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Estimating your retirement nest egg

For most Americans, retirement planning is ultimately focused on accumulating a “nest egg” of savings and investments to generate enough income to pay for a comfortable lifestyle.

To find out how large a nest egg you will need you must first estimate your “retirement income gap”. This is the difference between how much you’ll need each year to enjoy the lifestyle that you want and the amount of income that you expect to receive from sources including Social Security, employer pensions and part-time work. This gap will need to be filled from your personal savings and investments.

For example, using today’s dollars, let’s say you plan to retire at age 66 and determine you need $75,000 per year (before taxes) to enjoy a comfortable retirement. If you only receive $25,000 in income from Social Security, your investment portfolio will have to generate $50,000 every year after inflation for as long as you live. Using Social Security as the only income source simplifies the calculation because the benefits are automatically adjusted each year for inflation.

So how large a portfolio is necessary to generate $50,000 annually in inflation-adjusted dollars for as long as you live? Since running out of money is the number one concern for most retirees, much attention has been focused on this subject. The research has been directed specifically toward determining a “sustainable portfolio withdrawal rate”. This is the maximum amount that can be withdrawn from your retirement assets each year with reasonable confidence that the portfolio will provide a lasting income. Once you arrive at a withdrawal rate you are comfortable with, you can estimate the size of the portfolio required.

In 1994, Bill Bengen (a California financial planner) conducted a seminal study. His research suggested that based upon historical (1926-1975) inflation rates and investment returns, a retiree’s portfolio consisting of approximately 60 percent stocks and 40 percent bonds should, with a reasonably high probability, last for approximately 30 years. This was possible if an investor initially withdrew no more than 4 percent of the portfolio balance, and continued withdrawing that same inflation-adjusted dollar amount each year. Using this 4 percent guideline, if you determined that your retirement income gap was $50,000, you would need a portfolio of approximately $1,250,000 ($50,000 divided by .04) at the beginning of your retirement to fill that gap.

A caveat is in order here. While the 4 percent guideline can provide future retirees a target to shoot for, it is dependent upon several variables that differ from person to person and are impossible to predict with any accuracy. The best you can do is to make reasonable and conservative assumptions regarding how long you plan to live in retirement, what investment returns you expect to earn from your portfolio during retirement and what you expect inflation to be.

For those who want a high degree of confidence that they will not run out of money, it makes sense to be conservative about your future assumptions. Therefore, if you expect retirement to last longer than 30 years, or project future investment returns to be lower than historical returns, or anticipate future inflation to be higher than historical inflation, you should reduce your portfolio withdrawal rate below 4 percent. This means you will need a larger portfolio at retirement. Remember, the higher the withdrawal rate, the greater the chance the portfolio will not last as long as you need it to.

Striking the right balance with asset allocation

Harry Markowitz, Nobel laureate in economics and a pioneer in investment theory suggested that a fundamental responsibility of any investor is to manage the risk of their portfolio. The risk he was referring to is volatility: the ups and downs of stock prices during the year and from year to year. Investors who ignore risk in pursuit of returns expose themselves to intolerable portfolio declines prompting them to abandon their plan thereby converting temporary losses into permanent ones. Conversely, those who choose to minimize or avoid volatility entirely must be willing to accept returns that may prove insufficient to fund their future goals.

The world’s capital markets are comprised of different asset classes each with their own risk and return characteristics. The three major categories are stocks, bonds and cash. A portfolio’s distribution across asset classes refers to its asset allocation. Sophisticated investors have known for decades that asset allocation is the most significant determinant of a portfolio’s performance. Landmark studies published in the 1980s and 1990s analyzed the returns of large institutional plans and confirmed the crucial role of asset allocation estimating that it explains more than 90% of a portfolio’s returns and volatility over time. The message for all investors is that asset allocation is far and away the most important part of designing a successful portfolio.

In general, stocks provide the growth engine for the portfolio. The higher the allocation to stocks the higher the expected investment returns and along with it the greater the volatility. Bonds, on the other hand, offer stability, but not much long-term growth potential especially after accounting for inflation.

The appropriate mix of stocks and bonds will strike a comfortable balance between growth and stability and reflect the individual investor’s financial goals and ability to handle risk. Investing is often framed as a choice between eating well as a result of high stock market returns and sleeping well from the stability that bonds provide. The implication is that investors must choose one or the other. Markowitz showed us that a sensible asset allocation allows us to do both.

Beware of “expert” financial advice – Part Two

In my last post, I talked about the newest book written by self-help coach Tony Robbins, “Money: Master The Game.” A portion of the book is dedicated to his human performance and achievement philosophy as it relates to financial success. In the next section of the book, he offers some useful information including common sense principles like spending less than you earn, starting a savings program early and allowing compound growth to work its magic.

It’s the last part of the book where Robbins offers specific investment advice that I would like to address. He makes reference to the investing “secrets” of the ultra wealthy and how they can be applied to even the smallest portfolios. Robbins also claims to be able to show the average person how to take minimal risk and still be able to reap big rewards. To get what Robbins calls the “upside without the downside,” he proposes several investment vehicles, including structured notes, market-linked CDs, and fixed indexed annuities. Investors are likely to encounter these products in a variety of forms, each with different contract terms and conditions and potential risks. However, they will almost certainly share the following characteristics:

  1. Complexity. This means they are good for the seller but bad for the buyer. David Swensen, the head of Yale’s endowment fund sums it up by saying “As a general rule, the more complexity that exists in a Wall Street creation, the faster and farther investors should run.”
  2. The subject of numerous investor alerts and bulletins from concerned federal and state regulators.
  3. Marketed aggressively by investment firms and their sales representatives when markets are down and investor anxiety is high.
  4. Loaded with commissions and fees that investors will pay for in one form or another. This compensation structure can lead to sales practice abuses.
  5. Almost universally misunderstood. If everyone applied the basic rule of investing “If you don’t understand it don’t invest in it”, sales of these products would go to zero.

The simple fact is, in most cases, an intelligently constructed portfolio of broadly diversified, low-cost funds will provide investors a superior solution at a fraction of the cost.

Robbins does deliver a portfolio allocation recommended to him by his friend, billionaire hedge fund manager, Ray Dalio. Robbins calls it the “invincible, unsinkable, unconquerable, all-seasons strategy” because of its ability to “perform well in good times and bad – across all economic environments.” The portfolio consists of 30% stocks, 55% bonds and 15% in commodities and gold. Although investors could do worse, there are a few reasons why they should be wary about modeling that approach.

First, every investor’s personal and financial situation is different as is their emotional and financial ability to handle the downturns in the markets. A 55% allocation to bonds will be right for one person and not for another.

Second, the author uses back testing, a process of applying historical returns to a hypothetical portfolio to support his case. This can show how the portfolio has performed but not how it will perform.

Third, this is a bond-heavy investment plan that benefited from a 30-year period during which the Fed drove down interest rates pushing up bond values. Since rates are near record lows, it’s very possible that the All-Seasons portfolio will not be as productive going forward as it was in the past.

Fourth, the recommended portfolio includes an allocation, albeit a small one to gold and commodities. Both of these assets are volatile, generate no dividends or interest, and have long-term expected returns equal to the inflation rate. Their benefits as portfolio diversifiers and inflation hedges are unpredictable at best and questionable at worst. They take up room in the portfolio that could be used to generate better long-term returns.

I recognize that it’s a lot easier to critique a book than to write one and I applaud anyone for attempting to tackle such an important and complicated topic like money and investing. However, I think that in trying to cover as much breadth as he did, Robbins may have undermined some of the many important and valid points he did make. Bottom line: like all personal finance-related literature targeted at consumers, the book should be read with a critical eye.