 |
Weekly Insight |
July
30, 2004
IN THIS ISSUE:
Most people in retirement will trade actively earned income
from employment to passively earned income from investments and savings, supplemented
by Social Security. Success in retirement is certainly psychological, because
one must adapt to a major change of direction from employment to other pursuits,
but the financial underpinnings can have a major affect on lifestyle.
We noted in an earlier segment that many people will have a much more flexible retirement than perhaps their parents did. Our bodies are no longer worn out at age 65; in fact, some might even argue that today's modern economies have plenty of room for mature older workers who choose to continue working past 65, either full or part time and either in the old job or a new field entirely. All of this said, this is about YOU and the choices you make. We assert that a retirement plan (funding as well as well as lifestyle) is essential to preparing for retirement, as it keeps options open. Without proper funding, one has no choice but to work or to severely reduce one's lifestyle.
Backing up a bit, we argued that common stocks as a class outperformed bonds in every 30-year period since 1880. We did not, however, suggest ways to hold the common stocks or anything else.
The mix of assets one uses to build wealth is a function of interest, information, risk tolerance and money available. We think for most people the retirement plan at work presents a wonderful opportunity for tax advantaged savings. Why be concerned about taxes? Paying taxes in a current year reduces your contributions by some 20% to 40% or more. When you consider compounding, a 10% pre-tax return is far preferable to a 0.8% or 0.6% after tax return. As we noted, $100 invested at 10% amounts to about $2000 over 30 years; $100 invested at 5% amounts to just $400 after the same period. Thus, even a small drop in the rate of compounding will have a marked effect on your account size.
Of course, money deposited into a retirement plan is fully taxable at withdrawal. For this reason, it is advisable for people to have Roth IRA's in addition to savings in a retirement plan. Roth contributions are made after taxes are paid, but not only do they growth tax-free; all income taken from them is tax-free. Most people qualify for Roth IRA's.
Before we move to discussing sustenance
in retirement we must confront the nature of risk. Many people confuse volatility
with risk. Volatility is simply the natural breathing of financial markets,
as participants endeavor to find the true trend. Fortunately, we can choose
the level of volatility we want and we note a general association with higher
volatility and higher returns over time. However, it should be stressed that
the highest volatility most often does not express as consistency, much less
in optimal long-term gains. Too much turnover and judgment is necessary to
produce optimum returns when volatility is off the charts, so to speak. The
opposite is also true; too little volatility does not produce an optimum return,
either. CD's and Treasury bonds are examples of very low volatility.
We think that the 30-year cycle is ideal as a unit of retirement measurement.
They actually represent cycles of completion. Specifically, the cycle from
30 to 60 represents full adult maturation; the cycle from 60 to 90 (or even
50 to 80) is characterized by less dependence on employment for sustenance
and, [potentially, a period of personal exploration and growth as well as
service to humanity.
Note that volatility is NOT risk; it is only the necessary up and down movements as people's psyches adapt to the barrage of current information. However, it is exactly when market participants get too carried away with current situations that great money can be made. For the long term investor, then, one need not be so concerned with movement in one's account balance as much as one would be if they had to depend on it all in a very short period of time.
We assert that risk is simply the
chance that your money will go to zero before your blood pressure does. Running
out of money is not a pleasant experience. Lower returns will give you a smaller
account. Thus, you can spend less and will have less room for opportunities
and emergencies.
Unless you just can't sleep if your account rises or falls more than 10% in
a year, you should have a hefty portion of common stocks in your portfolio.
As we mentioned in another segment, we use rebalancing techniques to take
profits on areas which mushroom and add to areas which have underperformed.
After all, beyond the notion that each epoch has its leaders and laggards
we note, "the first one now will later be last". Rotation is normal
and can be exploited. Thus, we can reduce some of the volatility one would
experience through a heavy reliance on stocks.
Last time, we suggested that a portfolio of 75% stocks and 25% bonds (with
a bit of cash taken from both areas) produces about 2% in income, depending
on the bond yields and the dividend yields in stocks. Furthermore, the stock
portion will grow at about an 8% clip on a price-only basis. Between the two,
withdrawals of 4% to 5% annually are certainly supportable. Of course, the
returns will vary from year to year and, maybe, from decade to decade.
