DAL 88 Driver

I received the following article today in a newsletter. Thought it was worth sharing here:
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The Fastest Way to Sabotage Your Retirement
by Erin Klingbeil

We’ve talked about this before - on a few occasions - but it never hurts to revisit timeless truths that help keep things in perspective. Last year, a survey by Allianz Life Insurance Company of North America reported that more Americans would rather die than run out of money in retirement. While neither is a pleasant thought, at least the latter can be avoided.

Making your retirement savings last for thirty years is no small task. Assuming you have saved enough during your working years to be able to maintain your lifestyle, you have to have the know-how and gumption to manage this money in the distribution phase. And that’s when it counts. Make the wrong moves, and there’s a good chance you’ll run out of money before you run out of breath.

There are two culprits to sabotaging your retirement: the sequence of returns your portfolio experiences and reverse compounding. You can’t control the sequencing of returns; the market is going to give you what it gives you. You can, however, avoid reverse compounding - despite what the market does - if you understand this simple lesson: Selling assets for a loss so that you can spend cash will put you in the poorhouse.

In other words, if the market is down and you’re selling assets to sustain the same withdrawal rate, the negative sequence of returns coupled with the losses will create a huge reverse compounding problem. And here’s the kicker: the effects are far worse if you’re in the early stages of your retirement. Take a look:





Both portfolios start with $1,000,000 and have 5% of their first-year account value taken in withdrawals, adjusted by 3.5% for inflation each year thereafter. Both experience the same returns, with a final average of 6.5%, but the sequence in which they occur has been flipped. Portfolio X starts with early losses; Portfolio Y begins with early gains. The withdrawal rate is constant for each, no matter what their respective returns are, and for Portfolio X, this proves to be catastrophic. The portfolio has been spent by the age of 84.

Portfolio Y reaches age 100 with $1.2 million left. What’s the massive difference and how could Portfolio Y have managed a better outcome? Reverse compounding. We’ve all heard of positive compounding, but it can work the other way, too. Because Portfolio X experienced losses early on, the portfolio could never recover those losses. Add the constant withdrawal on top, and it’s easy to see how this person ran out of money.

This example shows you how your retirement can become a crapshoot if you’re not careful. The reverse compounding that occurs when assets are liquidated at a loss to raise cash, is what creates the sequencing of returns problem. Take away the need to sell and you remove the biggest flaw in current retirement income models. The good news is that you don’t have to rely on a stellar sequence of returns to ensure a successful retirement.

Bear markets are inevitable throughout your retirement, so how do you survive? A cash flow investment strategy will do a better job at protecting you from the sequencing of return problem than capital appreciation will. Living strictly off the income your portfolio generates, rather than selling assets to raise cash will eliminate the risk of reverse compounding.

This is a relatively new problem, seeing as the generations before us didn’t have to self-fund their entire post-working life, but your retirement doesn’t have to be left to chance. With this knowledge, the right investment strategy, and the fortitude to do the right thing - even when it’s hard and everything is incredibly uncertain - running out of money isn’t an option.

jungle

Assumptions are everything in any long term forecast. Allowing a 23% loss in any year means you didn't pay attention, expecting double digit long term yearly gains means you haven't watched the markets over the last ten years.

Management is everything if you expect to keep your head above water.

DAL 88 Driver

Can't disagree with most of that. But that's not the point of the article. The point is to show how yo-yo returns (the kind of returns many investors get) can bite you in the rear end, depending on the sequence in which they occur.

jungle

That is why shoving all your chips across the table and waiting for something to happen has been a losing strategy for a long time. Real buying opportunities are rare and understanding that will help.

You cannot control your returns, but you can limit your losses. Managing risk is an important component of retirement planning. There are many ways to do this.


More on this subject:

From Lance Roberts of StreetTalk Advisors

Boomers - Are Going To Be A Real Drag

Recently the San Francisco Federal Reserve Board released a study on the aging "Baby Boom" population and the effects of the demographic pull on stock valuations as these "boomers" move en mass into retirement. From the report: "The baby boom generation born between 1946 and 1964 has had a large impact on the U.S. economy and will continue to do so as baby boomers gradually phase from work into retirement over the next two decades. To finance retirement, they are likely to sell off acquired assets, especially risky equities. A looming concern is that this massive sell-off might depress equity values." [The report isn't long and a good read.]


