RETIREMENT MATH
A big
question for many Americans is “How large of a portfolio will I need to
generate a comfortable retirement income that will last the rest of my
life?” It’s a complicated question with
a lot of variables and it relies on predicting the future but the financial
planning community seems to use a rule of thumb that you can draw about 4% per
year as income. This rule is roughly
based on a 3% inflation rate, an 8% average annual investment return and some
normal volatility of returns.
In order to offset inflation a
retiree’s income needs to rise over the years.
And in order to produce a higher income the retiree’s portfolio needs to
grow, preferably with the rate of inflation.
So if we assume an 8% total return and a need to reinvest 3% for
inflation that leaves 5% available to spend.
Unfortunately investment markets fluctuate and to offset the impact of
taking income in a low return or negative return year we need to reduce the 5%
figure to about 4%. For a more complete
explanation see our
Retirement 102 video.
The
problem for investors today is getting the 8% investment return. Clearly investing in bonds that yield 3%
won’t work. Buying CD’s that yield 1%
won’t work and money market funds yield near 0%. You can hope that inflation will stay low but
a 3% bond yield with even 1% inflation means that you can only spend 2%,
requiring a portfolio that’s twice as big.
Article is from our On the Money issue Winter 2010/11.
HOW BONDS WORK
Bonds may be offered by government
entities or corporations as a way to borrow money. The biggest issuer of bonds is the US
government and one of their more popular bonds is the ten year maturity. In mid-November, 2010 rates were around 2.7% for
the ten year US Treasury bond that matures in 2020.
Investors that buy a bond will get
a fixed yield based on their purchase price and the coupon which is the amount
of interest the bond pays. Assuming the
bond issuer doesn’t default (as GM and Chrysler did in their bankruptcies) then
the bondholders will receive the return of their principal at maturity and the
locked-in interest, often paid semi-annually.
Investors in ten year US Treasury bonds today then would receive their
2.7% interest each year until 2020 when their principal would be returned.
The biggest risk facing most bond
investors is inflation. If the interest
rate is lower than the rate of inflation investors will sustain a real, or
inflation adjusted, loss in purchasing power.
Inflation over the past fifty years has averaged a bit over 4% so
locking in 2.7% for the next decade doesn’t appear very smart.
Like stocks, bonds trade daily so
investors with a bond that won’t mature for years can sell it to someone
else. The bond’s price, though, will
fluctuate based on current interest rates.
Let’s assume interest rates on Treasury bonds move back up to 5% over
the next couple years. Today’s bond
investor would have locked in 2.7% and still have 8 years until maturity with
total interest of 21.6% left (8 x 2.7%).
At 5%, Treasuries would pay total interest of 40% over the next eight
years. The 2.7% bondholder could sell
his bond but the price would be discounted to offset the 18.4% (40%-21.6%) less
interest that it would pay. So, as
interest rates rise, bond prices drop.
And prices can drop by much more than the interest that the bonds pay.
Many mutual fund investors are
likely confused today by the high returns bond funds have enjoyed over the past
couple years. As interest rates have
fallen since the credit crisis, mainly on corporate bonds, prices have increased
sharply. This is reflected in the bond
fund’s total return which includes the price change along with the interest
paid.
With many government and corporate
bond yields under 3.5% today there’s little reason to think investors will see
gains any higher than the current yield and, if yields rise, the funds may show
negative returns.
Article is from our On the Money issue Winter 2010/11.
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HISTORICAL BOND RATES
Today’s bond yields are pretty low
by any measure. Investors will factor
inflation into yields so looking at the yield relative to inflation is
important. Since 1980 the ten year US
Treasury bond has yielded an average of about 3.7% more than inflation. Today, with inflation of just 0.8%, the
Treasury yield is only about 1.9% above inflation, well below the normal
spread.
In the corporate bond market yields
are similarly low. Bonds rated AA today (mid-November)
yield about 2.8% or about 2.0% over recent inflation. Historically they’ve yielded about 4.8% more
than inflation.
