Post Crisis Retirement Investing Articles

 

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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