I want to talk about life-cycle investing, and the advice usually dealt out to people on the path to retirement. I think you all know the refrain: go heavily into stocks when young, and move gradually into more "stable" alternatives (bonds, annuities) when entering retirement. Even then, most experts recommend a heavy dose of stocks to make up for the ever-expanding life expectancy of the elderly. I think this advice is, by and large, crap.
Consider, first of all, the plight of someone nearing retirement who still has a hefty (50-70%) commitment to stocks. Since retirement is typically the point at which you begin drawing down assets, you are painfully exposed to volatility. Take the example of a targeted 4% draw-down (the most common percentage generally recommended) on a $1 million portfolio . You might enter retirement expecting to draw down $40,000 a year. In 2011's 3% ten-year bond world (the kind of "safe" bonds experts recommend), that would involve income of $15,000 on the 50% bond portion ($9,000 if 30%), and stock sales of $25,000 to $31,000. If, however, the stock market takes a plunge of 50% (think 2008-9), that portfolio is now worth only $750,000 to $650,000 (ignoring paper losses on bonds, as they will return to par eventually). In this extreme, but clearly possible scenario, your 4% draw-down shrinks to $30,000 (or $26,000). If you take out the planned-for $40,000, you'll erode an eroded asset base, making it ever harder to recover. Don't ever forget that stock swoons can be very long-lasting. The worst case was 1929 to 1955 for the DOW, an astonishing 26 years! To break even! More recently, 1966-83 (yeah, a couple of brief recoveries, followed by more swoons) and perhaps most relevant, 2000-2010. That's an entire decade, just completed, with no gain whatsoever. If you had been drawing down on your eroded assets throughout that decade, you might in in real pain by now.
If, however, you have followed the Bodacious Bond Plan, you will be mostly exposed to bonds at retirement, as you will have been throughout your investing career. So, what happens to you when prices plunge just as you retire? NOTHING! Repeat, NOTHING! For example, beginning the 2008-2009 period, a Bodacious $1 million portfolio was spinning off around 7% yearly (the average BAA bond yield of those two years), or $70,000 yearly. Sure, the market value of the bonds might have plummeted 25% to 35% (probably not 50%) at the worst moments, but income was unaffected. So, if you spent that money, all of it, what would have happened to your income going forward? NOTHING. Next year, you would have made that same $70,000, and bond prices would have recovered very nicely. By 2011, you would probably have been sitting on large capital gains, as BAA yields are now around 5%! And, all of this income would have been available without drawing down principal, i.e., selling bonds.
By the way. Did you notice the different draw-downs for the two portfolios? The generally recommended stock-based withdrawal mandates $40,000 per year; the Bodacious bond portfolio gushes $70,000. That is 75% more income from the beginning! The yearly stock draw-down involves selling stocks, perhaps at distressed prices. My model doesn't require any sales at all, unless you need more than $70,000 per year.
Yes, the stock draw-down usually posits increases along with inflation, so the $40,000 would go up, over time, to keep purchasing power stable. However, you could achieve much the same effect by spending 65% of the Bodacious income (in this case, $45,500), and reinvesting the difference at rates that usually compensate for inflation. Then you, too, could see inflation-adjusted retirement income. As for selling at a distress price? That will not happen (barring credit rating erosion, of course) if your bond portfolio is 30 years old. Why? Your oldest bonds will mature yearly, at par. Since your practice has been to buy at or below par, there is no loss whatsoever! The principal being returned is yours to spend or reinvest.
Here is how this reinvestment approach could work. The 35% you DON'T spend from the $70,000 interest stream will leave you with about $24,500 to reinvest. If rates have gone up to, say, 8% over the year,the will enable you to purchase bonds that will yield an additional $2000. Repeating for ten years will enable your income to go up by about 28%, even as value of the portfolio bounces up and down with the vagaries of the market. That translates into a inflation "rider" of nearly 2.5%, roughly the average over the past umpteen years. Note, this initial allowance of $45,500 is still 10.5% higher than the $40,000 recommended by the gurus. I have run many scenarios, with yearly rates ranging widely along the way. These variations don't seem to matter, as income goes up steadily. You might wince to see what high rates do to the market value of the portfolio, and rejoice prematurely when rates dip, but income maintains a steady upward trajectory.
Summing up (and repeating points made in earlier blogs):
With stocks, you have many enemies. 1. Stocks prices pogo up and down, often without rhyme or reason. As you near retirement, that volatility is very dangerous, as you might plan to sell soon. 2. Even stocks with a yield (dividends) aren't all that safe. A dividend is only as good as the most recent earnings statement. When tough times arrive, the dividend can be, and often is, slashed to the bone. To be fair, though, dividends often increase to compensate for the toll of inflation. 3. Fees can kill you, both with stock and bond funds. Take a management fee of 2% off the top, each and every year, and a nice 7% yearly return drops precipitously to 5%, before taxes and inflation. You'll be lucky to stay even. 4. Churn can kill you. Each time a professional buys and sells, transaction costs (direct, as in fees, and indirect at in bid/ask spreads) erode the value of the investment. 5. Death can kill you. By this, I mean that some stocks drop to zero, never to rise again. They don't appear in the indexes, but they do in your own returns. 6. For a stock to be a good investment, you must make two correct decisions: when to buy and when to sell. Botch either, and you're gonna feel it.
With Bodacious bonds, you have some enemies too, but they're easier to recognize and combat. 1. Bond prices pogo up and down too. But as mentioned above, this is largely irrelevant, as income from the bonds is steady. 2. Bond interest is MUCH safer than a dividend. If a company can pay, it must. Most companies (particularly investment grade) do pay. If they don't, you still have a legal claim on that company's assets. You might get the money (and interest) back anyway. As to inflation, well, BAA bond payments won't increase, but they generally are issued at a yield substantially above the existing rate of inflation. 3. If you do it yourself (my hearty suggestion), there are NO fees! This is a huge advantage of managing your own portfolio. 4. There should be almost no churn in a Bodacious portfolio. You buy a 30-year BAA bond, and hold it to maturity. Next year, you do the same. As a small investor, you won't get the very best price, which is reserved for the big boys. However, you can get close, if you're patient and focus on small-size offerings. Typically they sell at a discount to large lots because the big boys can't be bothered. You will get the best price at maturity: par. 5. Death is a risk here too. You must watch the prices and ratings of the bonds in your portfolio. If an issue plummets below investment grade, sell it (even at a loss), or at least lighten up substantially. 6. For a bond to be a good investment, you need only make one correct decision: when to buy. The sale is built into the bond: maturity.
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