Systematic Relative Strength

A very interesting tidbit from an article on retirement distributions in Financial Planning:

To find out, he [financial planner Jim Shambo] looked at inflation calculations by the Bureau of Labor Statistics and found something interesting: Inflation tends to strike retirees harder than preretirees. Most notably, health care costs are rising faster than the inflation rate.

Beyond that, the CPI calculation factors out cost increases that are attributable to improvements in the goods and services you purchase. A car may cost 4% more this year than last, but if there are new fancy electronics in the standard model, the government may decide that inflation only counts for a half-percent of the increase. Of course, if you buy the car, you still have to pay the full higher cost. Add it all up, and people aged 65 to 74 appear to be experiencing an inflation rate that is a remarkable 1.11 percentage points a year higher than CPI, and this grows to 2.09 percentage points (a year!) when retirees get past age 75.

That’s rather remarkable.  The rule of thumb that you should be able to retire on 70% of your working income appears to have a big hole in it.  Inflation is even worse for retirees than we thought.

Somnath Basu has a very interesting article in Financial Advisor magazine about the demographics of the baby boomer retirement market.  This is something that every advisor needs to pay attention to.  He pulls together a lot of good data from EBRI and BLS, and also has a few conclusions like this one:

For retirement savings data, we turn to Employee Benefits Research Institute (EBRI) reports. For 2010, EBRI data shows that people over 60 employed for 30 or more years had about $200,000 in their 401(k) accounts, while people in their 50s are poised to retire with similar account balances. Even if we didn’t take living costs into account, it is obvious that these amounts are inadequate, even for two-income families. Moreover, the time required to undo such gross errors is running out.

When I look at quotes for even a joint life annuity, $200,000 generates only about $950-1000 per month—clearly not enough to live on.  Must reading for advisors.  Save until it hurts.

With more and more investors now responsible for their own retirements through their 401k plans, advisors have one more thing to worry about.  At many firms, advisors are not able to handle the 401k plan directly, but clients still ask for advice and information.  One of the most important pieces of information is how much to save.  From the Washington Post:

At the core of any reform, Munnell said, there has to be massive education of employees on how to plan for retirement. Many people think that saving 6 percent with a 3 percent match, for example, is enough. Not so, according to the Center for Retirement Research.

As a baseline, the group estimates that a household earning at least $50,000 needs roughly 80 percent of its earnings to maintain its pre-retirement lifestyle.

To pull that off, a person who is 25 and earns $43,000 needs to be saving 15 percent a year in order to retire at 65, assuming a 4 percent rate of return on his investments. Wait until 35 to start saving, and the necessary savings rate creeps up to 24 percent.

The solution for many people, Munnell said, will be to work longer. If that 25-year-old doesn’t retire until 70, he would only have to save 7 percent a year.

When you do the math, that 15% savings rate comes up a lot.  If your investments do really well, it might turn out that you saved too much.  But under a lot of scenarios, especially adverse ones, a 15% savings rate will often bail you out.  Advisors can have a huge impact in getting their clients to save.

The alternative of having to go back to work at an advanced age because your savings were inadequate is not very appetizing.  (And let’s face it: if you’ve been in the business for 25 years or more like I have, you’ve seen this happen to clients who were unwilling to save.)  If it’s a question of living too well in retirement—well, that’s something most clients will not lose sleep over.

I harp on savings a lot.  It’s really important in building a portfolio.  After all, if you don’t save, there is no portfolio to manage in the first place.  Mike Patton had a very good article at AdvisorOne demonstrating exactly how important savings is.  Here was his test: he assumed that an investor would make an annual contribution of $10,000 to an investment account each year for 20 years.  That pool of money would compound at rates ranging from 5-10% per year.  Then he stripped out how much of the return was from investment performance and how much of the return was just from the savings.  The results are eye-opening, to say the least.  The percentage number shown is the percentage of the return coming from investment performance.  Here’s the table from his article:

You Need to Save to Grow!

Source: AdvisorOne    (click to image to enlarge)

In true miracle-of-compounding fashion, investment performance only starts to overwhelm savings in the out years!  All of the years where investment performance are more than 50% of the return are in red, and even when the assets are compounding at 10% annually, it takes more than a decade before investment performance outstrips savings.

