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Summary

  • Many well read studies suggest that one can fund a lasting retirement by withdrawing 4% to 4.5% of portfolio assets.
  • Warren Buffett suggests that investors simply hold 90% S&P 500 and 10% in a bond fund. Is he serious?
  • We'll examine how an all-equity portfolio would have performed in the draw down period over the last 10 years and through the last two market corrections.
  • An all stock portfolio has an incredible track record of making money last for 30, 40, 50 years or more in the spending stage.

Many well-mentioned studies point out that an investor can generate income of some 4% to 4.5% from their portfolio in retirement and face a probability that the funds will last as long as they do. Typically the studies cite that you could get 30 years or more out of your balanced portfolio. It's not absolute, but there's the probability that things will work out. On a million dollar portfolio, that means having the ability to harvest $40,000-$45,000 per year, with inflation adjusted dollars. That may be a nice top up for public and private pensions. Obviously, the average American or Canadian is not going to generate a million dollar portfolio.

In the retirement stage investors are told to play it safe with lots of cash and bonds in addition to those stocks that have hopefully treated them very well for decades, as those stocks have been the main driver of portfolio success. There's another rule that states one should hold a percentage of bonds equal to one's age. I don't agree with that rule, but ironically I hold about 50% bonds. That's just a coincidence, honest.

And then there's Warren Buffett, who is of course the most successful investor "of all time" as Muhammad Ali would put it. We see Warren as a genius in the accumulation phase as he has beaten the snot out of the market on a regular basis and he has made investors in his fund gloriously rich and comfortable and ready for retirement. They love Warren for obvious reasons. Here's the Berkshire Fund (NYSE:BRK.A) (NYSE:BRK.B) against the rest of us (NYSEARCA:SPY) from 1985.

(click to enlarge)

We can all agree Warren is the man when it comes to the accumulation phase. But Mr. B. also offers up advice for those in the retirement phase. In his recent letter to shareholders he suggested that in retirement investors hold 90% S&P 500 and 10% in a bond fund. I thought that was crazy talk. I know Warren is a big fan of holding great companies but that sounded like unsound advice, and that maybe not a lot of thought had gone into that statement.

Being a fan of checking the facts, I decided to run the numbers to see what happens when a retiree holds stocks only. That certainly increases the risks as the severe market fluctuations will dictate that the investor will have to sell more assets (shares) to fund retirement when the stock market is in correction mode. That's some pretty simple math of course, if you need $20,000 to spend, and that money is not covered by your portfolio dividends, you will need to sell shares. If the share price is $20 you will need to sell 1000 shares. If the share price falls to $10 you then need to sell 2000 shares. Once those shares are gone, they're gone, you no longer have those 2000 shares available for the dividends they will generate, and when the markets do recover you have less shares available to help in that portfolio price recovery. Selling shares hurts in a market downturn.

Holding a stock portfolio that typically offers the greatest amount of risk or volatility increases the need to sell holdings to fund retirement. So what happens when a retiree held a stock-only portfolio over the last 10 years? The investor has redeemed $40,000 per year, allowing for a consistent 2% income boost (let's call that personal inflation) each year.

Year

Starting Balance

Income

Remaining Balance

Total Return

Balance

2004

1,000,000

$40,000

960,000

10.7%

1,062,720

2005

1,062,720

$40,800

1,021,920

4.8%

1,070,972

2006

1,070,972

$41,616

1,029,356

15.9%

1,193,023

2007

1,193,023

$42,448

1,150,575

5.2%

1,210,404

2008

1,210,404

$43,296

1,167,108

-36.8%

737,612

2009

737,612

$44,162

693,450

26.3%

875,827

2010

875,827

$45,045

830,782

15.1%

956,230

2011

956,230

$45,946

910,284

1.9%

927,579

2012

927,579

$46,864

880,715

16%

1,021,629

2013

1,021,629

$47,802

973,827

32.2%

1,287,339

Well surprise, surprise. That crazy (don't try this at home) all stock portfolio not only provided the income, it increased in value from $1 million to over $1.25 million.

Now certainly that portfolio was off to a great start from 2004 with 4 years of stock market gains before the stock market correction in 2008. Remember too that the correction in 2008 was number 2 on the list of annual all-time S&P 500 smack downs in market history.

So what happens if we take on two of the worst start dates in recent history; 2008 and 2000? Here's the 2008 start date.

