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Summary

  • Warren Buffett has suggested that a retiree might hold a mix of 90% equities and 10% bonds.
  • The all-stock portfolio actually works quite well funding 4% or more of portfolio value, inflation adjusted, over most 30 year periods.
  • But the equity portfolio increases risk during years of successive market declines.
  • We'll have a look at the 90/10 portfolio for retirees, a 60/40 mix, along with bucketing with cash and bonds to fund retirement in stages.

In a previous article I explored Warren Buffett's suggestion that retirees hold a portfolio that consists of 90% stocks (NYSEARCA:SPY) and 10% bonds. From Warren...

My advice to the trustee couldn't be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors - whether pension funds, institutions or individuals - who employ high-fee managers.

Being one of the only investors on the planet still a believer in the importance of bonds, that one was a head-scratcher for me. But I had to investigate the world's most successful investor's recommendation, after all he is the world's most successful investor in the accumulation phase. Is Warren spot on when it comes to the spending stage? I started by having a look at an all-equity portfolio in the spending stage.

Running the numbers showed that an all S&P 500 portfolio delivered a very high probability that it could provide a 4% plus annual income with an inflation adjustment. In fact, according to the Monte Carlo tool on moneychimp.com an all-equity portfolio had an impressive 95% success rate delivering income for 30 year spans. That's nothing but incredible. An all-stock portfolio in the inflation adjusted (2%) draw down phase over the last ten years would have increased in value.

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

The above scenario worked out quite well due to the fact that the start date delivered four years of positive equity returns. The portfolio had a great head start heading into the great recession, and the incredible bull run of the last 5 years allowed the portfolio to recover in full from 2007. The all-equity portfolio could even survive a horrible start date of 2008, but it's a different story if an investor has the unfortunate situation of starting their retirement in a period of successive stock market declines. The year 2000 start date delivered 3 down years, a very rare occurrence as we'd have to go back to the Depression to find that same scenario. But anything and everything is possible, and an investor should protect against the hazards.

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

The year 2000 start date decimated most equity-heavy retirement portfolios. As we can see the above portfolio stands little chance of providing income for a 25-year period. The next stock market correction combined with increasing income needs of the retiree is a one-two punch that will leave this portfolio on the mat with the referee counting to ten. The equity portfolio will not likely survive.

So what about Warren's suggestion that a retiree hold 10% bonds? Will that provide the insurance necessary? As I stated in the previous article, bonds did their thing from 2000; when the stock markets were sinking the bonds were sailing. But is 10% enough? For this demonstration I used 10-year Treasuries on a total return basis.

Year

Starting Balance

Income

Total Return

Balance

2000

Stock

900,000

36,000

-9.03%

785,981

Bonds

100,000

4,000

16.6%

111,936

Total

897,917

2001

785,981

36,720

-11.85%

660,474

Bonds

111,936

4,080

5.57%

113,863

Total

774,337

2002

696,899

37,454

-21.97%

515,224

Bonds

77,438

4,161

15.12%

84,356

Total

599,580

2003

539,622

38,203

28.36%

643,621

Bonds

59,958

4,245

00.38%

55,925

Total

699,546

2004

629,591

38,966

10.74%

654,058

Bonds

69,955

4,329

4.49%

68,573

Total

722,630

2005

654,058

39,744

4.83%

643,985

Bonds

68,573

4,416

2.87%

65,998

Total

709,983

2006

643,985

40,539

15.61%

697,644

Bonds

65,998

4,504

1.96%

62,699

Total

760,343

2007

697,644

41,350

5.48%

692,259

Bonds

62,699

4,595

10.21%

64,036

Total

756,295

2008

692,259

42,182

-36.8%

410,848

Bonds

64,036

4,687

20.1%

71,287

Total

482,135

2009

433,922

43,020

26.3%

493,709

Bonds

48,213

4,780

-11.12%

38,603

Total

532,312

2010

479,081

43,881

15.1%

500,915

Bonds

53,231

4,876

8.46%

52,446

Total

553,360

2011

500,915

44,759

1.9%

464,823

Bonds

52,446

4,973

16.04%

55,088

Total

519,911

2012

467,920

45,653

16%

489,829

Bonds

51,991

5,073

2.97%

48,311

Total

538,140

2013

489,829

46,566

32.2%

585,993

Bonds

48,311

5,174

-9.1%

39,212

Total

625,205

That 10% bond allocation simply came up short. It saved the investor over $125,000 in losses, but that $625k portfolio value is limping with little chance of survival. Like the wounded brave knight in Monty Python's Holy Grail it might declare "I'm not dead yet," but it is certainly more than a flesh wound. An investor holding that portfolio would be best served by giving up some "lifestyle" and dropping the income demands from over $51,000 back to the 4-5% of portfolio value which would bring the total income drawn to the $30,000 area.

BUCKETING

Another popular style of retirement planning is creating buckets that would fund the retirement in stages. The cash would cover the first two years, the bonds would cover the next two or three and the equities can cover the longer-term needs. So what happens when we still use Warren's 90/10 portfolio but with 2 years' worth of cash? The portfolio is rebalanced after the initial 2 year period.

