With Treasuries paying about the same as inflation, let's see what kind of strategy retirees need to live the dream.
Living the Dream
- What the market is, and is not, giving us
- A strategy to adapt
- Timing issues
The Market - Buried Treasuries
Yields are at all time lows - bonds are keeping pace with inflation, and that's about it. The 1-year Treasury is paying 0.55%, the 10-year is paying 1.71%, the 20-year is paying 2.14%, and the 30-year is paying 2.55%.
So where does that leave the Treasury-invested retiree? If a 60-year-old retiree has $1,000,000 in inflation-equaling Treasuries, they get about $43k in annual payouts:
That payout may not be enough, so let's look at investing in stocks.
Equities' Elusive Returns the Only Game in Town
The stock market is famously said to return 10-12% per year, depending upon when you start counting. The NYU Stern School of Business gets data from the Fed, and calculates an arithmetic average annual return of 11.41% for the S&P 500 (NYSEARCA:SPY) from 1928-2015.
If a 60-year-old retiree has $1,000,000 in the S&P 500 and gets an 11.41% compound annual growth rate, they get about triple the annual payout of Treasuries:
That's a little more like it.
Too Much Equity Risk
100% equities is a little too risky for the average retiree, so let's have a look at the tried and true 60% Equities/40% Treasuries portfolio.
We will only get 3/5ths of the S&P 500 return, which comes to 6.85%. That annual payout on $1,000,000 still comes to about twice what Treasuries gave us:
Not bad, but there's another problem.
The difference between compounding at 10% or 12% is significant, and data from Shiller goes back to 1871 and puts the average return of the S&P at 10.71%. With a 60/40 split, annual payouts are a little lower:
Not bad, but we forgot about inflation.
Inflation Adjusted Returns
On an inflation adjusted basis, the average return drops to 8.53%. With a 60/40 split, our return is down to 5.12%, and payouts fall some more:
Still, we are doing much better than we were with just Treasuries.
The 8.53% average is not wrong. If an investor were in the market for one year, this is the likeliest return they would get. But the number is arithmetically calculated, and misleading.
The rate of return often cited for the stock market of 10-12%, or 8-10% after inflation, is calculated by adding up each year's return and dividing by the number of years. This gives an inaccurate result.
For example, if our $1,000,000 goes up 10% in Year 1, and then down 10% in Year 2, what is the average?
Arithmetically, you would add up the two numbers and say the average is 0.
But if our $1,000,000 goes up 10% to $1,100,000, and then goes down 10%, it does not go back to $1,000,000, but to $990,000. The averages have to be calculated geometrically.
And geometrically calculated, after inflation, including dividends, the S&P 500 has returned 6.86% annually since 1871.
Again, this is disappointing news as it pertains to our annual payout.
With our 60/40 strategy, our return drops to 4.12%.
Alternate Strategy Courtesy of the Oracle
The stock market is returning a little less than advertised, but it still sets us up for a much better annual payout than bonds. If we could get more than 60% into equity, we could expect a better payout still. Must we have 40% in bonds? Not everyone thinks so.
Warren Buffett's instructions for his wife's money, if he were to pass on first, had just 10% in bonds:
What I advise here is essentially identical to certain instructions I've laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife's benefit…My advice to the trustee could not 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
The idea here is 10% cash, which will return about -2% each year with inflation, and 90% S&P 500. Re-balance once a year. If the market is up, that means selling stocks when they are high, if the market is down, that means buying stocks when they are low.
In good times, take the payouts from equities. In bad times, take the payouts from cash.
An interesting strategy from the Oracle, let's look at the projected payouts:
6.86% X .9 = 6.17%
-2% X .1 = -0.2%
Total return = 5.97%
Now our annual payout is all the way back above $80,000, about double where we were with Treasuries alone, and 19% higher than the 60/40 strategy.
Mr. Buffett's strategy looks good in general, and especially so in a low rate environment.
Timing the Market
So, if we are on the sidelines, should we dive right into this strategy, or wait for a better entry point?
If we wait, we may get a better entry point, and that would be nice.
On the other hand, a better entry point may not come along, and we would be forced to buy in higher, or stay in bonds perpetually, with an annual payout of $43k instead of $80k+.
So the downside is clear, half of our potential return is left on the table. What about the upside of waiting for a better entry point?
Let's say that from right here the S&P 500 will indeed return 6.86% compounded annually for the next 23 years. But we wait, and the market drops 10%. We buy $900,000 worth of the SPY and leave $100,000 in cash. The market quickly rebounds 11.12%. Now the S&P 500 is back to where it was, but we have $1,100,000. Now our annual payout looks like:
The payout is higher, but still in the $80k's.
Even if we were to get a 20% drop, followed by a 25% gain, and we timed it perfectly, we still don't quite get to six figures in payouts:
The payouts are nicer if we can time the market. But they are not that much better, especially compared with the risk of no return at all in bonds.
There are no guarantees as to what the returns of stocks will be. Over a long enough period of time, like 23 years, stocks should do quite well. Warren Buffett's strategy looks like a good one in general, and especially to combat the low yields of Treasuries.
The stock market's returns are often advertised as higher than they really are. But they are still good returns, especially when compared to Treasuries. Baby boomers that retire today can expect to get about twice their annual payouts by using Warren Buffett's 90/10 strategy over Treasuries, and about 19% more than with the 60/40 strategy. In addition, waiting for a dip will yield a better payout if the timing is right, but the risk of missing out altogether may be the greater risk.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.