This document covers several key issues as you plan for retirement and is divided into four sections:
Section 1: Determining How Much to Save and Spend
Estimating a Retirement Spending Amount
If you are 10 years or less away from retirement, you may be able to estimate retirement spending based on your current spending. Be sure to exclude expenses that may not continue in retirement, and remember to include expenses that may be higher in retirement. In determining how much of these expenses need to be funded by your portfolio, subtract any income you’ll receive in retirement from Social Security or pensions.
If you are more than 10 years away from retirement, it may make sense to estimate retirement spending as a percentage of your current pretax income. A starting point you can use is to assume that 50 percent of your pretax salary needs to be funded from your portfolio. While 50 percent may seem low, keep in mind that in addition to this level of spending, you’ll likely have Social Security or pension income on top of this. In addition, after retiring, you no longer have to save for retirement or pay FICA taxes.
Estimating How Much to Save
If you are 10 years or less away from retirement, we recommend working with a financial advisor to develop a savings plan using Monte Carlo analysis. Monte Carlo simulation is a statistical method for analyzing issues that involve randomness, like the returns of different asset classes. The inputs used in the simulation include the return, volatility and correlation of the asset classes. The simulator provides thousands of “versions” of each year in the future, and then reports back how the portfolio held up in each of these versions of the future. This simulator can help determine when you can retire and how much you’ll need to save for retirement.
If you are more than 10 years away from retirement, Monte Carlo may not be as useful due to uncertainty surrounding retirement expenses and the limitations surrounding the number of years you can run a Monte Carlo simulation. This simulation is useful for up to about 30 years, but analyses that are run much longer than that become unreliable. As a replacement, you can use the table below:
The rows of this table are your current age while the columns are how much you have saved for retirement. The percentages show the pretax income you should save annually. The assumptions behind this chart are a 50 percent replacement rate, a retirement age of 65, a 30-year retirement and a 60-40 portfolio. As an example, if you are 35 years old and you’ve saved 1x your annual salary (as indicated by the shaded box above), you would need to save 10 percent per year going forward. The table, which was created by Professor Wade Pfau, looks at a worst-case scenario using historical data back to 1871.
Plan for Potential Early Retirement
The above chart assumes a retirement age of 65, but it is wise to plan for the possibility that you might retire earlier than planned. There can be positive and negative surprises. For example, the investment returns you experience may be higher than expected, your earned income may be higher than expected or you may receive a large unexpected inheritance. On the other hand, you may retire earlier than expected due to negative surprises. For example, you may have a health issue that forces you into early retirement. It is important to have a “Plan B” for this possibility, which could include reducing annual spending or downsizing your home.
Section 2: Portfolio Management
Deciding on an Asset Allocation
Selecting an appropriate asset allocation is largely a function of your ability, willingness and need to take risk.
Your ability to take risk is largely a function of your time horizon. The longer your horizon, the greater is your ability to wait out the virtually inevitable bear markets. In addition, the longer the investment horizon, the more likely equities will provide higher returns than fixed income investments.
Your willingness to take risk is determined by the “stomach acid” test. This is the degree to which you’ll be able to stick with your plan during bear markets.
Your need to take risk is determined by the rate of return required to achieve your financial objectives. We discuss estimating future returns in the next three subsections.
Do Not Assume Constant Rates of Return
When planning for retirement, it is common to plan for the average returns you hope to achieve. However, actual returns will vary from one year to the next. Even if you could predict the actual average return in your retirement, the sequence of returns is also very important when it comes to retirement planning.
For the period of 1926–2014, a portfolio invested 70 percent in the S&P 500 and 30 percent in five-year Treasuries returned an average of 10.1 percent. In real terms (adjusted for inflation), the return was 7.0 percent. You might conclude that it would be possible to withdraw $70,000 per year from a $1 million portfolio and maintain the same real income over the long term, increasing the $70,000 by the future rate of inflation.
The problem with this approach is that inflation rates and investment returns vary each year. If you retire before the start of a bull market, you may be able to withdraw 7 percent per year and maintain a portfolio in excess of $1 million. However, retiring at the beginning of a bear market can produce very different results.
