Historical Portfolio Returns Irrelevant for Today's Retirees

Includes: AXJL, DEM, EMAG, JNJ, LEG, T
by: Aaron Katsman

I recently met with a 60 year old woman who had visited a CFP (Certified Financial Planner) to do a financial plan in order to help map out her retirement finances. They went through all her assets and liabilities, pensions, social security and he then ran a Monte Carlo simulation, and told her that she had an 85% chance of successfully having enough money until she dies.

Her situation is the following:

  • She will get about $20,000 from Social Security
  • Small pension
  • She rents
  • Has about $35,000 a year in expenses
  • She has $600,000 in an IRA and individual brokerage account

She would like to enhance her standard of living somewhat, travel...etc. so she thinks she will need about $20,000 a year in supplemental income a year off her investments to make it.

The planner said that a 20% stock portfolio and 80% in bonds is what she needs. Historically that allocation has generated a 6% return. As such she will be able to enhance her standard of living without dipping into her principal.

I told her that that is all based 100 years of data and that much of that data has no relevance today. The simulation is using 6-7% fixed income returns and 4-5% returns on cash. That may be good for the CFP’s marketing, but it’s useless and misleading in today's interest rate reality. Without any fancy software, just back of the napkin calculations, this 20/80 portfolio may generate 3-4% a year if you are lucky in the current market environment.

USA Today ran a personal finance article recently that encourages a similar approach to that of our esteemed CFP above.

Financial reporter Matt Krantz writes:

For instance, an investor might decide it's possible to live off of $50,000 a year. The investor might also expect inflation to be about 3.5% a year and their returns to be about 5% a year. Using these numbers as a guide shows that this investor must put away $1.2 million dollars at the beginning of the 30 year period.

Where can you get a 5% return? That's a key to the puzzle. With U.S. Treasury rates so low, you'll need to take some risk to achieve 5% yields in the current environment.

One example portfolio that might get you there could be a mix like IFA.com Portfolio 10, which is the safest one the investment firm offers. This portfolio holds 8% in U.S. large company stocks, 4% in small company stocks, 2% in real estate, 4% in international, 2% in emerging markets and 80% in bonds. Historically, which isn't a predictor of future success, over time this portfolio generated a long-term average return of 5.6% on average a year.

Investors are clearly being misled on this important issue. With investment grade bond yields at a whopping 1.5-3%, the woman I spoke with will never be able to generate the income needed. She would be much better served with more equity exposure, especially dividend paying stocks, both domestic and international.

For example, Johnson and Johnson (NYSE:JNJ) with a 3.6% dividend yield and 49 years of dividend growth would make for a good substitute. Leggett & Platt (NYSE:LEG) with a 4.7% yield and 39 years of dividend growth, or even an AT&T (NYSE:T) with a 5.5% yield, are the kinds of stocks she should be looking at. Other solid dividend payers that have a history of increasing dividends, yield over 3.5%, have growing earnings and are diversified across many industries are potentially a better way to go. They provide the income needed for the portfolio as well as potential capital appreciation. Even if stock price drops over a short period of time, the constant dividend from each of these stocks will still be paid and will generate enough money to cover her needs.

In addition, the equity allocation of 4% international and 2% in emerging markets have little significance today. Almost all of the global economic growth is coming from Asia and Latin/Central America. Why would an investor want to be cut off from that potential? Just because some model suggest it?

This part of her allocation can be on the more aggressive growth side. ETFs such as WisdomTree’s Emerging Market Equity Income (NYSEARCA:DEM) with a 3.7% yield, or their Asia-Pacific ex-Japan (NYSEARCA:AXJL) offering a 5.42% yield pay nice dividends and have the potential for big gains as well.

A more appropriate retirement portfolio in her situation may look something like this:

  • 40% in individual dividend payers (an average yield of slightly more than 4% will generate $10,000)
  • 25% in Asian, Latam equity ETF’s focusing on dividends ( an average yield of 4% generates $6,000)
  • 20% in a 1-4 year corporate bond ladder using investment grade bonds ( average yield of 2.5% generates almost $3,000)
  • 10% in Market Vectors Latam Aggregate Bond ETF (BONO) (with 5.7% yield generates over $4,000)
  • 5% cash

This portfolio is much more balanced, generates more than she needs and allows for capital appreciation.

Retirees must think more strategically and not rely on data that was relevant when they were younger. The world has changed and in order to hit your retirement goals, your investments need to change as well.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. However, I have clients who have positions in some or all of these stocks