Clearly, in the early phases of capital accumulation, savings is much more important than investment performance.  Instead of worrying about investment recommendations, you can best help the client by keeping them focused on making regular account contributions.  When the regular contributions become small relative to the overall account size, investment performance will tend to be the main driver of growth.

Investment management is most important for clients who have already acquired critical mass; saving is most important for clients trying to get there.

From an article at AdvisorOne, a reminder about the situation for the under-35 crowd:

Workers under the age of 35, the generation most likely to depend almost solely on defined-contribution plans rather than the typical Social Security-savings-pension three-legged model, need to be diligent if they expect to save enough for retirement, a report released in October by Northern Trust found.

“Sponsors have to engage younger workers to save, save a lot, and to continue saving,” Lee Freitag, product manager of defined contribution solutions for Northern Trust, told AdvisorOne on Monday.

Yep.  Save ’til it hurts.  No investment advisor can help you grow your money if you haven’t saved any.

…isn’t really magic.  Christine Benz of Morningstar discusses the assumptions behind it in this useful article.  Plot spoiler: she advocates the bucket approach for retirement income.

From the Washington Post, an article about older Americans in the workforce:

Though the recession has thinned the ranks of other generations in the workforce, more people older than 55 are employed than ever before, according to the latest figures from the Bureau of Labor Statistics.

The reasons for the surge of older workers are complex, experts said, but one of the primary economic forces behind it is the growing fear among older Americans that they lack the means to support their retirement needs.

The phenomenon is closely linked to the broad shift in the United States that began in the ’80s away from reliance on company pensions toward the adoption of 401(k) plans and other personal savings.

“Fear is a wonderful motivator,” said Alicia Munnell, director of the Center for Retirement Research at Boston College. “Some of these people are just clinging by their fingernails to jobs.”

Fear is a wonderful motivator?  It’s horrible that people have relied on cultural guidance to spend, instead of the guidance of a qualified financial advisor to save and invest.  As the article mentions, many people are still working only because they have not saved enough, whether in their 401k or in their personal accounts.

If you are a financial advisor, here is a way for you to have a huge positive impact on the lives of your clients–become their savings and investment coach and you will never lack for business.

Saving the New Year is the title of Megan McArdle’s excellent article on saving.

If your neighbors aren’t saving much (and trust me, they aren’t), that means a less productive economy in the future–and more people trying to claim a very limited supply of public funds. You don’t want to be among them.

The whole article will make you think twice about the legitimacy of your rationalizations for failing to adequately save.

Alicia Munnell, writing in Smart Money, discusses the retirement preparedness of the Baby Boom generation.  The highlights:

…while the boomers have been accumulating wealth at much the same pace as their parents, the world has changed in four important ways.

1) The prevalence of defined benefit pension plans has declined dramatically over the last 25 years.

2) Real interest rates have fallen significantly, so a given amount of wealth will now produce less retirement income.

3) Life expectancy has increased, so accumulated assets must support a longer period of retirement.

4) Health care costs have risen substantially and show signs of further increase, indicating a need for greater accumulation of retirement assets.

So, yeah, it’s somewhat discouraging to think that you will have to save even more since the onus of retirement has now been put entirely on your shoulders.  It just points out the need to find a competent advisor early and get cracking.  It might make a good resolution for the New Year.

I’ve been meaning to post on this book for a while, but this morning’s report on the consumer savings rate falling back to the lowest level since December 2007, got me off the dime.

Thomas Stanley’s book Stop Acting Rich…And Start Living Like A Real Millionaire offers some fascinating data on the behaviors of millionaires. The great thing about his book is that the conclusions made are all data-driven (Dr. Stanley has spent decades intensively studying the affluent in America).

I suspect that many would be very surprised by the following points made in his book:

• More than two-thirds of those who are country club members are not millionaires.
• Real millionaires pay about $16 (tip included) for a haircut.
• The median price paid for motor vehicles among millionaires surveyed was $31,367.
• 70% of millionaires in America have never owned a boat or a yacht or even a raft.
• 64% of millionaires did not own a second home.
• Most millionaires do not live in homes that have a market value of $1 million or more.  About 90 percent live in homes valued at under $1 million.
• The majority of millionaires report that their spouse is more frugal than their frugal husband (in the case where the males were the bread winners).
• Only 7 percent of millionaires own a bottle of wine that costs more than $100.
• 67 percent of millionaires own wine that costs somewhere in the range of $10-$25.
• Millionaires usually pay $19.59 (median) for the dinner that they order at their favorite restaurant.
• Toyota make of automobile was found to be the number one in market share among millionaires (10.9 percent).

