Tag Archives: Retirement Planning

Your Back-Of-The-Envelope Financial Plan

We do a lot of financial planning with fancy software for clients at RIA Advisors. We think a financial plan is the basis for someone having a successful financial life. But sometimes you don’t need a fancy computer program with a lot of bells and whistles to get started. There are only a few things you have to know about planning for retirement. And if you do your own back-of-the-envelop calculations, that may spur you to see an advisor and get a more detailed plan in place.

Work Backwards From Income Needed

Strangely enough, it helps to start backwards. So the first thing someone planning for retirement should think of is how much of an annual income they’ll need. There are rules of thumb including one that says 80% of your income in your last working years is adequate. Nobody really knows for sure though, so you should spend some time thinking about that. Keep in mind that an amount of income you think is adequate today will likely be more in the future because of inflation. We’ll address that below.

Nest Egg Required To Generate Income

Once you come up with that required income number — and, by all means, it can be a range instead of a precise number — you can use it to figure out how big of a nest egg you’ll need to generate income on top of Social Security and any other pensions you anticipate receiving. The old rule of thumb in financial planning is the 4% rule, which states you can take 4% from your assets the first year in retirement and then increase that by 4% of the initial withdrawal amount each successive year. (So if you take out $10,000 the first year of retirement, you can take out $10,400 the second year, $10,816 the third year, and so on.) If you’re very close to retirement (a year or two away), it might be better to cut that withdrawal rate to 3.5% now. If you’re very conservative, you can even cut it to 3%. Remember the 10-year U.S. Treasury is yielding around 2.7% currently. Also, stocks are trading at high prices relative to past earnings, and that usually means future returns will be muted. So a balanced portfolio (roughly half stocks half bonds) is unlikely to deliver more than 4% annualized, and may deliver less over the next decade. It probably won’t deliver the 7% annualized that it has in the past and that many financial planners cavalierly tell their clients.

So let’s say $10,000 isn’t enough, and you want more like $35,000 per year to supplement Social Security and any other pensions you might have, when you retire at 65. In that case, you’ll need to have a nest egg of $1 million. The formula for figuring that out using our 3.5% rule is $35,000 = .035*nest egg. In other words, take the annual income you need and state mathematically that it equals 3.5% or .035 times the nest egg or pile of money you’ll need to have.

If you need your assets to generate $70,000 per year in the first year of retirement – double the amount of annual income in our first example — you’ll need a $2 million nest egg – double the nest egg in our first example. If you need $17,000 or $18,000 of annual income – half the amount of income in our first example, you’ll need a $500,000 nest egg – half the amount of the nest egg in our first example.

If you’re far from retirement, and you think you need a certain amount of money, given what it can buy today, you should compound that “nominal” amount by something for inflation. So if you’re, say, 20 years from retirement, and you think you’ll need $35,000 of income from your assets in retirement, it might be reasonable to compound that $35,000 by 3% per year to come up with the number of dollars you’ll need 20 years from now. Nobody knows how much inflation will run over the next two decades, but 3% has been a decent rule of thumb. It turns out that $35,000 compounded by 3% every year for 20 years amounts to around $63,000. That means it will take $63,000 in 20 years to buy what $35,000 buys now. It also means you’ll need a nest egg of  $1.8 million in 20 years to generate that $63,000 of income using the 4% rule adjusted down to 3.5%.

Savings Required To Produce Nest Egg

Finally, now that you have a handle on how big your nest egg needs to be, you can figure out how much to save to get there. Any online financial calculator, such as this one, will let you put in a number of dollars already saved, future annual savings, and an estimated rate of return to get a future value estimate of your nest egg.

If you’re within a decade of retirement, you should count on modest returns. Check out a recent article by Morningstar’s Christine Benz on how some well-respected investors are saying financial markets won’t deliver robust returns for the next decade or so. If you’re two decades or more from retirement, go ahead and plug in 6% returns from a global balanced portfolio.

