rules align spending with the market's ability to deliver returns, reducing sequence risk by withdrawing less from expensive portfolios and more from cheap ones. While CAPE is imperfect and future returns are never certain, the principle—respect market valuations in your spending decisions—is sound. A retiree who adjusts spending based on CAPE signals is unlikely to suffer the fate of those who withdrew 4% from the 2000 bubble or failed to increase withdrawals when CAPE signaled cheap valuations in 2009. Over a full retirement cycle, CAPE-based withdrawal typically produces both higher portfolio longevity and higher total spending than fixed percentage rules.

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