The reality is that it is ultimately those individuals that embrace a frugal lifestyle who are able to enjoy a life of financial independence.  As discussed in Dr. Stanley’s book, the affluent understand that what brings happiness in life is not the watch on your wrist, but life activities, relationships, the peace of mind associated with financial independence, and the ability to donate to charitable causes.

Finally, I did enjoy the following quote from his book (a philosophy taken at face value by so many…)

Anyone who lives within their means suffers from a lack of imagination. –Oscar Wilde

Robert Powell of MarketWatch writes about a critical, but very sensitive topic in his article “Our Financial Smarts Erode Quickly After Age 60.”

Regardless of gender or education level, Americans become considerably less literate about all things money after age 60, according to a new study.

The scores on a test measuring knowledge of investments, insurance, credit and money basics fell about 2% each year starting after age 60, falling from about 59% correct — hardly a passing grade — for those in their 60s to a dismal 30% for those 80 and older, according to Michael Finke, an associate professor at Texas Tech University and a co-author of the study.

Here’s what’s even worse: Our confidence in our financial decision-making abilities rises with age. We are not older and wiser. Rather, we are older, less smart and overconfident.

This notion of confidence rising while financial literacy is falling spells trouble for that group of Americans that now represents more than 12% of the population and controls half of all the financial wealth in America, according to Finke, who is also head of Texas Tech University’s Ph.D. in financial-planning program.

Obviously, there are noteworthy exceptions to this tendency.  In fact, it is likely that each of us could immediately think of a number of people who seem to defy this trend.  However, it would be unwise to disregard these results.  The very population with the bulk of the financial wealth in this country is also the population that can benefit most from good financial advice and money management.

Can a retirement portfolio sustain 4% withdrawals in retirement?  That’s the generally accepted rule of thumb, but Dr. Wade Pfau, writing in the Journal of Financial Planning, points out some of the complications in that theory.

Bottom line: current valuations might have a big impact on the withdrawal rates, since what happens early in retirement is much more critical than what happens after a portfolio has had an opportunity to grow for many years.

Dr. Pfau’s findings dovetail nicely with work from James Garland.  I do think that it’s useful to consider withdrawals in a relative sense.  From an earlier article here at Systematic Relative Strength:

Sustainable spending is a tricky concept.  Dozens of studies have been performed on historical data that suggest that the proper spending rate is 3 to 5%.  A lot of endowments use 4%, for example.  In reality, I think the sustainable spending level depends quite heavily on financial conditions at the time.  A stock market with a 6% dividend yield is going to support more spending than a market yielding 3%.  In other words, I tilt toward a relative calculation first developed by James Garland.  He shows that you can generally spend more than just your dividend and interest income, but far less than your total earnings yield.  His rule of thumb is that sustainable spending is about 130% of the yield on the major stock indexes.  (You can use this link to find the current dividend yield on the major stock indexes.)

Recommended reading for all advisors with clients hoping to retire!

Michael Lewis concluded his recent Vanity Fair article “California and Bust” with the following:

When people pile up debts they will find difficult and perhaps even impossible to repay, they are saying several things at once. They are obviously saying that they want more than they can immediately afford. They are saying, less obviously, that their pres­ent wants are so important that, to satisfy them, it is worth some future difficulty. But in making that bargain they are implying that, when the future difficulty arrives, they’ll figure it out. They don’t always do that. But you can never rule out the possibility that they will. As idiotic as optimism can sometimes seem, it has a weird habit of paying off.

His whole article is a fascinating read about the factors that have led California  to its present level of over-indebtedness.  The article is also great food for thought about the timeless topic of current vs. future consumption and prudent financial planning on both the government and individual levels.  Great articles, such as this one by Michael Lewis, have the power to change behavior by all those open to avoiding the unpleasant realities of an underfunded retirement because they allow the reader to visualize the end-game (see the part of the article on Vellejo, CA).

At Marketwatch, columnist Robert Powell has some commentary on a recent article by Dan Ariely about asset allocation and retirement expectations.  For me, one of the interesting things was the way in which Mr. Ariely quantified retiree expectations:

But according to research conducted by Dan Ariely, people need 135% of their final income to live the way they want in retirement. The reason for this astounding difference has to do largely with the way Ariely, a professor of economics and behavioral finance at Duke University, did his research.