To recap, if you want a back-of-the-envelop financial plan, start backwards with how much annual income you’ll need from your assets. You’re really trying to solve for an income number in retirement. Then figure out how much capital is required to generate that amount of income safely. Then figure out how much money you need to save to build that nest egg or pile of assets.

It’s true there are other things involved in retirement planning, including questions about when someone should take Social Security, whether and how to buy supplemental healthcare coverage, how to leave a legacy to heirs, etc… And a good financial advisor can help you with these things. But, if you want to get a head start, train yourself to start thinking about the first three parts of financial planning – income needed, nest egg needed to generate the income, and amount of savings needed to build the nest egg.

Please feel free to contact us with your financial planning needs.

You Are Different This Time

You don’t always see a respected member of the financial commentariat argue that it’s different this time. But that’s almost what Morningstar’s Christine Benz has done in an excellent recent article.

What Benz means is that you’re different now than you were during past market cycles. More specifically, you’re older now than you were during the last market debacle, so you have less time to recover from another one if it should occur. That might not mean much if you were 10 in 2008 and 20 now. But it means a lot if you were, say, 50 in 2008 and 60 now or even 45 in 2008 and 55 now. If you’re five to 10 years from retirement, the risk of encountering a period when bonds outperform stocks is high enough – and dangerous enough to your retirement plans — so that you should reduce stock exposure.

The Math Is Different in Distribution

And, if you’re retired and withdrawing from your portfolio, the “sequence-of-return” risk – the problem of the early years of withdrawals coinciding with a declining portfolio – can upend your entire retirement. That’s because a portfolio in distribution that experiences severe declines at the beginning of the distribution phase, cannot recover when the stock market finally rebounds. Because of the distributions, there is less money in the portfolio to benefit from stock gains when they eventually materialize again.

I showed that risk in a previous article where I created the following chart representing three hypothetical portfolios using the “4% rule” (withdrawing 4% of the portfolio the first year of retirement and increasing that withdrawal dollar value by 4% every year thereafter). I cherry-picked the initial year of retirement, of course (2000), so that my graphic represents a kind of worst case, or at least a very bad case, scenario. But investors close to retirement should keep that in mind because current stock prices are historically high and bond yields are historically low. That means the prospects for big investment returns over the next decade are dim and that increasing stock exposure could be detrimental to retirement plans once again. In my example, decreasing stock exposure benefits the portfolio in distribution phase, and that could be the case for retirees now.

 

 

 

The Psychology Is Different In Distribution

But it isn’t just that stock prices are high and that bond yields are low now. Benz argues that your mindset is likely different too. “Even if you sailed through the 2007-2009 market meltdown without undue worry or panic-selling, the next downturn could prove more visceral if retirement is closer at hand and starting to seem like a realistic possibility. It’s not fun to see your portfolio drop from $500,000 to $225,000 when you’re 45. But it’s way worse to see your $1 million portfolio drop to $500,000 when you’re 55 and beginning to think serious thoughts about the when and how of your retirement. The losses are the same (in percentage terms); the ages are different.” In other words, your proximity to retirement could make you sell at the bottom more than it might have a decade ago.

Sure, everyone probably needs some stocks in their portfolio in retirement. Returns from cash and bonds may not keep up with inflation, after all. But stock returns might fall short too. And if stocks do lag, they probably won’t do so with the limited volatility that bonds tend to deliver, barring a serious bout of inflation. So, if you’re within a decade of retirement, it may be time to think hard about how much stock exposure is enough. The answer might be less than you think for a portfolio in distribution phase.

It’s Okay To Hold Some Cash

The great sage and baseball legend, Yogi Berra, once said:

“It’s tough to make predictions – especially about the future.”

But financial planning is all about contemplating how much money will result from a particular savings rate combined with an assumed rate of return. It’s also about arriving at a reasonable spending rate given an amount of money and an assumed rate of return. In other words, plugging in a rate of return is unavoidable when doing financial planning. Perhaps financial planners should use a range of assumptions, but some assumption must be made.