For example, an individual who retired in 1972 and withdrew 7 percent of his or her original principal and adjusted that figure each year for inflation would have run out of funds within 10 years, or by the end of 1981. This is because the S&P 500 Index declined by approximately 38 percent in the 1973–74 bear market.
Systematic withdrawals during bear markets exacerbate the effects of the market’s decline, causing portfolio values to fall to levels from which they may never recover. For instance, if you withdraw 7 percent plus 3 percent for inflation in a year when the portfolio declines by 20 percent, the result is a decline in the portfolio of 30 percent in that year. A 43 percent increase is then required the following year just to return to the previous value.
Given the possibility that a market decline might occur at a very early stage of your retirement (when it tends to cause the most damage to long-term portfolio outcomes), consider remaining conservative as you determine how much money you can withdraw annually and still minimize the risk that you outlive your assets. We recommend consulting with a financial advisor who uses a Monte Carlo simulator to determine a prudent spending rate in retirement.
Estimating Equity Expected Returns
There are two primary ways of estimating expected returns, either using historical averages or using current valuations to forecast returns.
From 1926–2014, the annual average real return on the S&P 500 was 8.9 percent (not compounded). If you use current valuations, you can use the dividend discount model (which uses dividend yields), the Shiller CAPE10 model or a combination of the two. As of June 30, 2014, the Gordon model yields a real return estimate of 4.5 percent. The Gordon model is calculated using the dividend yield on the MSCI All-Country World Index (2.5 percent) plus an estimate of future growth of 2 percent. The Shilller CAPE10 model yields an estimate of 5.1 percent by taking a 60 percent U.S., 30 percent developed international and 10 percent emerging markets weighted average of the CAPE10 ratios and then multiplying by 1.075 to normalize for growth in earnings.
As you can see, the various methods can yield very different results. Further, all methods of calculating the expected return have flaws. Historical returns are subject to survivorship bias and changes in valuations. The dividend discount model doesn’t account for alternative ways of getting cash to shareholders. Also, not all firms pay dividends, and this model uses current dividends as a proxy for future dividends. As for the Shiller model, it doesn’t account for changes in accounting practices.
We generally prefer to err on the conservative side for these estimates, so we use an average of the result from the Gordon and Shiller CAPE10 models. If you plan for returns that are higher than what actually occur, this could result in you falling short of your goal.
Estimating Fixed Income Expected Returns
On the fixed income side of the portfolio, you are also able to use historical averages or current valuations in the form of current yields.
From 1926–2014, the average real return on five-year Treasuries was 2.5 percent. In looking at current valuations, the yield on a five-year TIPS is 0.2 percent.
Again, the method you use can yield very different results. We prefer to use long-term TIPS rates for determining the highest real return you’d be able to earn over the period. For example, if your horizon is 20 years, we’d recommend using the yield on a 20-year TIPS as your real return estimate on fixed income.
Equity Portfolio Construction
The first step to building a solid equity portfolio is to invest in a globally diversified portfolio. Investing in international stocks, while delivering expected returns similar to domestic stocks, provides the benefit of diversifying the economic and political risks of domestic investing. There have been long periods when U.S. stocks have performed relatively poorly to international stocks. The reverse has also been true.
The logic of diversifying economic political risks is why you should consider allocating at least
30 percent and as much as 50 percent of your equity holdings to international equities. To obtain the greatest diversification, your exposure to international equities should be unhedged from a currency perspective.
Fixed Income Portfolio Construction
The main role fixed income assets play in a portfolio is to reduce its volatility. Therefore, we generally recommend investing in high-credit-quality fixed income. This can include AAA/AA rated corporate bonds or municipal bonds, bank CDs under FDIC limits, agency bonds or bonds issued by the U.S. Treasury. Along the same lines, short-term and intermediate-term bonds have the benefit of less volatility and lower correlation to equities than long-term bonds. As a result, we think most individual investors are best served by avoiding long-term nominal bonds.
Section 3: Risk Management
Long-Term Care Coverage
According to the U.S. Department of Health and Human Services, roughly 37 percent of people turning age 65 today will need long-term care in a nursing home or assisted-living facility. The average cost of a private room in a nursing home is $229 per day or $83,580 per year. The average cost of a room in an assisted-living facility is $3,293 per month or $39,516 per year.