Instead of asking people to ballpark how much of their final salary they will need, he asked the following questions: How do you want to live in retirement? Where do you want to live? What activities do you want to engage in? And similar questions geared to assess the quality of life that people expect in retirement.

Ariely then took the answers and “itemized them, pricing out their retirement based on the things that people said they’d want to do and have in their retirement.” Using those calculations, he found that people want to retire to a standard of living beyond what they currently enjoy. (Who wouldn’t if money were no object?) Read Ariely’s blog post on the topic here.

When retirees’ desires were actually priced out, they clearly desired to have their standard of living increase!  It takes a lot of capital to do that, capital that most retirees do not have.  The old rule of thumb was that retirees needed 70% of their working income to retire.  But no one knows who came up with that number or how they ballparked it!

Having spoken with many advisors over the years about this topic, my experience suggests that a more realistic estimate is that clients are comfortable when they have closer to 100% of their working income when they retire.  Some expenses do go down, but other expenses, particularly travel and healthcare, tend to go up.

In some cases, when expenses go down, it’s not voluntary!  Expenses go down because they have to—the retiree simply does not have enough income and is forced to cut back.

The retirement predicament really cries out for advisors to get to their clients early, get them started on a savings plan, and stay very focused on their investment performance throughout their working careers.  It’s going to be tough to meet goals otherwise.  The best time to get started is when you take your first job.  The second-best time to get started is today!

Moshe Milevsky, a professor at York University in Canada, has written a lot of articles discussing lifetime income.  He is an advocate of annuities, although that is a somewhat controversial position in the industry.  (Some argue that the default risk of the insurance company itself is somewhat of a wild card.  Hello, AIG.)  He discusses annuities in this article from Advisor One too, but what struck me most was just the raw cost of retirement income.

If you are retiring at the age of 65 and would like a $1,000 monthly income stream until life expectancy, which is age 84.2 — after which, I presume, you plan to shoot yourself — and this money is invested at a real rate of 1.5%, then you need a nest egg of a little over $200,000 at retirement. So says the math.

….

Now I deliberately selected 1.5% as the investment return in the above paragraph, since it is the best rate you can actually guarantee in today’s environment on an after-inflation basis. Note that in late July 2011, long-term inflation-linked (government) bonds are yielding 1.5%. We all might believe this is artificially low, but it is the best you can get if you want something that is guaranteed. The mighty bond market speaks.

Of course, if you worry about events that have probabilities smaller than 50% — like living beyond life expectancy — and you plan your retirement to the 75th percentile, which is age 90, then you need a retirement nest egg of approximately $251,000. This will generate the $1,000 monthly income for the extra six years. Stated differently, the present value of $1,000 per month until the age of 90 is $251,000 when discounted at 1.5%. And, if you worry about events with probabilities smaller than 25% and you plan to the 95th percentile of the mortality table, which is age 97, then you need a nest egg of $306,000 to generate the $1,000 of monthly income. Big numbers. Low rates.

He includes a table of returns in his article, but anyway you cut it, $250-300,000 to generate only $1000 of monthly income is a lot!  Many retirees are planning—or maybe “hoping” is the appropriate word—to retire with the same level of income as they are currently earning.

Many retirees would be delighted to get $6000 per month in income, but turn green when they realize they will need a minimum portfolio size of $1.5 million.  One of the big risks this can create, according to Mr. Milevsky, is a thinking error, often perpetuated by some retirement planning software:

Assuming a more aggressive portfolio, in the hopes that you can move to the upper right-hand corner of the table — and hence require a smaller nest egg for retirement — is a mirage. You can’t tweak expected return (a.k.a. asset allocations) assumptions until you get the numbers that you like.

Boosting your expected return by adjusting your asset allocation must also consider the possibility that you won’t achieve your expected return!  After all, there is no guarantee of results in any market.

The safest and best way to avoid a retirement shortfall is simply to save more, save longer, and invest better.  If your assumptions are conservative and your investment results are favorable, you might end up with extra capital.  That’s a high-class problem to have.  If your assumptions are too aggressive, you’ll end up like all of the public and corporate defined benefit plans: under-funded.  The further you are away from collecting Social Security, the less likely it is you’ll see all of it, so you can’t count on that to bail you out.

It’s time to roll up your sleeves and start saving.

Meal Planning for the Bad Saver