This is something that we have discussed previously, however, the report points out the obvious concern; "Many baby boomers have already diversified their asset portfolios in preparation for retirement. Still, it is disconcerting that the retirement of the baby boom generation, which has long been expected to place downward pressure on U.S. equity values, is beginning in earnest just as the stock market is recovering from the recent financial crisis, potentially slowing down the pace of that recovery."

There were several very interesting implications in the report such as:

US equity values (in terms of P/E ratios) have been closely tied to demographic trends over the last 50 years.
The baby boom generation has had a large impact on the U.S. economy as they saved and invested; now they will have the reverse effect as they become net liquidators of assets - particularly risk related assets (ie. stocks).
These demographic shifts may present headwinds for the stock markets recovery from the financial crisis
Due to these demands on assets "real stock prices" may not recover to their 2010 level until 2027.
The last point was the most startling. Most analysts and economists believe it to be a theoretical impossibility for the economy, and by default the markets, to remain stagnant. However, the extent to which the aging of the U.S. population creates headwinds for both the economy and the stock market is something that you can see by taking a retrospective look at Japan.

The Fed report looked only at the middle-aged (40-49) and old aged (60-69) groups. However, I think the issues are more encompassing than just two groups. If we think about the current employment levels relative to the population as a whole we can began to understand this is a larger problem. Assuming that the "baby boomer" generation will begin to liquidate assets as they move into retirement in order to fund living expenses; this is turn potentially leads to lower economic growth. Therefore, if the economy is growing at lower rates then we have to further assume that we will maintain higher levels of unemployment. These assumptions imply that not only will the two age groups identified by the Fed begin withdrawing assets; but that a much larger percentage of the entire population will be saving and investing less.

The problem that these assumptions impose is that savings are required for productive future economic investment. When Japan entered into their post crisis decline they had very high personal savings rates which initially sustained their economic system. Unfortunately, the U.S. does not have the luxury of high savings rates as detailed by the following statistics in our recent post "Beware Of Long Term Investing":

"Let's consider the following facts in regards to the average American worker:

56% of the average workers in America today have less than one years salary saved with less than $25,000.
76% have less than $100,000; and
90% have less than $250,000 saved.
If we assume that the average retired couple will need $40,000 (the average annual salary) in income to live through their "golden years," they will need roughly $1 million dollars generating 4% a year. Therefore, 90% of American workers today have a problem.

However, what about those already retired? Given the boom years of the 80's and 90's that group of baby boomers should be better off, right? Not really.

54% have less than $25,000
71% have less than $100,000; and
83% have less than $250,000."
Low personal savings rates do not leave individuals much wiggle room in an economy where incomes are under pressure due to a large unemployed labor pool. The chart above shows the strong statistical evidence concerning the historical relationship between U.S. employment and equity markets. The dotted lines represent the likely path of both employment to total population and the stock market into 2020 assuming the migration of "boomers" into retirement.

The implications of declining employment to population due to the demographic shift potentially shake the foundations of conventional investing wisdom which assumes that markets always rise over time. The potential impact of these demographic shifts in the U.S. parallel closely with the Japanese economy since their financial crisis took hold almost 30 years ago.

The Japanese Experience

In response to their own real estate/financial crisis, Japan implemented many of the same economic policies that are implemented in the U.S. currently. The result of those policies, combined with an aging population, has plagued Japan with a slow growth economy and struggling financial markets.

The Fed report points to this correlation between the financial markets and these demographic shifts.

"Since an individual's financial needs and attitudes toward risk change over the life cycle, the aging of the baby boomers and the broader shift of age distribution in the population should have implications for capital markets (Abel 2001, 2003; Brooks 2002). Indeed, some studies attribute the sustained asset market booms in the 1980s and 1990s to the fact that baby boomers were entering their middle ages, the prime period for accumulating financial assets (Bakshi and Chen 1994)."

However, one of the key arguments against the U.S. being like Japan has been the strength of employment. While the U.S. may not have as severe of an aging gap between generations; a quick comparison between employment to population ratios leaves little question.

Since both countries face similar hurdles of overburdened social welfare programs, a weak economy and struggling financial markets; sustained levels of high unemployment drag on economic growth. This in turn reduces assets that would potentially be invested back into the system.

We can look at Japanese stock market set against the S&P 500, advanced 10 years to align time frames, in order to see the impact of demographic trends on stock prices. The long term trend of the Nikkei continues to be negative as Japan has followed its path of long term economic decline which has impacted employment levels relative to their total population.

Beginning In 1980, the U.S. has similarly been in a slow degradation of economic growth. As debt levels have increased to sustain a higher standard of living; savings rates have fallen which has detracted from productive investment.