Year

Starting Balance

Income

Total Return

Balance

2000

Stock

827,280

-9.03%

752,576

Cash

80,800

40,000

40,800

Bonds

91,920

16.6%

107,178

Total

900,554

2001

Stock

752,576

0

-11.85%

663,395

Cash

44,000

40,800

0

Bonds

107,178

5.57%

113,147

Total

776,542

2002

Stock

698,887

37,454

-21.97%

516,116

Bonds

77,654

4,161

15.12%

84,605

Total

600,721

2003

540,648

38,203

28.36%

644,938

Bonds

60,072

4,245

00.38%

56,039

Total

700,977

2004

630,879

38,966

10.74%

655,484

Bonds

70,097

4,329

4.49%

68,720

Total

724,204

2005

651,784

39,744

4.83%

641,601

Bonds

72,420

4,416

2.87%

69,770

Total

711,371

2006

640,234

40,539

15.61%

693,307

Bonds

71,137

4,504

1.96%

67,969

Total

761,246

2007

685,121

41,350

5.48%

679,049

Bonds

76,124

4,595

10.21%

78,832

Total

757,881

2008

682,092

42,182

-36.8%

404,423

Bonds

75,788

4,687

20.1%

85,392

Total

489,815

2009

440,833

43,020

26.3%

502,437

Bonds

48,981

4,780

-11.12%

39,285

Total

541,722

2010

487549

43,881

15.1%

510,661

Bonds

54172

4,876

8.46%

53,466

Total

564,127

2011

592,836

44,759

1.9%

558,490

Bonds

78,056

4,973

16.04%

84,805

Total

643,295

2012

578,966

45,653

16%

618,643

Bonds

64,329

5,073

2.97%

61,016

Total

679,659

2013

618,643

46,566

32.2%

756,285

Bonds

61,016

5,174

-9.1%

50,760

Total

807,045

Well that gives the portfolio a fighting chance. It's wounded most certainly, but the portfolio would likely be able to deliver decent income for many years to follow. In the above approach, an investor could have followed stage 2 of bucketing and used the bond component (entirely) to fund year 3, meaning there would have been no selling of stocks in the down years.

It once again might be advisable for the retiree to adjust their spending plans modestly.

So being a balanced investor (I'm talking numerically here, only) I had to have a look at what happens when we use the traditional 60% stock and 40% bond portfolio. We know that mix works incredibly well in the accumulation phase, but what about in retirement? The portfolio is rebalanced annually.

Year

Starting Balance

Income

Total Return

Balance

2000

Stock

600,000

24,000

-9.03%

523,987

Bonds

400,000

16,000

16.6%

447,744

Total

971,731

2001

583,038

24,480

-11.85%

483,205

Bonds

388,692

16,320

5.57%

393,113

Total

876,319

2002

525,791

24,969

-21.97%

390,791

Bonds

350,527

16,646

15.12%

384,363

Total

775,154

2003

465,092

25,468

28.36%

564,301

Bonds

310,061

16,978

00.38%

294,196

Total

858,497

2004

515,098

25,977

10.74%

541,652

Bonds

343,398

17,317

4.49%

340,722

Total

882,374

2005

529,424

26,496

4.83%

527,219

Bonds

352,949

17,663

2.87%

344,908

Total

872,127

2006

523,276

26,998

15.61%

584,151

Bonds

348,850

18,016

1.96%

337,318

Total

921,469

2007

552,881

27,537

5.48%

554,132

Bonds

368,587

18,376

10.21%

385,967

940,099

2008

564,059

28,087

-36.8%

338,734

Bonds

376,039

18,743

20.1%

429,112

Total

767,846

2009

460,707

28,648

26.3%

545,690

Bonds

307,138

19,117

-11.12%

255,993

Total

801,683

2010

481,009

29,221

15.1%

520,007

Bonds

320,673

19,499

8.46%

326,653

Total

846,660

2011

507,996

29,805

1.9%

487,276

Bonds

338,664

19,888

16.04%

369,907

Total

857,183

2012

514,309

30,401

16%

561,334

Bonds

342,873

20,286

2.97%

332,167

Total

893,501

2013

536,101

31,009

32.2%

667,731

Bonds

357,400

20,691

-9.1%

306,068

Total

973,799

In both market corrections it got knocked down by about 25%, but was able to get off the mat and fight back. The 2013 portfolio is not at full strength as we are now spending over $51,000 compared to $40,000 in the year 2000. But the portfolio has held up very well due to the inverse relationship between stocks and bonds and the rebalancing that feeds the money back into the best performing asset class - equities.

If I was the retiree in the above scenario, (and given the recent market run) I would immediately pull 2 to 3 years of spending requirements from the portfolio, equally from the stocks and the bonds.

Another option would be to combine the two years of spending (bucketing) with a 60/40 portfolio. After the first two years (end of 2001) the equity value would have been $442,264 and the bond allotment would have totaled $452,594 for a portfolio value of $894,858. That strategy would have seen the portfolio return to an area above $1,000,000 by the end of 2013.

Bucketing plus a nice traditional mix of stocks and bonds appears to be a very prudent approach to the retirement kickoff party. It would appear to offer wonderful peace of mind as well. Certainly a retiree would be able to sleep well in those first two years knowing that the spending is covered by guaranteed cash. Hopefully something is then working on the stock or bond side of the equation. At the very least, the retiree could collect income over the initial two years that would cover the next two years of spending. All told, that's a very low risk way to approach the very crucial initial stages of retirement.

Conclusions

Warren Buffett's suggestion of an equity-heavy portfolio would work in most conditions. But it's not worth the risk of happening into a very unfortunate start date.

It's very important to protect against stock market declines; the tools available are cash, bonds and portfolio income. But make no mistake, a very healthy allocation to the best performing asset class (stocks) is still very, very important.

Happy investing (retiring) and be careful out there.

Source: The Time Warren Buffett Got It Wrong