Tag Archives: Saving for Retirement

Retirement Savings Lessons From A Baseball Player’s Contract

(A previous version of this article appeared on MarketWatch on July 29, 2017.)

On July 1, the New York Mets sent a check to a former player, Bobby Bonilla, for $1.19 million. In fact, this past check was the eighth annual one the Mets have sent Bonilla, and they will send him 17 more, according to a deal they struck with their former player at the end of his career.

But Bonilla, a 55-year old retiree and former 3rd baseman/outfielder, hasn’t played a game of major league baseball since 2001. Why do the Mets still pay him? The reasons are instructive for anyone saving for retirement.

In 2000, the Mets released an aging and decreasingly productive Bonilla, while still owing him $5,9 million in salary. Bonilla and his savvy agent at the time, Dennis Gilbert, negotiated a deal whereby the Mets kept that $5.9 million for the next 10 years and then paid it out to Bonilla annually for the 25 years after that. In exchange, the Mets reportedly had to compound the amount of money they owed Bonilla by 8% annually for the next 35 years in total.

When we do the math, the 8% return checks out. If you compound $5.9 million for a decade at 8% annualized, you end up with $12.7 million. That comprises the “deferred period” of Bonilla’s deal when the Mets are investing Bonilla’s capital however they want, and hopefully generating a better-than-8% return without paying him anything. Then, after that deferred period, the math shows if the Mets continue to compound the $12.7 million at 8%, but also pay out $1.19 million of it to Bonilla every year, they pay out Bonilla completely after the 25th payment. That’s the “payout period” of Bonilla’s deal when the Mets continue to retain some of the capital, but also pay some of it out every year until Bonilla has all of it.

Lessons for Investors

Getting an annual payment for nearly $1.2 million is beyond possibility for most retirees, but there’s a lot people can learn from Bonilla’s deal. First, we are all Bobby Bonilla in that everyone who saves is deferring part of their paycheck to build a pile of assets they can live on in retirement. It’s true our former employer doesn’t necessarily hold our assets and guarantee a return on them. But if you’re saving for retirement in a 401(k) or some other vehicle , you’re doing the same thing Bonilla did with that $5.9 million the Mets owed him in the last year of his contract – you’re just doing it with less money over more pay periods. So keep saving and deferring money. You may not ever get to save and defer $5.9 million in one lump sum, but do what you can.

Second, don’t turn your nose up at 8%, but consider the source of the return and if there’s a guarantee. One of the things that encouraged the Mets to do this deal with Bonilla is that the Mets’ owners had some of their money “managed” by Bernie Madoff. They thought Madoff was producing 10%-12% annual returns, without down years, so it probably seemed like a no-brainer to guarantee Bonilla 8%.

Of course, we now know Madoff was a fraud. The lesson here is don’t believe an investment strategy can deliver 10%-12% on an annualized basis without declines. It’s true that the stock market has delivered around 10% annualized for the last century – though not at all for every 10- or 20-year period – but it has delivered that average annual return with a lot of volatility, including many gut-wrenching down years. It wasn’t Madoff’s returns that were so spectacular; it was their consistency. His Sharpe and Sortino Ratios (measures of volatility-adjusted return) were the clues to the fraud more than the annualized returns themselves.

On the other hand, if a healthy business or an insurance company contractually guarantees you an 8% return, chances are that’s a great deal. While the Mets should have been suspicious of Madoff, Bonilla was correct to take an 8% return on his capital from the Mets. Yes, he gave up some liquidity, but the Mets are obligated to pay Bonilla by a contract or in a way a stock investment or other investment strategy isn’t. That doesn’t mean an enterprise like the New York Mets can’t fail, but a guaranteed payment from a healthy enterprise is safer than counting on an 8% annualized stock market return or than counting on a high single digit payment from, say, a triple-C rated bond.

Additionally, although a Mets bankruptcy could be a blow to Bonilla, depending on where his payments rank relative to other team obligations, it’s likely that he has saved some of his other career earnings. The $5.9 million deferred payment that turned into this annual windfall for him in retirement only represents one year’s worth of income, and Bonilla had a 15-year career. Unless he squandered all of his other earnings, a Mets failure likely wouldn’t sink Bonilla in retirement.  In other words, all of Bonilla’s fortunes probably aren’t tied to the Mets’ financial success. He’s probably diversified his assets, and so should you.

Another lesson is to consider stock market valuation. When Bonilla made his deal in 2000, the stock market was roaring as the prices of technology stocks reached the stratosphere. But it was also very expensive so that it couldn’t keep up those returns. Bonilla and his agent seemed to know what others discovered, or rediscovered only after the technology meltdown – that 20% or greater annualized returns are unrealistic and that an 8% guaranteed annualized return from a solvent institution is great. I’ve never read interviews with Bonilla and Gilbert discussing this, but, judging from the deal they made, they didn’t think the world had entered a “new paradigm,” where 8% was a paltry return. You should be skeptical of new paradigms too.