The good news is that bond returns stand in defiance to Berra’s dictum; they aren’t too difficult to forecast. For high quality bonds, returns are basically close to the yield-to-maturity. Stock returns are harder, but there are ways to make a decent estimate. The Shiller PE has a good record of forecasting future 10-year stock returns. It’s not perfect; low starting valuations can sometimes lead to low returns, and vice versa. But it does a decent job. And the further away the metric gets from its long-term average in one direction or another, the more confident one can be that future returns will be abnormally high or low depending on the direction in which it has veered from its average. Currently, the Shiller PE of US stocks is over 30, and its long term average is under 17. That means it’s unlikely that future returns will be robust.

The following graph shows end-of-April return expectations for various asset classes released by Newport Beach, CA-based Research Affiliates. One will almost certainly have to venture overseas to capture higher returns. And those likely posed for the highest returns – emerging markets stocks – come with an extra dose of volatility. Along the way, there will be problems caused by foreign currency exposure too, though Research Affiliates thinks foreign currency exposure will likely deliver some return.

Hope for a correction? Move some money to cash?

Given this return forecast, investors will have to contemplate saving more and working longer. But investors who continue to save should also hope for a market downturn. As perverse as that sounds, we are in a low-future-return environment because returns have been so good lately. We have basically eaten all the future returns over the past few years. And nothing will set up financial markets to deliver robust returns again like a correction. That’s why the Boston-based firm Grantham, Mayo, van Otterloo (GMO), which views the world similarly, though perhaps a bit more pessimistically, to Research Affiliates has said that securities prices staying at high levels represents “hell,” while a correction would represent investment “purgatory.” If prices stay high, and there are no deep corrections or bear markets, there will be little opportunity to invest capital at high rates of return for a very long time.

Investors who aren’t saving anymore should hold some extra cash in anticipation of purgatory. If we get purgatory (a correction) instead of hell (consistently high prices without correction), the cash will allow you to invest at lower prices andva higher prospective return. How much extra cash? Consider around 202%. The Wells Fargo Absolute Return fund (WARAX) is run by GMO, and 81% of its assets are in the GMO Implementation fund (GIMFX). Around 6% of the Implementation fund is in cash and another 16% of the fund is in U.S. Treasuries with maturities of 1-3 years, according to Morningstar. So more than 20% of the Implementation fund – and nearly 20% of the Absolute Return fund — is in Treasuries of 3 years or less or cash.

Around 52% of the Implementation fund is in stocks, most of them foreign stocks. So around 40% of the Absolute Return fund is in stocks. (The other holdings of the Absolute Return fund are not invested in stocks as far as I can tell.)

If you normally have something like a balanced portfolio with 50% or 60% stock exposure, it’s fine to take that exposure down to 40% right now. There is no question that this is a hard game to play. The cheaper prices you’re waiting for as you sit in short-term Treasuries or cash, with roughly one-third of your money that would otherwise be in stocks, may not materialize. After all, as Berra said, “It’s tough to make predictions.” Or the lower prices may materialize only after your patience has expired, and you’ve bought back into stocks at higher prices just before they’re poised to drop.

These adverse outcomes are real possibilities. But the buy-and-hold, strictly balanced allocation (60% stocks/ 40% bonds) also isn’t easy now for those who (legitimately) fear a 30+ Shiller PE. That’s why it’s arguably reasonable to move some of your stock allocation into cash and/or short-term Treasuries, but not the whole thing. And sitting in cash hasn’t been this easy for a decade or more, now that money markets are yielding over 1% and instruments like PIMCO’s Enhanced Short Maturity Active ETF (MINT) are yielding over 2%. Those yields at least act as a little bit of air conditioning if investment hell persists and prices never correct while you sit in cash with some of your capital.