These costs are quite high and many people have turned to insurance to protect against the risk of needing long-term care. The process for determining whether you need long-term care can be complex. We recommend consulting with a financial advisor to determine if it is appropriate in your situation.
Protecting Against Longevity
It is important to consider the “risk” of living longer than expected. This “longevity risk” is the risk that you outlive your financial assets. In certain cases, it can make sense to buy a form of insurance against longevity risk.
This insurance is either a single premium immediate annuity (SPIA) or a deferred income annuity (DIA). In a SPIA, you pay an upfront premium to an insurance company in return for an income stream that starts immediately. This income stream can be either fixed or adjusted for inflation. In a DIA, you pay an upfront premium to an insurance company in return for an income stream that starts at some date far into the future. For example, you could buy the DIA at age 65 in return for income starting at age 85.
The process for determining whether you should insure against longevity risk or self-insure is complex, and we recommend consulting an advisor to determine if it is appropriate in your situation. We generally prefer deferred income annuities over immediate annuities because we’ve found the deferred option leads to higher levels of success in Monte Carlo simulations.
Section 4: MaximizING Social Security Benefits
According to the Social Security Administration, Social Security benefits represent about 40 percent of the income for the elderly. Social Security benefits are essentially guaranteed income that:
These benefits often are a significant source of retirement income and unlike any other income or investment vehicle. It is important to know how to optimize lifetime benefits. Benefits are determined by birth year, retirement age and lifetime earnings. Once workers reach full retirement age (FRA), they are eligible for full retired worker benefits, also known as the primary insurance amount.
Workers who claim benefits prior to reaching FRA will receive a reduced benefit of up to 25 percent of the primary insurance amount. Delaying a claim until age 70 results in a benefit of up to 32 percent more than the primary insurance amount due to cost-of-living adjustments and delayed retirement credits.
The optimal strategy for claiming Social Security benefits might not be obvious because of various rules for how those benefits are paid. For instance, a husband who earns high wages but does not expect to live long may still want to delay filing because, at his death, his benefit will go to his lower-earning wife. If he claims early, she will have a lower benefit for the rest of her life.
Strategies for claiming Social Security benefits can get incredibly complex, so we recommend consulting a financial advisor to help you make this decision.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
The financial media loves volatile markets. When the market drops, investors understandably become anxious. They have questions like: What is causing the decline? How low will the market fall? Should I sit on the sidelines until things “settle down”? Are there “defensive stocks” I should buy that will protect me during this period of uncertainty?
Pundits then come out of the woodwork to answer these questions, and more. They give lofty-sounding explanations for what is happening and often make predictions about the future direction of the market.
Ignore the pundits
Jim Cramer frequently leads the charge. On June 21, 2012, when the S&P 500 index closed at 1,325.51, Cramer “explained” the sharp decline on that date as follows: “…lots of investors freaked out that there might not be enough end demand for everything that’s fashioned from commodities, not just the commodities themselves.”
How should investors have reacted to this one-day drop? According to the article, Cramer “reiterated that it’s perfectly reasonable to take some profits after the market’s big run. Investors shouldn’t sell everything, though, he said. There are still plenty of stocks that will thrive in today’s environment.”
The S&P 500 index closed on Sept. 11, 2015 at 1,961.05, an increase of 48 percent over the close on June 21, 2012. Investors who took “some profits” on June 21, 2012 likely reduced their returns when compared to those who stayed the course.
“Watching” the market is nonsense
The secret to investing in volatile times is counterintuitive. Here’s how I learned about it. As an attorney, I used to cross-examine brokers on behalf of investors who suffered losses due to misconduct. I found these brokers frequently testified about how they “watched” the market every minute. They seemed to believe this gave them special insight. So I asked them to describe what they did to monitor the market. They said they “watched the tape.” Then I posed this question: “What were you looking for?” Not a single broker was able to provide a coherent response.
The stark reality is that “watching” the market is a non-productive exercise that’s often harmful to your returns.