Today’s
bond investors are making some interesting bets. They are betting that inflation will not
revert to its historical norm which would translate into inflation adjusted
losses. And they are also betting that
yields won’t revert to their historical spread over inflation.
As
students of investment history we find that investment classes tend to go in
cycles from cheap to expensive and back to cheap again. While it’s always difficult to call the tops
and bottoms of the cycles it appears that bonds are at the expensive end today
and may well disappoint investors that thought they’d found a “safe”
investment.
Article is from our On the Money issue Winter 2010/11.
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RISK: A MATTER
OF TIME
Since 1926, which asset class
produced the worst ten year, inflation adjusted returns?
A.
U.S.
Treasury Bills
B.
Long Term Government Bonds
C.
Large Cap Stocks (S&P 500)
And which of the three produced the
best?
If you guessed that Large Cap
Stocks produced the best ten year return, you’re right. The average annual, inflation adjusted gain
was 17.9% for the best ten year period.
Stocks, of course, are more volatile than Treasury bills or bonds and
have produced higher average returns over the long term.
What you may not have guessed is
that stock’s worst ten year real return was better than the worst returns for
both Treasury Bills and Long Term Government Bonds. Most people think of T-Bills and bonds as
less risky investments, and in the short term, they typically are. Inflation, though, can have a big impact on
these low yielding investments.
If we look back at inflation over
the past 50 years it has averaged just over 4%.
Yet today (mid-August) the 10 Year U.S. Treasury bond yields just 2.7%. If inflation for the next ten years is the
same as the long term average then investors will lose over 10% of their
purchasing power (before taxes) by buying the bonds today.
The worst ten year average, real
returns were -3.8% for stocks, -5.4% for long term government bonds and -5.1%
for T-Bills. For an investor with a long
term time horizon stocks have had the smallest losses. And with today’s low bond and T-Bill yields
stocks may well be the lowest risk class over the next decade.
Article is from our On the Money issue Fall 2010.
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LOOKING FOR INCOME?
Historically investors have looked to
bonds to provide income and stocks to provide growth. With interest rates at very low rates today
stocks may offer better income along with the potential for growth.
Americans have been saving well
over the past year but the vast majority of their savings have gone into bank
accounts and bond funds. Bond funds have
taken in over $475 billion in the two years ending June 30th while
stock funds have seen withdrawals of over $200 billion. This savings, along with the Fed’s actions
have pushed bond yields to very low levels.
The current yield on a 10 Year U.S. Treasury bond is just 2.7% while the
2 Year Note yields under 0.5% (as of mid-August).
Stocks are not generally known for
their generous dividend income but the current yield of the Dow Jones Industrials
Average is 2.7%, the same rate as the 10 Year Treasury. Dividends are not guaranteed but generally
rise over time while Treasury bonds pay a fixed yield. For investors looking for income that may
rise over the years blue chip stocks today are an attractive alternative.
Stock dividends may also receive
preferential income tax treatment. The
current top Federal tax rate on most dividends is just 15% though it will
likely rise come January. Bond interest
is taxed at income rates which range up to 35% today.
Today’s rate environment is very
unusual. Over the past 40 years stock
dividend yields (based on S&P 500) have averaged 3.7% less than the 10 Year
Treasury. Today’s yields suggest that
stocks are very cheap and/or bonds are very expensive. Putting all your money into bonds, as most
Americans have done recently, may turn out to be a poor strategy.
Article is from our On the Money issue Fall 2010.
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INSIDIOUS RISK
The past couple years has seen a
dramatic amount of volatility in the stock market brought on by the credit
crisis and, more recently, the situation in Greece. The volatility, along with a decade which saw
average returns that were slightly negative, has driven many investors out of
the stock market. Some investors have
even put all of their funds in guaranteed savings accounts. Unfortunately this tactic can have some
serious long term consequences.
Insidious is defined as “operating
or proceeding in an inconspicuous or seemingly harmless way but actually with
grave effect.” Inflation is one
investment risk that is insidious. It
typically doesn’t make the daily headlines like a stock market drop but over
time it can permanently erode people’s wealth and standard of living.