Year

Starting Balance

Income

Remaining Balance

Total Return

Balance

2008

1,000,000

$40,000

960,000

-36.8%

606,720

2009

606,720

$40,800

565,920

26.3%

714,757

2010

714,757

$41,616

673,142

15.1%

774,785

2011

774,785

$42,448

732,337

1.9%

746,251

2012

746,251

$43,296

702,955

16%

815,428

2013

815,428

$44,162

771,266

32.2%

1,019,652

Obviously, like me, Warren was waking up early to manually calculate the probabilities of returns and portfolio values. This is all quite impressive in a secular bear market, perhaps Warren is on to something, or perhaps market success is all too obvious to the world's most successful investor. Stocks provide the greatest total return potential, and I would advise that investors take on all the risk that they can handle in the accumulation phase. Should I also be adding...

take on all the risk that you can handle in the retirement phase

That's not a phrase I would instinctively repeat often, or at all. I do think there are "better" ways to address spending requirements in retirement. But the above examples do demonstrate how important it is to hold a healthy allocation to stocks in that retirement phase - that's where we find that traditional inflation beat.

Moneychimp.com seems to agree. It has a Monte Carlo function that takes into account the historical market conditions and offers that from 1900 there was a 91% success rate with a 4% income level lasting for 35 years or more - with an all-equity portfolio.

It reports 7 failures in the following periods:

1906-1940 (34 years)

1929-1952 (23 years)

1965-1995 (30 years)

1966-1991 (25 years)

1968-1994 (26 years)

1969-1993 (24 years)

1973-2006 (33 years)

An all equity portfolio had an impressive 95% success rate delivering income for 30 year spans. None of the failures show up in the 2000's. Incredibly that 90% plus success rate holds true for time spans of 40, 50 and 60 years according to the moneychimp tool.

That's an impressive record for an all stock portfolio and the numbers do support Warren's recommendation. Thing is, in retirement a very small percentage of investors would be able to handle the emotional component of watching that nest egg fall so far in value. And of course there is the chance that your portfolio could run out of steam before you do. The year 2000 and the recent secular bear market might be showing up one day on the Monte Carlo models as a period that decimated retirement portfolios. Here's what would have happened to date if one had placed their total retirement funding in the hands of the market from 2000.

Year

Starting Balance

Income

Total Return

Balance

2000

1,000,000

$40,000

-9.03%

873,312

2001

873,312

$40,800

-11.85%

733,859

2002

733,859

$41,616

-21.97%

540,157

2003

540,157

$42,448

28.36%

638,859

2004

638,859

$43,296

10.74%

659,526

2005

659,526

$44,161

4.83%

645,088

2006

645,088

$45,044

15.61%

693,711

2007

693,711

$45,945

5.48%

683,264

2008

683,264

$46,869

-36.8%

402,201

2009

402,201

$47,801

26.3%

447,607

2010

447,607

$48,757

15.1%

459,076

2011

459,076

$49,732

1.9%

417,121

2012

417,121

$50,726

16%

425,018

2013

425,018

$51,740

32.2%

493,473

This has been one of the most severe periods in stock market history. It is rare to have three successive down years as we had from 2000. And then just as the portfolio was trying to recover we had that 36.8% collapse in 2008. The portfolio is fighting back from 2008, but inflation (and hence the extra spending requirements) is making it a losing battle. It would take a continued and impressive stock market run to give this period a fighting chance. Sustained market gains of 12% plus per year would be required for many years, and even then, one more severe market correction would leave this portfolio fatally wounded.

But we should also remember, according to market history the above recent period is an outlier. The only other occurrence of 3 successive down years takes us back to the Depression. And if an investor had started drawing down in '97, '98 or even '99 there would have been an impressive head start. From a 1999 start date an investor would have had a portfolio value of $1,162,656 heading into the three down years. But the risks should not be ignored and an investor should attempt to bullet proof their portfolio against happening upon a very unfortunate start date.

Conclusions

Keep a very healthy component of stocks in the retirement stage to increase the likelihood that your portfolio will fight inflation and support your retirement years for an extended period. Many studies show that once you get above that 4 to 4.5% spending rate, you run a much greater risk of running out of money.

There are certainly a few strategies that can help you keep (and protect) that spending rate at 4.5% or above, and I will be looking at that in the near future.

Next up we'll look at Warren's equity retirement portfolio that includes cash and also that 10% bond allocation. Bond fans will not be surprised to read that in that 2000 to present time frame, when the stock markets stumbled the bond markets did their thing and delivered impressive returns, especially mid to long term Treasuries.

And it goes without saying, dedicated retired investors in the Berkshire Hathaway Fund would have likely laughed at the market corrections, and their portfolios would have breezed through all of the market gyrations.

Happy investing (long live Warren Buffett) and be careful out there.

Dale

Source: Warren Buffett Was Right About Retirement