Projections Are Imprecise, But Not Useless

It seems banal to say, but financial planning requires return projections or estimates. If you’re saving money for a goal like retirement, sending a child to college, buying a home, or taking a vacation, you need to know three things (at least) — how much to save, how much of a return that savings will earn, and the distance to the goal. Without any of those three things, there can’t be a plan. And all of this doesn’t take into consideration your own temperament or how you react to volatility and the potential for permanent loss.

Of course, the return projection won’t be precise if any part of the capital is being invested in stocks. It’s not easy to forecast how much stocks will return over a given time, and the shorter the distance to the goal the more unpredictable and random stock returns are. And that’s one reason stocks shouldn’t be used for short-term financial goals. They can do virtually anything over one- or two-year periods of time. However, over longer time frames — 7-10 years or more – forecasts can be more reasonable, though still not precise. But one is never absolved from making an estimate or a range of estimates.

Unfortunately, some prominent financial planners, who often double as pundits, denigrate all forms of forecasting. Financial planner and sometimes New York Times columnist Carl Richards recently tweeted that the only thing we know about projections is that they are wrong. He applied the hashtag “projectionfreeplanning,” which, of course, is an oxymoron. There’s no such thing as financial planning or projecting a future value of an investment, after all, without a return estimate.

Similarly, prominent advisor and pundit, Barry Ritholtz, has argued that forecasting is “almost useless” and that we “stink at it.” Ritholtz says assertions like “stocks tend to go higher” are vague enough to be exempted from his critique, but “The Dow will hit 25,000 by the second quarter of 2018” aren’t. What’s frustrating about his writings is that they don’t say anything about the ordinary forecasting of long term (say, 10- or 20-year) returns financial advisors must do to satisfy future value calculations for their clients.

The pundits like to say that the Shiller PE isn’t a valid metric anymore because it’s been well over its long-term average – around 16.5 – for over 25 years. But the annualized return of the S&P 500 Index, including dividends has been 5.4% from 2000 through 2017, and the Shiller PE was over 40 in 2000. In other words, in 2000, it did a good job of telling investors future returns would likely be tepid. Moreover, that return has depended on the dazzling 15% return of the index since the financial crisis that has driven the Shiller PE up again to the low 30s. And, as Rob Arnott has said, we can have a reasonable argument about whether the new normal for the Shiller PE is 20 or 22, but not whether it’s 30.

Advisors are rebelling so much against forecasting because they don’t like to deliver bad news to clients. Bad news can be bad for business. Clients will choose the advisor with the highest future returns projections because they want to be soothed. But delivering optimism when it’s unwarranted can lead to projections that border on malpractice on the part of the advisor. Investment professionals usually know this when it comes to bonds. It’s difficult for a bond or a portfolio of bonds to return more than its yield-to-maturity. However, when it comes to stocks, advisors often resort to using the longest term return numbers they can find. Those usually come from Ibbotson Associates, now a division of Morningstar, which popularized a stock market return chart dating from 1926. But most investors aren’t investing for a century, and there have been enough 10- and 20-year periods of poor returns to give investors and advisors pause. More importantly, those periods are associated with high starting valuations.

And now it has become clear that estimating, say, 7%, for a balanced portfolio over the next decade is a stretch. Bonds are likely to deliver less than 4%, and that means stocks will have to deliver more than 8.5%. Advisors are becoming increasingly pessimistic about that possibility for stocks, but they aren’t responding by expressing that pessimism clearly Instead, they are responding by bashing forecasting altogether. It’s not the most mature response, but the possibility of losing clients because of poor forecasts has its bad effects. And it’s true that the Shiller PE — or any other valuation metric — isn’t perfect in forecasting returns, but it can’t be prudent to count on stocks delivering 8.5% for the next decade with a starting Shiller PE in the low 30s.

Investors should question their advisors about returns, because they need to know how much money their current savings rate will leave them with to spend in retirement. The return assumption is just that — an assumption — but that means investors can ask for a range of assumptions to see what different returns will deliver. That doesn’t mean the optimistic assumptions are truer ones though, but it helps investors understand what they’re up against without being precise. And that is far from useless. The second thing investors should do is something financial journalist Jazon Zweig discussed in an old column – they should ask their advisors how much return the advisor would deliver to the client in a “total return swap,” whereby the client hypothetically hands over their entire portfolio and gets an annualized return on that portfolio in exchange. There’s no better way to put the screws to your advisor when it comes to getting his or her opinion on future returns.

Divorced From Reality: Prices & Fundamentals

There are many ways of assessing the value of the stock market. The Shiller PE (price relative to the past decade’s worth of real, average earnings) and Tobin’s Q (the value of companies’ outstanding stock and debt relative to their replacement cost) are likely the two best. That doesn’t mean those metrics are accurate crash indicators, or that one can use them profitably as trading signals. Expensive stocks can stay expensive or get more expensive, and cheap stocks can stay cheap or get cheaper for inconveniently long periods of time.

But those metrics do have a good record of forecasting future long-term (one decade or more) returns. And that’s important for financial planning and wealth management. Difficult though it is sometimes, everyone must plug in an estimated return into a formula for retirement savings. And if an advisor is plugging in a 7% or so return for a balanced portfolio currently, he or she is likely not doing their job well. Stocks will almost certainly return less than their long-term 10% annualized average for the next decade or two given a starting Shiller PE over 30. The long-term average of the metric, after all, is under 17.

Another way of looking at how expensive the market has gotten recently is to look at sales of the S&P 500 constituents and relate it to share price. Companies are always manipulating items on income statements to arrive at a particular earnings number. Recently, record numbers of companies have supported net income numbers with non-GAAP metrics. That can be legitimate sometimes. For example, depreciation on real estate is rarely commensurate with reality. But it can also be nefarious, as Vitaliy Katsenelson recently argued in criticizing Jack Welch’s stewardship of General Electric, which Katsenelson characterized as being more interested in beating quarterly earnings estimates rather than in creating long-term wealth. And that’s why sales metrics can be useful. They are less easily manipulated.

So I created a chart showing sales per share growth and price per share growth of the S&P 500 dating back to the end of 2008. From the beginning of 2009 through the end of 2016, companies in the index grew profits per share by nearly 4% annualized, a perfectly respectable number for a mature economy. But price per share grew by a whopping 14.5% over that time. Over that 8 year period, sales grew less than 50% cumulatively, while share prices tripled.

Anyone invested in stocks should worry about this chart. How do share prices get so divorced from underlying corporate sales? One likely answer is low interest rates. But there must be other reasons because we’ve had low interest rates and low stock prices before – namely in the 1940s. That was after the Great Depression, and stocks were still likely viewed as suspect investments. Today, by contrast, stocks are not viewed with much suspicion, despite the technology bubble peaking in 2000 and the housing bubble in 2008. Investors still believe in stocks as an asset class.

And yet, the decline in rates over the past four decades has been breathtaking, as has Federal Reserve intervention. James Montier of Boston asset manager, Grantham, Mayo, van Otterloo (GMO), has studied stock price movements over the past few decades and found that a significant percentage of upward price movements have occurred on or before Federal Open Market Committee (FOMC) days. Montier estimated that 25% of the market’s return since 1984 has resulted from movements around FOMC days. Moreover, the market has moved higher regardless of what the FOMC decision was.

If this is a stock market bubble – and the data shows unusually high prices relative to sales and earnings – it is a strange one. One doesn’t hear the anecdotal evidence of excitement – i.e., cab driver’s talking about their latest stock purchases, etc…. This is perhaps a kind of dour bubble, where asset ownership at any price seems prudent in an economy that is becoming less and less hospitable to ordinary workers. Or, as Montier wrote in a more recent paper, this may be a “cynical” bubble where investors know that shares are overpriced, but think they can be the first ones out when the inevitable decline begins.