Furthermore, the shift from a production and manufacturing base to a service based economy has further impeded growth by shifting invested dollars into areas with a lower economic "multiplier" effect.

We outlined this in greater detail in "The Breaking Point".

The impact of these shifts almost 30 years ago in the U.S. have just now started to be realized with the bursting of the financial/credit bubble in 2008. With consumers now entrenched in a "balance sheet" recession, the process of deleveraging an entire economic system is a process that occurs over a decade or more. This creates a vicious feedback loop as consumers re-task spending to pay down debt. Reduced expenditures puts businesses in a defensive position which respond by reducing hiring and increasing cost cutting (ie. layoffs) measures to maintain profitability. With higher unemployment comes a competitive available labor pool which lowers wages and salaries. Lower wages decreases the ability for consumers to expend discretionary income which creates lower final demand on businesses. This cycle, once entrenched, is extremely difficult to break. This is the reason why the various stimulus programs have failed to create any lasting economic growth.

Many may scoff at the Fed's report that stock prices will not recover to their 2010 highs until 2027. The migration of "baby boomers" into retirement, combined with sustained high unemployment, low savings rates and a weak economy, does not bode well for strong financial markets into the future. While there are many hopes that the economy will recover in spite of the abundance of factors building against it; the reality is that we may be dealing with the "Japanese Experience".

Bluesky1

Agreed, Many do-it-yourselfers think they are saving money because, hey they're smart (read pilots), and they can manage their portfolio while holding down a full time flying job. They couldn't be more wrong. They/we need a full time advisor we "trust" and who knows what he/she is doing. Many investors are making quite respectable returns, limiting the downside risk while capturing more upside, even in this market. PM for more info if you wish.

DYNASTY HVY

When wages are consistently stagnant and don't keep up with inflation that in itself poses another problem altogether in regards to saving for retirement and most people have seen their wages flatline over the past 5 or so years and a retirement lifestyle for them may not be what they expected it to be .

globalexpress

I think the article is just a complex way of stating something that is common knowledge in the financial planning world: the worst case scenario for a new retiree is to run into a bear market during his first years of retirement. Your portfolio take an immediate hit from the get go, which is obviously very damaging and affects your balance for your ENTIRE retirement.

Also note how the author gives the other 'successful' portfolio a big gain the first year. As stated above, a big loss in your first year(s) is really bad. Conversely, a big gain in your early years is really good.

A few more points from the article. One, if a guy is taking the risks associated with the returns shown in the tables, he likely has a very high equity allocation or at least significant exposure to a risky asset class or two. Is that what you want to do as a retiree? Expose yourself to risks that could wipe you out from the very beginning? Well, if you're crazy enough to do that, hey, more power to you. I think the point here is to not put yourself in a position where you expose yourself to that kind of risk in the first place.

Also, I don't know if the author just picked 5% as a withdrawal rate or he states it as a rate that is 'OK' but a 5% withdrawal rate is quite high and is likely to fail anyway unless the retiree gets pretty darn lucky with his investments. The Trinity Study hashes out what a safe withdrawal rate could look like, and the numbers that more than likely would work are closer to 3%, maybe 4%.

Finally, if a retiree saw his portfolio take a big hit early on, he might be able to go back to work to stop or minimize taking withdrawls. Hopefully a retiree would be smart enough to reduce his withdrawal rate if he saw his portfolio take a big hit early on.

SkyHigh

My take away from all this is that nothing beats a pension. No matter how long you live or what the stock market does a pension check will come in the mail. You don't have to think about it, calculate earnings or watch the stock market.

When the airlines took away their pensions it was a huge loss for workers and changed the value of the career immensely. Back in the mid-1990's I remember well FAPA calculated the total career income expectations from each airline. It was inclusive of all the perks, benefits and salaries earned over a 20 career. At the time UAL lead the pack with an estimated overall career earnings potential of $10.5 million dollars.

Loosing the retirement plan was a big deal. Even a million dollars in the bank is not as good as a pension.

Skyhigh

DAL 88 Driver

Well, that would be good thinking 20 years ago. But we've all seen what actually happened with that. All it takes is a little planning and a convenient trip through bankruptcy, and management can make that pension magically disappear. Not the kind of retirement I want to be counting on. I'll take the money in my name, thank you.

Columbia

My Dad who used to work for Eastern would disagree. Not a dime saved in 401K as he had a "guaranteed pension."