Sleeping Well and Retiring Well

By Barry Hyman, MBA

Posted March 10, 2010

Current Observations

March Edition

Sleeping Well and Retiring Well

by Barry Hyman

Retirement Planning Variables

by Jeff Lokken

PDF Version

Subsequent to the dislocation that occurred in global securities markets from 2007 to 2009, shaken investors and investment advisers have contemplated, "What should we do now?" At the center of this consideration are questions such as, "Should I move to cash?" "Should I get more conservative?" "Should I ‘get out' now temporarily and ‘get back in' after the uncertainty subsides, after the market drops again or after the recession is over?" There are many answers better suggested by different advisers to the dilemma of how to invest retirement savings to help investors sleep. The challenge is how to meet that objective and at the same time the overriding one: how to make sure investors can retire and stay retired.

As we have addressed in our newsletters several times before, timing the market is nearly impossible. There is no bell that goes off that says, "The coast is clear … you can now get back in." Going to cash with the intention of it being only temporary is simply not realistic. As many anecdotes and studies (such as the DALBAR study we have referenced in the past) have shown, investors are better off constructing an investment plan and sticking with it than trying to jump in and out of investment classes such as stocks or real estate. In order to benefit from the returns of investing "over a market cycle," success increases when you remain invested throughout the entire market cycle. So the better question is. "What portion of one's liquid assets should be invested, and how?"

One solution that was popular in the days of higher interest rates and has had resurgence of late is to "lock up" many years worth of a person's future expenses in "riskless" interest-bearing investments. The rationale is to lock in several years of guaranteed cash flow, empowering the investor to not worry about the rest during market volatility, since that portion of their wealth will not be needed until after the market has had time to recover. A common example of this recipe is to "ladder" 10 years (or longer) of living expenses in Treasury bonds or CDs with each year's allocation maturing as it is needed. There are other variations on this theme, but they all have one thing in common: a recipe to keep people invested during market declines.One solution that was popular in the days of higher interest rates and has had resurgence of late is to "lock up" many years worth of a person's future expenses in "riskless" interest-bearing investments. The rationale is to lock in several years of guaranteed cash flow, empowering the investor to not worry about the rest during market volatility, since that portion of their wealth will not be needed until after the market has had time to recover. A common example of this recipe is to "ladder" 10 years (or longer) of living expenses in Treasury bonds or CDs with each year's allocation maturing as it is needed. There are other variations on this theme, but they all have one thing in common: a recipe to keep people invested during market declines.

That goal of remaining invested to benefit from the subsequent recovery is worthy. But the problem with trying to apply a static recipe to an ever-changing, volatile world is not unlike trying to solve today's problems having only yesterday's tools at one's disposal. It is also like trying to treat every ailment with variations of a single remedy. Flexibility is the missing and critical element.

For example, a 10-year laddered Treasury or CD portfolio a decade ago would have had yields in the 4% to 6% range. Using historic averages as a guide, expected future returns of the stock portion of a portfolio would be in the 10%/year range over a market cycle. Thus, for an investor who put one-half his money in such a ladder and the other half in equities, the expected future average return on the entire portfolio would be in the 7% to 8%/year range.

Now, however, in what many economists are calling the "new normal," rates on one-year Treasuries are 0.33%, three-year 1.5%, five-year: 2.4% and 10-year: 3.8% (Source: www.bloomberg.com/markets/rates/index.html, 2/22/10). Thus, the average annual return on a 10-year treasury ladder would be in the 2%/year area. In this new normal world of debt, deficits, deleveraging and reregulation, those same economists, as well as many seasoned investment professionals, expect stock market indexes to return half of their historical averages. I might add that such a scenario does not address the effects inflation can have on real return, nor does it address the real possibility that there could be deflation as well, including negative returns on stock indexes. But let’s look at the "our cup is half full" scenario first.

In an environment where bonds and CDs are paying 2% and stock indexes return 5%, investors who have sufficient assets to live on 7% to 8% of their retirement assets, but have too much allocated to "riskless" investments and stock indexes will be spending principal to live on. Within several years after retirement they could deplete a large portion of their wealth and, more important, their future income earnings power.

If that's not warning enough, what if the U.S. experiences what Japan has experienced in its recent two "lost decades"? That is not a stretch given that the source of Japan's maladies – overly leveraged banks and real estate investors coupled with inflated asset prices – is what the U.S. and other economies are facing today. Some may even consider ours a "worse" situation, since Japan's public started that period with ample savings, whereas our consumers are laden with debt to boot. In Japan, government bonds have had zero real returns for 20-plus years, and Japan stock indexes have produced negative returns for that period. Retirees who put their savings in the Japan stock index and a ladder of J-Bonds got killed financially.

By contrast, investors who invest in high-yielding securities with good management, solid balance sheets and sufficient cash flow, and who hold such investments only while they are bargain-priced, especially those who diversify globally in such a portfolio, fare well over nearly all full market cycles, including those with inflation, deflation, and low and high interest rates.

Bond ladders and equity index investing are a little like horses and boxcars. They had their day, but the world has changed.The premise of “locking up” a large portion of an investor’s portfolio in riskless interest-bearing investments is no longer supported by financial reality. For all but extremely wealthy retirees, passive bonds/CDs and equity indexing does not make sense in the current environment (and most likely in the foreseeable future). Instead, I believe retirement savings, sans several months’ living expenses, should be managed such that all assets are working as hard as they can in an income-favored, actively managed, dynamic portfolio in which the asset allocation fluctuates as values and opportunities do.