Investing for Retirement in Uncertain Times

We live in dangerous times. The governments of the world are fighting off major deflationary pressures generated by trillions in bad loans and valueless derivatives based on those loans by printing paper money and buying up mortgage bonds worth maybe twenty cents on the dollar at face value. The world’s economy is severely distorted. Asset bubbles like real estate bubbles in the United States, Ireland, Spain, and Australia grow and pop. Now interest rates on bonds, certificates of deposit, short term money market funds, and insured savings accounts are in the toilet. The market currently carries a Shiller PE Ratio of 24.45. Historically, 16 is considered about normal. Over 25 is considered evidence of a speculative bubble.

Current Shiller PE Ratio: 24.45 +0.04 (0.17%)

Shiller PE Ratio Data from 1881-May 21, 2013

Mean: 16.47
Median: 15.89
Min: 4.78 December 1920
Max: 44.20 December 1999

So how can we realistically plan for the future? If we can not predict a return of our investments, we can not decide how much to save for our future needs. It turns out there are some useful numbers that are remarkable constant over any “sufficiently” long period of time. The U.S. stock market has averaged 9 percent a year over long periods of time, but that is not a particularly useful number given the threat of inflation. Then there is that “sufficiently” long period of time problem. The stock market is subject of considerable volatility including years when investors have lost as much as 40 percent of their capital.

Jeremy Siegel, the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania, has discovered that since 1801 the U.S. stock market has delivered a remarkably consistent return of 6.5% to 7.0% after accounting for the effects of inflation. This number is widely accepted by the academic community and is now know as Siegel’s constant. Siegel has also discovered that bonds return 3.5% after inflation and short term money returns 2.9% after inflation. However these last two numbers do not correlate as closely to a linear model as the history for stocks.

This is pretty much what Warren Buffett is telling American investors. He projects an expected return of 6% to 7% on U.S. stocks in the foreseeable future. He bases this number on a projected increase in the Gross Domestic Product of about 3% and a rate of inflation of 2%. Evidently the sage of Omaha doesn’t believe the Federal Reserve can reignite the inflation of the 1970s with so much debt choking off growth in the world’s economy. He expects that increases in stock prices and dividends will give a return slightly below Siegel’s constant for the next few years. This seems reasonable given the current high valuation of equities.

Really, the more things change the more they remain the same. Investors still need some “safe” money in bonds and near cash assets. You may not earn enough to cover inflation now that the Federal Reserve and Treasury are relentless punishing risk adverse investments, but at least at the end of the term of the bond you do get your money back.

How much in bonds? As I frequently mention, the old rule of thumb was your age in bonds. Hence at age 60 that would be 60% in bonds and 40% in stocks. The new rule of thumb believes that number is too conservative given the risk of inflation. It would suggest at age 60 that an investor hold 55% in stocks and 45% in bonds and cash. I have seen some suggestions that would even bump up the amount held in stocks by another 5%, but this suggestion does not appear to be widely accepted or even widely discussed in the literature.

Even the young, who do not need to worry about the definition of a “sufficiently” long period of time, need to hold something in bonds and cash. When the market does experience a 40% crash, that reserve could give them a once in a lifetime opportunity to scoop up very valuable assets for pennies on the dollar. The older investor does need to worry about the definition of a “sufficiently” long period of time. His productive years are over. There will be no more savings generated by a job to continue to invest after a crash. His time horizon is generated by the actuarial tables. If a 60 year old man loses 50% of his net worth in a single year, it might take 30 years for the market to recover to returns predicted by Siegel’s constant. Such a “sufficiently” long period of time is of no interest to the older investor. I saw that happen to rich old people living at my parents’ retirement community and my mother in law’s senior high rise in 2008. They had too much money in the market, particularly shares in major money center banks. Now they are poor old people living with their children. As of our last visit to Atlanta in March there were still nearly 30 empty units in that senior high rise. Ten years ago there was a waiting list.

I am now on the other side of that problem. I am retired. How much can I safely draw without the fear of outliving my money? The latest numbers from the updated version of Cooley, Hubbard, and Walz’s seminal research published in 1998 as “Retirement Savings: Choosing a Withdrawal Rate that is Sustainable,” has been updated to 2009. These findings have been published in the April 2011 edition of the Journal of Financial Planning. This data now includes the crash of 2008. Once again the 4% rule is vindicated. That means if in the first year of retirement you withdrawal no more than 4% of your retirement savings and then every year thereafter you withdrawal the same amount adjusted for inflation or deflation it is very unlikely you will ever outlive your money.

Here are the rates of success for a 4% inflation adjusted draw for a portfolio of 50% Stocks for 55 thirty year periods beginning in 1926. These numbers indicate that there is only a 4% chance you will outlive your money in thirty years of retirement if you follow the 4% rule.

15 Years 100%
20 Years 100%
25 Years 100%
30 Years 96%

How about a portfolio consisting of 100% stocks with an 8% inflation adjusted draw? The numbers indicate approximately a one in four chance of outliving your money in 15 years. It’s a coin flip that I will outlive my money by year 25. I do not like those odds.

15 Years 76%
20 Years 63%
25 Years 52%
30 Years 42%

One more thing before you go, Please! Let’s be careful out there!