Systematic Relative Strength

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.

Figuring out what you need to retire is not as simple as it seems. Calculating your “number” is as straightforward as punching a few numbers into a calculator, but understanding the context of the inputs and the output is more complicated. This article from Advisor Perspectives, by way of dshort.com, is the best discussion of retirement calculators I have seen.

After covering some of the issues with assumptions, Todd Tresidder summarizes with six rules for using retirement calculators:

Below are 6 rules for getting the most value of retirement calculators and not being deceived:

1. The Map Is Not The Territory: Never delude yourself into believing your retirement estimate is accurate. It is simply a calculated projection of the assumptions used. If any assumptions are incorrect the estimate will be similarly wrong.
2. Walk-forward Process: Don’t perform the retirement savings goal exercise once, put it on a shelf and forget it. Instead, check back every few years and see what assumptions proved valid and which ones did not. Adjust the assumptions, recalculate, and shift your plans accordingly. Rinse and repeat every few years. This way you will hit your retirement target like a rocket ship that constantly course corrects toward its target.
3. Errors Multiply: Small errors in estimates compound into large errors in results. Retirement savings are built and spent over multiple decades. A 2% error in inflation or investment return that is manageable over 5-10 years is a complete disaster when compounded over 30-40 years. Small details make big differences so pay close attention to the details.

In short, retirement calculators should not be used as commonly practiced. You should never take a guess at the required assumptions, create a fictitious number, and plan your financial future based on it. That is a dangerous mistake even though it’s exactly what most people do.

After years of working with clients as a retirement planning coach, certain techniques have emerged that are extremely valuable in providing viable workaround solutions to the impossible-to-make assumptions. You can plan your finances into the future with confidence and security when retirement calculators are used as follows:

4. Scenario Analysis: Use retirement calculators to test various retirement scenarios. For example, should you try to save your way to retirement with a traditional portfolio or pursue income-producing real estate as an alternative? Test both scenarios and see what the numbers indicate. How would a part-time hobby-business affect your retirement savings needs? What happens if you work 7 more years or convert your career into consulting for a phased retirement? Retirement calculators are fantastic tools for comparing the impact of various retirement planning scenarios. As you get creative applying various scenarios it usually becomes readily apparent what will work for your situation.
5. Teach Principles: Retirement calculators are invaluable for teaching essential retirement planning principles. Users quickly grasp how real return net of inflation is the only number that matters after just a few quick scenario tests. They also see the importance of time in compounding their way to wealth versus trying to save their way to wealth. They understand how much they must save to support $1,000 per month in spending. Without a calculator these concepts are difficult to grasp, but with a calculator they become obvious for even a layman. Each lesson learned will affect how you plan your retirement.
6. Confidence Interval: Since you can’t possibly estimate all the assumptions with accuracy, the next best thing is to use a range of plausible assumptions. Simulate one extreme by using all pessimistic assumptions like high inflation, low investment returns, and a very long life with prolonged medical expenses (just don’t have any razor blades nearby when you see the result). Then simulate the optimistic extreme with high investment returns, low inflation and a prompt, peaceful death without medical complications. You will be amazed. The pessimistic scenario can easily require 2-4 times the nest egg of the optimistic scenario. This can be a very instructive exercise for understanding the range of possibilities so you can plan accordingly.

Really, really good advice all around. You can’t just calculate your number once and then forget about it. It’s important to keep updating things as conditions evolve. Give yourself a margin of safety.

Trying to figure out withdrawal strategies is quite tricky—and there are different schools of thought on how to set withdrawal rates. Here is a link to a useful article by Morningstar (through Yahoo! Finance) on the simple mathematics involved in adjusting retirement withdrawals for inflation.

Apparently Congress is not alone in its profligate ways. According to US News:

More than 75 percent of advisers surveyed indicated that not saving enough was the major roadblock to their clients’ success. This is important because the amount saved is something that people can control, while investment performance or economic conditions are largely beyond our control.

Close behind, 73 percent of the advisers surveyed indicated that a client living beyond their means was the biggest obstacle to financial success. Again, an area that is within an investor’s control.

This is from a survey of more than 600 advisors done by Principal Financial. The two biggest barriers to client success were not saving enough and living beyond their means, two factors which are obviously closely related. If you are living beyond your means, clearly you are not going to be able to save enough. Americans’ compulsive overspending seems to be mirrored by America’s compulsive overspending.

I guess the good news is that overspending is a behavioral issue under our control. Willpower is hard. An automatic investment plan is probably the way to go, especially to get started. There are lots of good balanced funds around that can serve as a complete investment program. Of course, I am biased in favor of the Arrow DWA Balanced Fund (DWAFX).

To obtain a fact sheet and prospectus for the Arrow DWA Tactical Fund (DWTFX) or the Arrow DWA Balanced Fund (DWAFX), click here.

Source: wikimedia.org

Simple. Boring. Solid savings advice from Carl Richards in What to Do If You Haven’t Saved Anything Yet.

(Even if you are actively saving and investing, the article is good motivation to keep it up.)

Source: Carl Richards

The WSJ reports on the most recent sign that retirement planning is increasingly up to the individual:

One proposal under serious consideration would slow the way tax, spending and entitlement programs shift with inflation each year. The switch to using a different measure of inflation, known as a “chained” consumer-price index, is endorsed by many conservative and liberal groups who believe that inflation estimates in the government’s budget are overstated and lead the government to expand spending programs and adjust tax brackets too quickly, resulting in more spending and less revenue.

The Moment of Truth Project, a group established to help push into law last year’s White House deficit-reduction-panel proposal, projected that establishing a chained CPI measure would save roughly $300 billion over 10 years.

The biggest savings—an estimated $112 billion—would be from slowing the growth in the cost-of-living adjustments for Social Security beneficiaries. Another $33 billion would be saved by reducing cost-of-living adjustments for other federal programs. The Moment of Truth Project estimated that a chained CPI “would cause tax-bracket thresholds and other parameters to grow more slowly and raise an extra $87 billion” in revenue over 10 years. (my emphasis)

Tinkering with the CPI calculation has become a national pastime. Let’s just hope that Americans adjust their savings rates accordingly…