The Retirement Risk That No One Tells You About

| About: Vanguard Total (VTI)

Summary

Index investing and dividend-based strategies have become increasingly popular with retirees in the last 5 years.

Both strategies, despite strong recent returns, contain a significant risk that no one talks about and most retirees are not aware of.

A diversified, total-return approach is the most effective way to reduce the risks of traditional indexing and dividend-based strategies and can lead to vastly improved retirement outcomes.

The two most significant trends in retirement investing over the last 5 years have been the move towards index funds and dividend-based investment strategies (mutual funds, ETFs, individual securities, etc.).

Indexers recognize that traditional active management has not served them well - the fees are too high, the performance too low and the tax consequences too burdensome. Indexers mostly opt for S&P 500 and Total Stock Index funds, including in some cases their international counterparts (EAFE or Total Int'l Stock Index funds).

Dividend-based investors are looking for simplicity and convenience. While working, we're used to getting a consistent paycheck we can live comfortably on. This is the same objective retirement-driven dividend investors have - if you buy a basket of high-yielding stocks or stocks whose dividends are growing, you can simply spend the cash flow without being bothered to sell shares. There's a behavioral component as well - we feel more comfortable when we aren't forced to sell precious principal.

Despite the fact that dividend and appreciation are simply different components of total return, and both components are predicated on the prospects of an individual company, spending the dividend feels like house money, without needing to tap into the portfolio corpus. Companies that pay dividends aren't inherently superior to those who have lower or no dividend payouts (after adjusting for each company's value and small-cap orientation), but still, the ease of a direct payment is one of the main reasons that retirees have a penchant for these stocks.

Unfortunately, both of these approaches in retirement entail a significant risk that many investors are unaware of. If this risk happens to materialize, retirees could experience the very outcome they seek to avoid from inferior investment approaches: a drastic reduction in ongoing income or running out of money completely.

How can these seemingly different strategies have a similar risk? Simple - both traditional index funds and dividend-based strategies have one thing in common: Their holdings tend to be concentrated in the US large cap asset class - an asset class, like all others, that can go extended periods of time with subpar returns despite the expectation of good long-term results. If you happen to retire with one of these strategies at a time when US large stocks are about to embark on a long stretch of underwhelming performance, you could find that the combination of low returns and regular withdrawals leads to an irreversible decline in your retirement portfolio.

Importantly, I'm not pulling this risk out of thin air. It can be illustrated with an example from just recent history. Consider the hypothetical scenario where a person retired in 1999* with $1M needing $60,000 per year from their portfolio, adjusted for inflation. In reality, this could be someone who started with a lower income requirement but who saw their actual cash-flow needs unexpectedly rise (to average 6%), or someone who did in fact need a high starting value and also needed it to grow over time. Whatever the case, we see that their choice of investment approach had a significant impact on their relative success. This link takes you to the details that I will summarize and comment on below.

In the first of three examples, our retiree took the "low-fee" road, opting for a 70% Vanguard Total Stock Index (NYSEARCA:VTI), 30% Vanguard Total Int'l Stock Index (NASDAQ:VXUS) portfolio. In the second, our retiree purchased a basket of dividend-growth stocks, modeled using the T Rowe Price Dividend Growth Fund (MUTF:PRDGX), a professionally managed, low-cost, 5-star rated mutual fund portfolio that is surely representative of a well-executed dividend-growth strategy. The third approach will be familiar to those who have read my articles before; it is a broadly diversified stock portfolio spread sensibly across large/small and growth/value stocks globally.

Of course, over any random 20-year period, you would expect some approaches to come out further ahead and some to come out a bit behind simply by chance. But the outcome of these examples were much more dramatic.

Retirement Investing Approach

Starting Value

Ending Portfolio Value as of 9/30/2016

Low-Cost Indexing

$1,000,000

$164,357

Dividend Growth

$1,000,000

$131,493

Diversified, Total-Return Investing

$1,000,000

$1,829,264

Click to enlarge

The ending-value differences were remarkable across the three scenarios. The "low-cost indexing" and "dividend-growth" approaches wound up in the same place: just about bankrupt. Of course, 1999 was the last year of glory for US large stocks until just recently, and this headwind in the early 2000s punished both strategies despite differences in construction.

The retiree in the index and dividend-growth approach who made no income adjustments saw their $1M portfolio dwindle to $164,357 and $131,493 respectively. This represented less than 2 years of the remaining cash flow ($60,000 had grown to $86,593 by 2016). The "new" retirement plan for indexers and dividend-growth investors would have been either to drastically reduce spending or simply accept running out of money - a nightmare either way.

The same ill fortune did not befall the diversified, "total-return" investing retiree. They only held 40% of their portfolio in US large cap stocks, and half of that (20%) was in large value stocks which performed markedly better (+7.7% a year) than US large growth stocks (the S&P 500 returned just +5.2% a year).

Over a period where the Total US Stock Index returned just +5.7% a year, the International Index did only +4.2% and the dividend growth portfolio just +6%, our diversified investor held 6 different asset classes that produced returns of at least +10% a year. Two others eclipsed the +9% a year mark. The total portfolio managed to earn +9.1% a year, 50% more than either of the concentrated approaches. That is to say, diversification worked brilliantly. Low fees and a direct-dividend approach? Not so much.

This is more evidence, incidentally, that dividend-based or dividend-growth strategies don't have any additional long-term expected returns over the market (+6% vs. +5.7%) that aren't explained by their potential small cap or value exposure; it's simply that their returns come in a slightly different form: more in dividends and less in capital appreciation.

But the real testament to the diversified strategy for the retiree can be measured by the progress as of late 2016: The previous year's withdrawal only represents a spending rate of 4.7% of the accumulated principal ($86k from a $1.8M portfolio), an even lower amount than the 6% that was originally required. After almost 20 years, the total-return retiree had accumulated a significant margin of safety, despite a very difficult starting period.

The risks of the other approaches, the ones no one seems to be taking about, are on full display. The 2016 required income represents 53% and 66% of the remaining principal of the low-cost indexing and dividend-growth approaches. Clearly, if you put all your retirement eggs in one basket (such as US large cap stocks), regardless of the exact approach (low-cost indexing or cash-flow based dividend screens), sometimes that basket fails to achieve its expected results over your time horizon. You can diversify that risk away by holding a global asset class portfolio, or you can roll the dice.

It's true, a "total-return approach" to generating retirement income takes a little more work than a dividend-based strategy, and you have to face the reality that your ongoing cash flow will come not just from (smaller) dividend payments and bond interest, but also periodic sales of stock and bond mutual fund shares. But so long as this effort provides you the most income and the most reliable long-term cash-flow stream, this seems like a small price to pay.

Because there has been so much interest in this total-return approach as retirees are starting to rethink the traditional dividend-based approach to retirement, my next article will explain in detail exactly how to execute it by drawing on the scenario I've outlined here. Stay tuned!

And, as always, your comments, questions and thoughts are greatly appreciated.

*1999 was the first full year of available data on all the holdings in the "Diversified, Total Return Portfolio"

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Past performance is not a guarantee of future results. Mutual fund performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

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.