The Fidelity experience
According to an article on Business Insider, Fidelity Investments did a study to determine which of their accounts performed the best. The results were shocking. It found the best-performing accounts belonged to investors who forgot they even had one with the firm. Because they were ignorant of the existence of the account, these investors did no trading.
The same article quoted Barry Ritholtz, a wealth advisor, financial columnist and blogger. He related some of his experiences in estate planning where families were fighting over inherited assets. Because of these conflicts, the accounts were not touched for 10 or 20 years while family members worked out their differences. According to Ritholtz, families would later discover that these accounts often performed best during those periods of forced inactivity.
The secret
Instead of watching the breathless reporting from the floor of the New York Stock Exchange, do the opposite. Ignore the financial media. Pay no attention to what is happening in the market. Be blissfully ignorant. Spend the time you might normally devote to these anxiety-producing activities on pursuing your hobbies, spending time with your family and taking a vacation.
Once you understand that monitoring the markets is harmful to your long-term returns, a whole new world of opportunities will await you.
This commentary originally appeared September 15 on HuffingtonPost.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE
The success of the Yale Endowment has been highly publicized, leading many endowments, foundations and more recently, even high net worth individuals, to consider adopting the so-called Yale Model.
The Yale Model includes a focus on alternative investments and attempts to capture the liquidity premium available in illiquid investments (such as private equity). In addition to heavy exposure to private equity, the strategy frequently includes investments in hedge funds, many of which also invest in strategies that try to exploit the liquidity premium. And in general, hedge funds themselves are illiquid investments.
For individual investors thinking about adopting the Yale Model, it’s important to make sure that due consideration is given to the differences in the tax regime they face versus the tax-exempt environment in which Yale operates. Which raises an interesting question: What would Yale’s endowment do differently if it were taxable?
Patrick Geddes, Lisa Goldberg and Stephen Bianchi—authors of the study “What Would Yale Do If It Were Taxable?,” which appeared in the July/August 2015 issue of Financial Analysts Journal—sought to answer that question.
Don’t Forget The Taxes
The authors noted that in his book, “Unconventional Success,” Yale Chief Investment Officer David Swensen explicitly recognized the harm of ignoring tax ramifications once you change your tax environment: “The management of taxable … assets without considering the consequences of trading activity represents a … little considered scandal. A serious fiduciary with responsibility for taxable assets recognizes that only extraordinary circumstances justify deviation from a simple strategy of selling losers and holding winners.”
Because they could not know what return assumptions were being made by the managers of the Yale Endowment, Geddes, Goldberg and Bianchi begin by performing a reverse portfolio optimization. A typical mean-variance optimization uses as the inputs the returns and covariance of each asset class. The output is the allocation weights.
The reverse optimization starts with the publicly available allocation weights used by Yale’s endowment and historical covariances. The output is the expected return. Based on historical evidence, the authors then made adjustments for the tax haircut, converting pretax returns into after-tax returns, for each asset investment. Following is a summary of some of their key findings:
Taxes Change Everything
The authors concluded that when taxes are introduced, “the changes in asset allocation can be so dramatic that it is incumbent on the savvy investor to combine risk and taxes in the design stage of a portfolio. The tax effect cannot be layered in after the fact as some minor tweak, such as seeking slightly more tax-efficient hedge funds versus tax-inefficient ones.”
They also stated: “Alternative strategies that are highly correlated with equities, and also generate a lot of gains from trading, cannot survive in a portfolio designed to maximize after-tax returns.”
While for some it may seem extreme to recommend that taxable investors should avoid actively managed funds, here’s what successful active manager Ted Aronson of AJO Partners (with about $26 billion in assets under management) had to say regarding this subject: “None of my clients are taxable. Because, once you introduce taxes … active management probably has an insurmountable hurdle. We have been asked to run taxable money—and declined. The costs of our active strategies are high enough without paying Uncle Sam.”
He added: “Capital-gains taxes, when combined with transactions costs and fees, make indexing profoundly advantaged, I’m sorry to say.”
While Aronson invests his personal tax-advantaged assets in his own fund, following his own advice, he invests his taxable assets in index funds. In an interview with Barron’s, he stated: “My wife, three children and I have taxable money in eight of the Vanguard index funds.”
This commentary originally appeared September 18 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE