Saturday, June 28, 2014

Great Expectations?

How do rates of return affect your plans for retirement or for your child’s education?

As you build towards a long term savings goal it is necessary to guess at the rate of return in order to determine how much you will need to reach your goal. 8% is the traditional rate of return projected by the major pension funds operated by corporations and state governments. Because the actual rate of return has been considerably less than 8% over the last 15 years, some of the pension funds in states like Illinois, New York, California, and Rhode Island are essentially bankrupt. These entities are managed by some of the smartest people in the world. They are swinging deals that run in multiples of $10 Million giving them an economy of scale far larger than the individual investor hope to expect. If they can’t get 8%, do you think that is a reasonable rate of return?

But let’s start at 8%. In all the following examples we will use a couple with a joint gross income of $100,000 a year who consistently saved the recommended 15% in tax preferred retirement accounts such as 401(k) accounts and Roth IRAs over the course of 30 years. Since dividends are typically paid on a quarterly basis, we will compound the interest rate on a quarterly basis.

At 8% that would leave them with a balance of $1,843,131.57 or a lifetime annual retirement income of $73,725 indexed to inflation using the recommended 4% draw.

Assuming Social Security still exists, they will enjoy a comfortable retirement. They will actually be replacing more than 100% of their preretirement income since they were living on 85% of their income during their working years. Can you say, “This year we will be exploring the Greek islands on the luxury cruise ship, Athena.”

If 8% is unrealistic how about 7%, Siegel’s constant for return on equities?

That will give them a balance of $1,512,858.91 or a lifetime annual retirement income of $60,514 indexed to inflation.

In a recent report Richard Young is projecting a 4% return based on a more realistic projection of 5.5% return on stocks and 2.5% return on bonds in a traditional age appropriate balanced portfolio.

That will give our couple $865,517.51 at the end of 30 years or a lifetime annual retirement income of $34,620. Looks like they better put off retirement for a few more years. At 40 years instead of 30 years the number increases to a more realistic $1,472,571.26 or a lifetime annual retirement income of $58,902 indexed to inflation.

John Hussman, the successful manager of a family of funds that bear his name, would consider Richard Young an optimist. Every few months he revises his predictions using proprietary methods that have a very good track record. Currently he is looking at a 1.9% return over the next ten years! What does 2% over 40 years look like? Answer, $917,358.70 or a lifetime annual retirement income of $36,694 indexed to inflation. I guess this couple better be prepared to work until they are dead or live like paupers for the next 40 years.

Don’t despair. Siegel’s constant is based on two centuries of data (1803-2003). Americans have muddled their way through a lot of serious problems with only one really disastrous failure, the Civil War.

However, let me end with this warning quoted from the classic study of Modern Portfolio theory entitled, A Random Walk Down Wall Street:

Investors should also never forget the age old maxim, “If something is too good to be true, it is too good to be true.” Heeding this maxim could have saved investors from falling prey to the largest Ponzi scheme ever: The Bernard L. Maddoff fraud uncovered in 2008 in which $50 Billion was said to have been lost. The real con in the Madoff affair is that people fell for the myth that Madoff could consistently earn between 10 and 12 percent per year for investors in his fund.

The “genius” of the fraud was that Madoff offered what seemed to be a modest and safe return. Had he offered a 50 percent return, people might well have been skeptical of such pie in the sky promises. But consistent returns of 10 to 12 percent per year seemed well with the realm of possibility. In fact, however, earning such returns year after year in the stock market (or any other market) is not remotely possible, and such claims should have been a dead giveaway. The U.S. stock market may have averaged over 9 percent a year over long periods of time, but only with tremendous volatility, including years when investors have lost as much as 40 percent of their capital. The only way Madoff could report such a performance was by cooking the books.

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