Incidentally, if Bonilla had invested his money in the S&P 500 Index or in the Vanguard Balanced Index Fund, he would have underperformed what the Mets paid on his capital for the deferred period (2001-2010) by a 7 and 4 percentage points, respectively. I don’t know if Bonilla and Gilbert were looking at standard stock market valuation metrics, but when the Shiller PE hit 44 in 1999, it was a decent bet that stocks would do poorly for the next decade. So considering valuation can be useful for forecasting future returns, especially if valuations are at an extreme.

Last, inflation could hurt Bonilla. Anytime you make a deal for a fixed rate of return you are subjecting yourself to inflation risk. Fortunately, inflation is running at a low rate these days (in the 2% range), making Bonilla’s 8% an inflation-smashing return. It might not always be that way until 2035 though, so Bonilla might want to buy some real estate and gain some exposure to emerging markets stocks and commodities with some of that July 1 check every year. No publicly traded assets are screamingly cheap right now though, so building up another healthy pile of cash wouldn’t hurt him either.

Dump Your Stocks; Get A Financial Plan Instead

If you own an individual stock, can you say how much revenue its underlying business realized last year? Can you say what its operating margin was? Can you say what its earnings-per-share were? Can you compare those three metrics from last year to the past five years?  And if you don’t know any of these metrics, should you really own the stock?

Lately I’ve met with investors – if you can call them that — who own individual stocks, but can’t answer any of these questions about the stocks they own. They know something about how the stock has performed, but they know almost nothing about the underlying business. Perhaps they know the industry the business is in because they work in that industry or because they are otherwise enamored of the business – Tesla and electric cars! — but they don’t know how a lot of the revenue is generated, what might sustain it, what might threaten it, etc… Being enamored of a business or industry doesn’t mean you understand it. And just because a business or an industry is new doesn’t mean you have a good way to judge how profitable it will be. Airline travel has changed people’s live, but up until recently, when a few major carriers decided to divvy up routes and keep competition at bay, the airline industry has burnt through an astounding amount of capital.

Keep the technicals in their place

Buying a stock without understanding the underlying business is one of the dangers of emphasizing 200-day moving price averages and other technical metrics. The academic evidence is in, and momentum is a legitimate “factor” that drives stock prices. But over-emphasizing technical statistics or stock price movements runs the risk of directing investors’ attention away from the performance of the underlying business. Technical statistics are very democratic – can we call them populist? — because they flatter everyone with a computer screen who can look at a stock price chart. The truth is they render owners of stocks into something other than investors because investors must be concerned with a stock’s underlying business at least as much as the stock.

Have you heard the phrase “the stock is not the business”? Well, ultimately, it is, and you will get destroyed if you don’t realize that. Just ask former Enron shareholders. An ironic thing about those who doubt the validity of the “fundamentals” of a business is that they don’t dispute why the stock of a bankrupt company is worthless. Nobody disagrees that if a company is bankrupt, the stock price should reflect the status of the underlying business. So why do they dispute that the price must relate to the business in every other circumstance but bankruptcy?

Some might say that technical analysis would have gotten you out of Enron before it went to zero. But a good fundamental analyst realizing that it was impossible to understand how Enron made money – that it was impossible to answer the fundamental question about Enron’s business (or the fact that Enron wasn’t a legitimate business) — would have avoided it altogether.

You’re up against stiff odds

If technicals distract you from the underlying business, studying the underlying business pits you against the best fundamental analysts.

Knowing the business doesn’t only mean knowing — without needing to consult the financial statements, because you’ve studied them already — what revenues, operating margins and earnings-per-share are. Far from it. Knowing the business also mean knowing what a company sells to achieve its revenues and earnings, and what the competitive threats are to those products and services. Do other companies sell the same kind of good or service? What makes the things your company sells better? Or what makes the stock underpriced based on the quality of its products and the future prospects for sales and earnings? Knowing the business also means understanding the financial health of the business. If it has debt, can it cover its interest payments comfortably?

If you own a stock, you are competing against investors who are studying financial statements and trying to assess the prospects of the underlying business as their full-time jobs. Warren Buffett reads 500 pages of financial statements everyday. You can score some trading victories without knowing anything about a stock’s underlying business, and, yes, sometimes analysts know so many details about the underlying business that they lose sight of its two or three most important drivers when evaluating what it’s worth. But how long can that game of trading things you know nothing about go on? Can you really compete with this folks studying the underlying business full-time, if you’re operating on a part-time basis?

Every stock purchase is an act of arrogance, says hedge fund manager, Seth Klarman. When you make your purchase, you’re saying that you know more than the market about what the stock is worth. You’re saying you know more than others whose study of the underlying business is their full-time job. If you’re an ordinary retail investor, why should you be able to compete with such people? The fact is, you shouldn’t, and your arrogance in making the purchase is almost certainly unwarranted.

Get a financial plan

Instead of trying to pick individual stocks, go see a financial adviser and get a financial plan. Get yourself on the road to saving steadily for the important goals in life – retirement and sending your kids to college. See a financial planner who can help you put a budget in place so that you control spending and have some money to save every pay period. Figure out a plan that gets you saving periodically, allocates your assets in a way that won’t force you to sell when markets swoon, estimates future returns in a realistic way, and lets  you know when you might be able to retire and what retirement might look like financially. All of these things are much more important than wasting time thinking about individual stocks.

Don’t let trying to figure out which stock to buy, when to buy it, and when to sell it, get in the way of the steady business of saving money for your long term goals. If you’re finished spinning your wheels trying to pick individual stocks, and you’re ready to see an adviser, click this link.

Is Your Target-Date Fund Too Risky?

If you’re planning to retire in or around 2020, and you have most or all of your assets in a target date fund, is that fund too risky? It might be given current stock market valuations.

I recently published an article on how various allocations served a hypothetical investor retiring in 2000. Any backtest begun that year would admittedly be unflattering to stock exposure, but retirees must think in worst-case scenarios because they are at risk of running out of money. And stocks may not be much cheaper now than they were in 2000.

In that article, I used the following chart to show how each hypothetical portfolio performed using the so-called 4% retirement rule, whereby the retiree withdraws 4% from his account in the first year of retirement, and boosts whatever the dollar value of that initial withdrawal by 4% each year thereafter.

It turned out that a pure stock portfolio couldn’t withstand the 4% rule given the amount of declines in two bear markets – from 2000 through 2002 and in the 2008-early 2009 period. The original $500,000 would have declined to a little more than $100,000 in the 18 year period. A balanced portfolio did much better; it would be down to a little more than $400,000. A still more conservative portfolio – 30% stocks and 70% bonds – would have remained intact. In other words, the more bonds a portfolio had, the better it held up despite the fact that stocks outperformed bonds on a compounded annualized basis – 5.4% for stocks  versus 5.1% for bonds.

And now most 2020 retirement funds have more than 50% stock exposure, potentially setting up their investors for a bumpy ride and loss of capital. On our list of some of the largest funds with 2020 dates, only the American Funds offering and the JP Morgan entry have less than 50% stock exposure.

Stocks reached a Shiller PE (price relative to the past decade’s average real earnings) of 44 in 1999, and they are at 32 now. The 44 reading seems far away, but, besides that extravagant reading during the technology bubble, the metric has been over 30 only one other time – in 1929.

Moreover, the median stock, on a variety of valuation metrics, is more expensive now than it was in 2000. For example, GMO’s James Montier recently showed that the median price/sales ratio is higher now than it has been in any other time in history. During the technology craze, small cap value stocks and REITs, for example, were left for dead, and investors prowling for cheap stocks could buy them, and wait. They wound up delivering boffo returns for the next decade. From 2000 through 2009, when the S&P 500 Index delivered no return, the Russell 2000 Value Index delivered an 8.3% annualized return to investors. But now there are arguably no cheap parts of the market.

Valuation metrics aren’t crash predictors; they don’t tell you a crash will occur next week, next month, or next year. But it’s reasonable to anticipate that the higher valuation metrics go, the more likely a significant decline or significant volatility become. And big declines hurt retires withdrawing from their accounts dramatically.

It’s also true that foreign stocks are cheaper, but they’re not that cheap. GMO’s most recent asset class return forecast shows no region of the world is poised to deliver inflation-beating returns. That means target date funds may be putting their client assets unnecessarily at risk. In 2013, Jack Bogle argued that target date funds were too heavily weighted in bonds, potentially crimping investor returns. With a Shiller PE above thirty and bond yields creeping up, the opposite might be the case now.

Financial planner and author Michael Kitces has shown that the Shiller PE works well as a financial planning tool, indicating what future returns stocks might deliver over intermediate time frames — around 8-18 years. Though a bit short on details, Kitces argues that the metric can help retirees facing sequence of return risk by encouraging them to adjust their spending. But it’s unclear why the metric can’t influence gentle portfolio modifications as well. When the Shiller PE is over 30, the likelihood of robust returns — or even returns that can beat bonds, despite low yields — is diminished after all. Nobody should ditch all their stock exposure; markets can always surprise investors. But retirees face such a harsh outcome if their portfolios suffer big declines during the first decade of retirement that modest stock exposure — even less than 50% stock exposure — appears the most prudent course. Unfortunately, judging from their allocations, target date funds may not be aware of the risk they’re imposing on their shareholders.

Target date funds are allocated based on investors’ distance from their spending goals. Even setting aside the difficulty of the retirement spending goal, which run over years and decades, distance from goal shouldn’t be the only consideration in answering the allocation question. Target date funds should also consider valuation and sensitivity to volatility.