The talking heads on TV spend a majority of their time agonizing over the question of stock market direction. When they aren't talking stock market direction, they're talking economic trends - hoping that will help them predict stock market direction. Less often they will focus on individual stocks and try to predict their near-term direction. It is well understood within the industry that most "marks" (read individual investors) don't have the patience to actually buy a stock for the long-term (three to five years) and instead want their investments to start appreciating right away. Stock brokers get that, which is why they tout growth and momentum strategies, despite the mountain of evidence showing that those strategies under perform over the long run. Brokers know that most investors are all too happy to buy a sexy growth story, rather than buy a company selling for less than its intrinsic value.
Speaking of stock brokers, I want to be very clear what they actually do for a living. Stock brokers are out on point, selling whatever new hot products Wall Street wants sold. Oh, they've taken to calling themselves financial advisors, financial planners and "financial health coaches" (no kidding, I actually had a broker tell me recently that he tells his meal-tickets he's a financial health coach. I guess he's hoping the meal-ticket will view him like a personal trainer instead of as the commissioned based salesman that he actually is). But at the end of the day, stock brokers are exactly what they've always been, Wall Streets hit men, compensated handsomely for pushing product through the pipeline and into the hands of the unsuspecting public. John Bogle, founder of Vanguard, is on record as stating that most of Wall Street's innovations are designed to benefit Wall Street, not investors. Ya think! Legendary value investor Jean-Marie Eveillard told Consuelo Mack recently in an interview that, "When I’m in a good mood, I say Wall Street is a vast promotional machine,” Eveillard said. “When I’m in a bad mood, they are a den of thieves.” Amen! And don't forget that the "financial health coaches" aka stockbrokers, are the den-of-thieves' agents (think Mr. Smith from the Matrix)!
Okay, enough of the broker bashing (for now). Let's get to the retirement planning.
You can't know how to get there if you don't know where you're going. Sounds straight forward enough right? But you'd be surprised how many individuals really haven't sat down to figure out where they are going. For example, most individuals I talk with have actually spent very little time thinking about how big their investment portfolio should be in order to throw off enough cash in retirement to meet their desired lifestyle. One million? Two million? Three million?
How's 4 percent grab you?
William Bengen developed the 4% rule in 1994, arguing that investors could safely withdraw 4% from their balanced stock/bond portfolio in the first year, and then adjust that dollar amount upward for inflation each year. Bengen recommended an allocation as close to 75% stocks as possible, with the remainder in bonds. Subsequent research suggested a mix closer to 60/40 stocks and bonds was better. The consensus now seems to be somewhere in the 40% to 75% stock range. Cooley, Hubbard, and Waltz quantified Bengen's rule in 1998, determining that "safe" represented a 95% success rate with a 50/50 portfolio.
And success is defined as making your retirement portfolio last 30 years without running down to zero. Bengen's original findings were that the 4% rule allowed a retiree to live off his investment portfolio in every 30-year period on record from 1926 through 1994, some periods with only a few bucks to spare and some periods with millions left over. The 4% rule has maintained its success rate since 1994, despite the last eight years of horrible stock market returns.
Investors who are sophisticated enough to correctly gauge market valuations can fine tune the 4% rule based on current market valuations when they retire. It turns out (as common sense would suggest) that investors can increase their withdrawal rate when market valuations are depressed at the start of their retirement. Michael Kitces, publisher of The Kitces Report, showed in a 2008 study that safe withdrawal rates in a balanced portfolio depend on market levels. Withdrawal rates in excess of 4% are possible when valuations are depressed, based on Shiller's P/E (a 10-year trailing average). Conversely, of course, withdrawal rates should be reduced when market levels are high, as they were in 2000 and again in 2007. In fact, the greatest risk to a retiree's portfolio is severe market under performance at the beginning of the retirement period, a risk that many recent retirees are unfortunately experiencing first hand right now. The problem with stock exposure is that severe under performance at the beginning of the retirement period will leave the retiree with a depleted portfolio balance that will result in a smaller annual distribution, at least until the portfolio recovers - which can be a very long time depending on the investing period.
There are some retirement experts who believe that stocks should be avoided entirely, precisely because of the risk of early-year under performance. Robert Huebscher has written (Advisor Perspectives, March 24, 2009) that an all bond portfolio is preferable to a stock/bond portfolio. His main contention is that an all-bond portfolio offers far more certainty of success because cash flows are much more certain and total real return depends only on correctly forecasting inflation rates. He further maintains that "inflation is far more predictable than equity market returns and can be efficiently hedged using TIPS." His last main point is that, "the all-bond portfolio is insulated from the risk of historically unprecedented adverse-market conditions near the beginning of the retirement period." Although he admits that there is a risk to the all-bond portfolio - underestimating inflation.
I think Mr Huebscher makes some interesting points, but his over-all argument for an all-bond portfolio is dependent on not underestimating inflation, and that is, in my humble opinion, exactly where we stand today. I also take issue with his contention that TIPS provide an efficient means of hedging inflation. The U.S. government has a huge vested interest in under reporting inflation, since all of the cost of living adjustments for social security and federal employees and retirees are tied to the CPI. It is extremely naive to believe that our government is accurately reporting inflation. In fact, economist Dr. John Williams, of Shadowstats fame, estimates that inflation is currently running about 8% higher than the official number.
More importantly, we are at the cusp of a long period of rising inflation and rising interest rates, brought on intentionally by a government determined to debase our currency in order to make it easier to meet the $65 trillion in unfunded liabilities it has taken on over the last twenty years of unprecedented spending. Governments everywhere and always have chosen the least politically painful option of currency debasement, once they've recognized their inability to make debt payments. The process has just begun in the United States and is likely to culminate, as in the 70's, in double digit inflation rates and double digit interest rates. Now, I am making no guarantees. It is barely possible that our elected officials will do the right thing, sharply curtail spending, raise short-term rates to encourage savings, and defend the dollar at every turn in an effort to keep it front and center as the world's reserve currency. But I doubt it.
The main point, however, is that an all bond portfolio will leave retirees eating dog food in 10-years or so if my inflation scenario comes to pass (and I give it better than a 50% chance of doing so). A prudent investor would do well to maintain a balanced portfolio of stocks and bonds in order to balance the risk of a near term short fall in stocks at the beginning of retirement against a longer-term risk of loss of purchasing power with an all-bond portfolio. It is exactly the uncertainty surrounding both stock market returns AND inflation rates that demands using both asset classes to increase the likelihood of a successful retirement using the 4% rule. (And no I do not think that stocks are cheap enough yet to raise the withdrawal rate to 5%, but that is for a different blog).
Oh, and the average inflation rate since 1966 has been 4.6%, yet many financial advisors use the 2.5% to 3.0% default rates prevalent in the investment planning software used by many of them when projecting real, long-term portfolio returns for their clients. You might want to ask them why next time you speak with them...
