Tuesday, May 19, 2009

Pete and Repeat

Pete and Repeat are twins who spent forty years working for the same boss in the same button factory.

No, its not a joke.

Each brother has a wife and 2.4 kids. They both earned the same amount each year and saved away part of it. One year ago they each had $1 million in a 401(k) invested 70% in stocks, 30% in bonds. At that point, after 64 years of doing everything the same, Pete retired and Repeat did not.

Conventional economic wisdom says that when you retire, you should establish a withdrawal rate and maintain that rate, adjusted for inflation, for the duration of your retirement. There has been some debate about how much can be safely withdrawn, without depleting your savings before you die.

Peter Lynch suggested a seven percent withdrawal rate from a 100% stock portfolio. Many studies show that Lynch's advice is very dangerous. A withdrawal rate that high is very likely to deplete your savings too fast. If the market declines for several years, a 7% withdrawal rate turns into a much higher rate, which can eat up principal to the point where you can never recover. Dollar cost averaging, which in the accumulation phase works in your favor by causing a fixed dollar amount to buy more shares when prices are down, works against you in distribution by causing you to sell more shares when prices are down, exactly the opposite of what you would like to do. Applying Lynch's formula to historical stock market results shows than in 41% of the cases, the investor would go broke within 25 years. Lynch was great at running mutual funds. Seems he's not so good as a financial advisor.

Today most research suggests an initial withdrawal rate between four and five percent.

When Pete retired one year ago, he decided to use a 4.5% withdrawal rate from his savings, giving him an income of $45,000. Not lavish, but enough to live comfortably. Over the past year, his retirement account has declined due to the drop in the stock market and the withdrawal of $45,000. Today Pete has $645,000. Following the standard procedure, he will adjust his income for inflation. This year he will take $46,575, or 7.22% of his nest egg.

Repeat kept working for one more year. His 401(k) also took a major hit. Instead of taking money out, Repeat added $5,000 more. He now has $685,000, or $40,000 more than his brother. Repeat retires, and using the standard 4.5% formula, he computes his safe withdrawal rate as $30,825.

Now take a look at the situation. Repeat has more money than Pete, but conventional methods of financial planning tell Pete to take about 50% more income than Repeat. Pete followed the cautious advice of the Trinity Study, but is now worse off than the reckless and discredited 7% withdrawal rate of Peter Lynch.

I'm going to suggest that they both have the entirely wrong way of looking at the problem. Conventional financial wisdom is way off the mark. It forces you to plan for a worst-case scenario, and if we have learned anything in the past year, it is that the worst case is far worse than we thought. The simplistic, one-size-fits-all approach may sell books and help brokers sign up clients, but putting your finances on autopilot is never a good plan. It is very important to consider events as they happen and adjust your plan accordingly.

When you retire, you must plan based on what you know at the time. But five years from now there is no reason to stick with a plan based only on what you knew five years ago. The failure to respond to market movements works against you both ways: it can cause you to go broke when the market drops, and it prevents you from benefiting from increases in the market. Pete, faced with a loss of a third of his investment assets, needs to reduce his withdrawals to avoid going broke. When the market recovers, Repeat will be stuck with his low income even if he could afford to increase it.

Every investment plan has risks. It is possible to mitigate some of the risks, diversify the risk, or trade one risk for another, but you can't eliminate risk altogether. The conventional method exposes the investor to the risk of going broke, leaving him with no means of support for his last years of life. Even the safest possible retirement plan, building a TIPS ladder, carries the risk of missing better opportunities.

A few years back I invented a method to deal with these issues.

My proposal trades the risk of going broke prematurely for the risk of a declining purchasing power, but also eliminates opportunity risk. In other words, you may have less income this year than you did last year, but it is guaranteed that you won't run out of money before the time you planned to.

There are several important decisions to make. First, you have to select the date when you will run out of money. The idea is to pick the closest date that you are comfortably certain you will never reach. Your 100th birthday might be reasonable. Another school of thought is to plan until your 90th birthday and just assume that if you last that long, your finances are someone else's problem.

The key concept is that we are going to divide up the money into a parcel for every month from now until the date you picked. If that date is 35 years from now, there will be 420 parcels. Each month you only touch the parcel for that month. The performance of the investments determines the actual value of that parcel, but regardless of what the stock market does, you have one parcel for every month. Short of a total worldwide economic collapse reducing the value of all investments to zero, you are guaranteed to have some income every month. Given average market returns you can expect to do better than the conventional method. In the case of somewhat below average results, you'll do about the same. If there is a prolonged market downturn, your income will be less than those using the conventional method, but when they go broke, you won't. And if the market excels, so do you.

Using Modern Portfolio Theory, we can design an asset allocation which maximizes return at a given level of risk, and over the long term it should be possible to outpace inflation. Therefore, the parcels should not all start out equal. The earlier parcels should have more, and the later parcels start out with less, because they are expected to grow over time. I'm not going into the math here, but if you want to see it, ask me. Essentially it comes down to this: each month you take a percentage of the total value of your portfolio as income, and the percentage increases over time in a predetermined way.

Another decision you must make involves the tradeoff between initial income and expected income growth. If you start with too much income early on, it is very likely that over time your purchasing power will decline as the income fails to keep up with inflation. With careful consideration it is possible to find a reasonable balance between current income and inflation hedge. Typically you can start with an income a bit higher than the conventional method allows with a high probability of maintaining purchasing power.

I found that it works well to use the monthly withdrawal to help keep the portfolio balanced by taking the money from the fund which is most above its target allocation. This helps to further counteract the reverse dollar cost averaging I discussed earlier. Because you are selling a certain percentage of the assets, you don't sell more shares when prices are down, and by selling the fund which is most above the target allocation, you naturally sell high. Funds which are underperforming relative to the rest of the portfolio will not be sold as often, giving them time to recover.

If Pete and Repeat had used this method, their results would be much more sensible. Instead of the large and inexplicable gap in their incomes, with problems looming in Pete's future, both would have similar incomes proportional to their portfolio value, and they would have the security of knowing exactly how long that income would last.

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