Over the past twenty years
inflation has been relatively tame, averaging 2.7% through 2009. Yet even at that low rate it takes $1.71 to
buy goods that cost $1.00 in 1990.
Someone that retired in 1990 on $60,000 per year would need over
$102,000 today to maintain the same standard of living.
Over the past couple years the US
Government has dramatically increased the money supply and has also run record
budget deficits. While our situation
won’t likely reach the levels in Greece, the increasingly large US debt can
lead to higher inflation as the US dollar falls relative to foreign
currencies.
If we look back to the twenty year
period prior to 1990 we find a very different inflation environment. From 1970 to 1990 prices more than tripled as
inflation averaged 6.2%. In 1990, it
took $3.35 to buy items that cost $1.00 in 1970.
Imagine retiring today at age 60 with a
$80,000 fixed income and watching
helplessly as the cost of living increased at 6.2% driving your purchasing
power down to less than $44,000 by age 70 and just $24,000 by age 80. Social Security increases would offset some
of the decline but your investment portfolio would need to generate income
above and beyond the inflation rate in order to keep up.
Unfortunately fixed rate,
guaranteed investments today may well pay less than the rate of inflation. Investors that take this route may find over
time that there is significant risk in these “safe” investments.
Article is from our On the Money issue Fall 2010.
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STOCKS SEEM VERY CHEAP TODAY (7/13/10)
Over the years we’ve had a few novice investors ask us what
a particular stock fund “is paying”.
Stock funds may pay a small dividend yield but their total return is
largely dependent on the price movement of the stocks in the portfolio. Though the question may seem naive, looking at
the stock market fundamentals may give us some guidance on what stocks are
likely to pay in the future.
At Vintage we like to examine the stock earnings yield
relative to other investment options.
This is the expected earnings divided by the current price. As of June analysts expected an average of
$84.41 in earnings for the year for the S&P 500 stocks. With an index level at 1031 the earnings
yield would be about 8.2% (84.41/1031).
The companies would pay some of that out in dividends and use the rest
for acquisitions, research, share buybacks or activities that may increase the
value of the company and thus the share price.
In short, it is what stocks are estimated to be “paying” today though other
factors will impact the total returns.
When we look back over the years we find that the stock
earnings yield has closely tracked the yield on the 10 year US Treasury bond. These yields are both impacted by inflation
so we’ve adjusted the figures to “real” or inflation adjusted yields. What we find is that the 10 year Treasury
bond has averaged about 3.4% over the rate of inflation while stock earnings
yields have averaged about 4.0%. Looking
at the historical valuations gives us a good idea of whether Treasury bonds or
stocks are cheap or expensive today.
Since the 2008 credit crisis investors have been afraid of
risk and have driven the yield on the 10 year US Treasury bond to just 2.9% at
the end of June. With inflation at 2.0%
that’s a real yield of only 0.9%, well below the 30 year average of 3.4%. This suggests that these bonds are very
expensive today and could suffer losses if rates return to normal levels (When
yields rise, bond prices fall).
On the other hand the stock earnings yield is 8.2% or 6.2%
when adjusting for inflation. The 6.2%
compares to a historical average of 4.0% which suggests stocks are very cheap
today. When we compare the stock vs.
bond yields we find the difference in valuations is at the highest level of the
last 30 years!
If we assume that inflation remains at 2.0% and that the
analyst earnings forecast is accurate then if stocks were to return to their
normal valuations prices would need to climb by over 35%! This would put the S&P 500 index to
around 1,400 which is still over 10% below its 2007 high.
There are other factors that we analyze in our forecasts
which could limit the potential stock gains but we are very comfortable owning
them at these low prices. Dividend
levels are relatively excellent with the Dow Jones Industrials Average recently
yielding nearly as much as the 10 year Treasury bonds. We’re not optimistic about the economy but
the stock market seems to have priced in another recession so even if we have
one stock prices may not decline. And if the economy continues its slow recovery stock gains could be outstanding.
Article is from the Vintage E-News 7/13/10.
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