- Inflation may doom bond-holding retirees.
- The equity markets provide the return and inflation protection retirees need.
- A time buffer can allow retirees to move more money into equities.
What are we missing? Please shoot this apart.
Pre-emptive Q and A
Question: Why this funny-looking portfolio?
Answer: There are two main problems this strategy seeks to address - low fixed income returns, and inflation risk. This strategy is designed to give you the returns and inflation protection of the stock market, with a sufficient time buffer to smooth out market returns.
Question: Where is your fixed income/long-term bonds for the highest/safest yield you can get?
Answer: What treasuries are paying (30-year is at 3.41%) still may not keep up with inflation in the coming years. Even 30-year TIPS only pay 1% over CPI and many argue CPI understates real inflation. Inflation is the price of goods and services rising, so owning the companies whose rising prices is inflation is the real protection.
Then there is corporate debt, which comes with credit risk, and the reward you get for taking that risk is historically very low:
(click to enlarge)
Question: Why CDs?
Answer: There is no credit risk in FDIC insured bank CDs (over $250,000 you can spread to several banks), and while the interest may be taxable at the state and local level, CDs are paying more than treasuries of the same maturity. Convenient, risk free (inflation is the only risk), and slightly better than treasuries. This also keeps you out of bond funds, which rise and fall with swinging market rates.
Question: Why that ETF?
Answer: A bunch of reasons. Vanguard may be the most reputable finance company in the world. The ETF is very low cost (.09% expense ratio). It tracks the CRSP US Mid Cap Index, so being mid cap it automatically sells winners and bubblers after a certain market cap. Compare that to something like the SPDR S&P 500 ETF (NYSEARCA:SPY) that can't sell out of those types of stocks, and in fact over-weights them. VO has tracked but beaten the SPY in its 10-year history, returning a little more than 10% annually. We expect it will continue to keep pace and beat the S&P 500 by a little over time.
Question: Where is your international exposure?
Answer: We are card-carrying USA bulls for the rest of this century. The US military has virtually nothing left to strategically accomplish, and will continue to secure everything important to the US economy. The US has an independent central bank to look after the economy. The US has very low population density and can grow virtually unrestrained for a long time. The US has the best geography in the world with Europe on one side and Asia on the other. The US has the oldest constitution in the world and a remarkably stable government. The US dollar is the world's reserve currency and has advantages and stabilities built in relative to other currencies. If you live in the US, all the better - no currency exchange risk.
In addition, the ETF is domestic but the companies - SanDisk (NASDAQ:SNDK), Mylan (NASDAQ:MYL), Discovery (NASDAQ:DISCA), and Moody's (NYSE:MCO) are currently in the top 10 holdings - have international exposure. If you really want some more international exposure you could substitute some VO for some Vanguard All-World ex-US Small-Cap ETF (NYSEARCA:VSS). VSS tracks the FTSE Global Small Cap ex US Index with an expense ratio of .20%, and like VO has a mechanism to sell winners/bubblers.
Question: How much money do I need to retire using this strategy?
Answer: That answer is based on your needs and what the market is giving you at the time you retire. If you had $1 million in the market, needed $50,000 a year to retire, and the market returned 5% a year like clockwork, you could keep 1 million dollars in the market and have income forever. In this example the market has a PE of 20, you get one-twentieth of your investment as earnings each year.
The stock market is not steady like that, but that is a useful reference point - multiplying your annual needs by the expected PE of your investment.
VO currently has a PE of 23.7. The S&P 500 currently has a PE of 19.5. We expect that VO will track and slightly beat the S&P 500, and we think that its future return could be like its historical return of 10%+, but we will be conservative and use VO's PE of 23.7 which implies a return of less than 5% per year.
So the amount of money you need to retire right now is your annual needs multiplied by 23.7. With that amount, 7 years worth of money goes into a CD ladder maturing with your annual needs each year, and the remainder goes into VO.
Let's do an example:
You need $60,000 a year in retirement income.
$60,000 X 23.7 = $1,422,000 you need to retire
7-year CD Ladder = $60,000 X 7 X 1.01 (extra 1% to make up for the difference between interest and inflation) = $424,200
VO = $997,800
Question: Is that time buffer long enough to smooth out stock market returns?
Answer: It should be.
You have FDIC insured bank CDs maturing once a year for the next seven years. In addition, the SEC yield on VO is 1.3%, so all else equal and sticking with our example that is a $12,971 yearly dividend going into the CD ladder. After 7 years that's $90,800 gone into CDs with no selling stock. On average you can expect the dividend to grow, but let's look at the downside. During the 2008 financial crisis VO's dividend dropped 30% for 1 year, then recovered and made new highs. Even if the dividend drops 30% and stays down that's still $63,560. So you have an extra year in the CDs built in, giving you 8 years in the worst scenario to find a decent time to sell some stock.
If you look at the S&P 500 since 1950 (last 10 business cycles), an eight-year buffer meant you got to sell at a gain even if you picked the absolutely worst time to get into the market:
Since 1950, there have been 13 periods when you could have bought the S&P 500, and then would have to wait more than 12 months for a gain. They are:
Year - Max Drawdown %, Max Months Until Gain
1953 - 14.8%, 15 months
1956 - 14.8, 26
1959 - 13.6, 18
1961 - 26.9, 21
1966 - 22.2, 15
1968 - 36.1, 40
1973 - 48.2, 90
1980 - 27.1, 23
1983 - 14.4, 15
1987 - 33.5, 23
1994 - 8.9, 13
2000 - 49.1, 86
2007 - 56.8, 66
1973, 2000, and 2007 could have been scary if you were really unlucky in your timing, but even if you bought at the absolutely worst time like Mar 20, 2000, you still could have replenished your entire CD ladder at a gain within 8 years.
And probably you will be lucky - since 1950, you've had a 61% chance of buying in a month that will show a gain in the S&P 500 twelve months later.
Question: When do I sell assuming I did not buy at the worst possible time?
Answer: Once a year see if you are up, if so completely replenish the ladder. Otherwise, check in next year.
Question: How long will this last me?
Answer: Let's do a conservative model based on our $60,000 annual needs example.
The S&P 500 has returned 11% annually since 1950, with about 7% being real return and 4% being inflation. If VO's real return equals 3.5% (half the historical real return), then VO can buy $60,600 (101% of annual needs and in real dollars) of CDs every year for 23.6 years:
With the 7-year ladder you bought when you retired, that's 30.6 years of annually needed income.
According to the Social Security Administration, one in four 65-year-old Americans today will live past 90, and one in 10 will live past 95. This model gets a 65-year old into their 96th year.
Question: Do you really think this is the best passive strategy a retiring person can have?
Answer: Yes, we do. If you buy the notions that:
- The stock market provides inflation protection
- The stock market can give half its historical real return over time
- The time buffer will work
Then we think you can enjoy your retirement and not worry about "Fed printing" or about how "the Fed punishes savers."
The world economy will continue to be dysfunctional until the population pyramid looks like a pyramid again in about 25 years. The central banks of the world will continue to accommodate for a long time. Eventually the baby boomers will virtually all be retired and still consuming at the same time, and then we will have a lot of inflation as demand for services outstrips labor supply.
The pleas of the bond-holders for central banks to stop printing may seem at a fever pitch now, but the real inflation is coming as the boomers retire for the next decade and stay retired and consuming. The answer for retirees is the equity markets with a fixed income time buffer.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.