A word of caution: one decade out of three is usually a throw away, a time
with little or no gain punctuated by a lot of volatility. We think we're in
one of those times now. That said, there is enough choice globally to prevent
collapse and even to come out ahead. One can NEVER time markets with certainty.
Furthermore, if one is trying to reduce risk (volatility) one often is out
of the market just as it moves. This is an important point; much of a longer-term
move is accomplished in a relatively short time, often when people are either
too afraid or complacent to act. This is why we assert that professional management
is superior to one's own management. A professional will venture when less
experienced hands are stuck in either greed or fear.
The best formula for withdrawals?
Last time we asserted that an annual withdrawal of 3% less than the 3-year
average return in the period just preceding is sustainable. We actually prefer
to add one or two percent as a cushion, if one can afford the hit to income.
Thus, a 3-year annual return of 8%, less 3% for inflation and 1% for a cushion
would allow a 4% withdrawal for a given year. Of course, it may be true that
lots of a retired person's expenses are fixed and not subject to inflation.
As always, individual circumstances vary.
We aim for the 8% long-term return (the 25% stake in bonds reduce the returns
most times). If a higher return is needed, more stocks should be held. This
seems counter intuitive to most people, because stocks are volatile. Still,
the historical record shows that common stocks outperform bonds in the long
haul. Thus, it follows that increasing the common stock portion of an account
increases the long-term returns.
Suppose you have an account worth $10 million and you only need $100,000 a
year to live on. Should you invest in common stocks at all? The answer is
yes, but perhaps a smaller portion of stocks is warranted. After all, bonds
do not have any inflation protection. Thus, a bond or an annuity deteriorates
in buying power over time. At a 3% inflation rate, a fixed return of 5% deteriorates
to 2-1/2% in 24 years. Even with their volatility, common stocks have some
inflation protection, provided that companies have some pricing power.
We reassert the premise we made in the first installment in this series: volatility is the price to pay for having more money. How much volatility to accept, of course, is an individual decision, but from the evidence we presented, it is clear that commonly held notions that one should dramatically increase one's weighting in bonds as one approaches retirement are flawed. While an increased weighting in bonds reduces volatility, it also decreases returns and, hence, income available to you.
One important caveat about the income rule we presented above. In general, the 3-year average return less inflation and a small "kicker" will not threaten your account health. However, a 3-year period that has a negative return should be greeted with absolutely minimum withdrawals until the average turns positive again. This safety net is precisely why we suggested that withdrawals not be made right up to the return minus inflation. A little bit of insurance allows periods of poor performance to heal.
All of this said, we are not about to let client accounts incur 3-year negative returns, particularly among retired people. Still, for the sake of the model, we felt it necessary to build the possibility of under achievement.
In sum, then, one needs to be intrepid and long-sighted when designing and maintaining a retirement account strategy. Allowing short-term phenomena to dictate emotional reaction which has an impact on investment decision making is absolutely harmful. Emotions are the enemy of the investor.
Finally, we note that not everyone will have the patience or the risk tolerance (volatility tolerance) to own a large proportion of common stocks. We work with each client to achieve an optimum mix. We recognize that we are dealing with a very important matter which is close to one's sense of well being and do not want to promote sleeplessness at the expense of proving our point.
Next week we conclude the series with a look at some estate planning tips.
Good day to all of you,
Jim
Feel free to share this newsletter with others. Those wishing to receive future issues may contact us by email at jim.pursley@gaiacapital.com. Gaia Capital Management, Inc. is a Registered Investment Advisor, managing accounts for individuals, families, businesses and institutions. We welcome your inquiry about our services.
Jim
Pursley
Gaia Capital Management, Inc.
The opinions contained in this report represent the author's current knowledge and are based on sources known to him at the time of writing. Such opinions are subject to change at any time and are presented for educational value. Any other use, such as investment solicitation, is inappropriate and absolutely unintended by the author. Readers must evaluate information herein presented according to personal situations, goals and expected future needs.