Retirees, The S&P 500 And Cash Are All You Need

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Includes: SPY
by: Dale Roberts

Summary

What simple portfolio survived 40 years that included stagflation, the tech meltdown and the Great Recession? The S&P 500 covered by cash.

This $1 million portfolio delivered nearly $5 million in income from 1972 to 2012.

The total return of the S&P 500 can do the trick and provide the growth necessary to help retirees beat inflation.

We'll have a look at the spending ratio of the portfolio and explore what is "the tipping point".

Arch enemy #1 for retirees is inflation. OK, we might also include not having enough money saved to reach the lifestyle that the retiree would desire. But that's another story and series of articles.

Let's assume that a retiree has amassed a portfolio that will allow them to enjoy a wonderful retirement. The problem is, that retiree has to then harvest those investments to support that lifestyle and they have to increase the level or rate of harvesting of those investments to keep up with inflation.

Inflation can drastically increase the amount of money you need to harvest, in a very short period of time. Consider that if you had a $1 million portfolio in 1972 and began harvesting at 4% of portfolio value, you would need to harvest (in the area of) $79,000 ten years later in 1981, $122,000 in 1991, $161,000 in 2001 and about $207,000 in 2012. Inflation killed retirees' dreams in the 1970s. Of course that period was known as stagflation, and it was also known as the period when nothing worked. Stocks were no match for inflation. Bonds were no match for inflation. Cash delivered some very nice rates, but not when one factored in inflation. Here's my article on that period when "nothing worked."

That was a trying period for investors whether in the retirement or accumulation phase.

So what would have worked for retirees? What would have delivered a 4% draw down of assets with inflation adjusted spending, and allowed that portfolio and retirement funding to last an incredible 40 years? What strategy would have supplied the nearly $5 million in spending required on a $1 million portfolio?

What worked was the stock market index S&P 500 (NYSEARCA:SPY) and cash. Three years of total spending in cash to be exact. That strategy would have made it through the stagflation of the 70s and early 80s, through the tech meltdown of the early 2000s (where we experience three successive down years for SPY), and through the Great Recession. Now it was certainly wobbly through the 2000s but it made it through.

The reason for the 3 years of cash is time horizon protection, with the idea that the investor not sell any equities in a down year. Three successive down years is a record to date for the markets, though we should consider that anything can happen in the future. That event occurred in the Depression and again, in that 2000-2002 period. It is more common to have a single year of negative returns. In fact, two successive years of negative returns only occurred once, in 1973-1974. Meaning that most of the time, that cash is hurting your total return potential. But that's the case with insurance, it costs you until you need it. That's why the S&P 500 has a historical 95% success rate for delivering 4% inflation adjusted spending for the retiree, back to the Depression according to the Monte Carlo simulator on moneychimp.com.

So here's how that spending pattern played out, year by year with the spending ratio noted - that is the amount of spending relative to the total portfolio value.

The retiree started with a portfolio value of $1 million, with $874,000 in the S&P 500 and $126,000 in cash. In a down year for the markets, the investor harvested the cash, in a good year for stocks the investor harvested the stocks. The portfolio was rebalanced to 3 years worth of inflation adjusted cash at each year end. Moneychip.com was used for S&P 500 total return, bankrate.com was used for historical CD rates, Crestmont Research was sourced for Treasury bond returns. Aboutinflation.com was used for historical inflation rates.

Income = annual spending, Balance = portfolio balance. Ratio = percentage of portfolio value spent.

That's an aggressive portfolio mix that Warren Buffett would certainly like. Written into his will is that his personal holdings will go into 90% SPY and 10% bonds. You were close Warren, real close.

Year

Income

Balance

Ratio

1972

40,000

1,126,011

3.5

1973

42,000

940,977

4.4

1974

44,100

686,197

6.4

1975

48,069

835,646

5.7

1976

51,427

943,139

5.4

1977

54,512

835,495

6.5

1978

58,327

826,246

7.0

1979

64,159

884,845

7.2

1980

71,858

1,036,145

6.9

1981

79,043

957 836

8.2

1982

86,947

1,029,246

8.4

1983

90,424

1,113,380

8.1

1984

94,040

1,088,604

8.6

1985

97,801

1,239,309

7.8

1986

100,735

1,319,406

7.6

1987

102,749

1,286,879

8.0

1988

106,858

1,343,575

7.9

1989

111,132

1,547,624

7.1

1990

116,688

1,409,491

8.2

1991

122,522

1,602,665

7.6

1992

127,422

1,573,364

8.0

1993

131,244

1,563,835

8.3

1994

135,181

1,457,471

9.2

1995

139,236

1,682,394

8.2

1996

143,413

1,815,173

7.8

1997

147,715

2,100,002

7.0

1998

150,669

2,397,244

6.2

1999

153,682

2,643,071

5.8

2000

156,755

2,309,539

6.7

2001

161,457

1,947,320

8.2

2002

164,686

1,470,762

11.2

2003

167,979

1,543,342

10.8

2004

171,338

1,471,392

11.6

2005

176,478

1,345,121

13.1

2006

181,772

1,268,642

14.2

2007

187,225

1,160,053

16.1

2008

192,841

768,140

25.0

2009

195,000

622,505

31.0

2010

198,900

410,082

48.5

2011

202,878

222,737

90.9

2012

206,935

15,960

I could (and might) write several articles based on that set of calculations. There is so much to see and learn from those numbers and spending ratios.

There are two massive events to consider.

The portfolio was dead out of the gate. After 3 years the portfolio value was down to 686,000 and it was spending 6.8% of the total portfolio value. That would have been emotionally crippling for the retiree. To recover, that portfolio has to create returns above 6.8% plus inflation. Inflation was starting to really pick up momentum at that point. But sure enough the market then delivered returns of 38% and 24% in '75 and '76. That was a short-term boost, but the portfolio was still wobbly.

In the early 1980s, the retiree was spending over 8% of the portfolio value. No one would ever suggest an 8% harvesting of portfolio assets, but it made it through. Why? Because the stock market returns were outrageous. From January 1979 to end of 2006, the stock market provided average annual returns of 14.64% according to moneychimp.com. The inflation adjusted real returns over that period were 9.19% per year.

From January of 1979 to end of 1999 the market delivered average returns of 18%, annually. Ha, there's nothing average about those kinds of returns. So it's not a surprise that a portfolio that should have been "Dead Portfolio Walking" was given a new life, and kept delivering all while living on the edge. Its spending ratio was always in dangerous territory.

Event number 2 is the tragic death scene. It certainly met its maker when the tech crash came along. The tech meltdown delivered 3 successive down years in 2000, 2001 and 2002. The fatal blows were delivered, but the portfolio soldiered on to fight for another decade. But by that time the portfolio model simply has too much in cash and not enough in stocks to participate in any market gains.

Final Thoughts

If you need a generous spending ratio, consider a very healthy growth component in retirement. Total return and earnings power is what will keep your portfolio alive and kicking. Though we do need to cover our assets with cash (and perhaps bonds).

A very sensible defense against the tech correction was a balanced growth portfolio as I demonstrated in this article. I will be back with more research on the optimal mix (and match) for the 2000 correction, and why the above returns are not likely repeatable from today's stock market valuations. Given that, please do not rush out and make a massive investment in stocks. In fact never make a quick decision based on any Seeking Alpha article. Always factor in any research into your overall decision making process and ensure that you have a well defined strategy before proceeding. I did not address international diversification, and that may be a wise consideration as well.

For the retiree, every start date has its challenges and opportunities, but a simple balanced approach using stocks, cash and bonds should help you reach your income goals.

Happy investing, be careful out there, and always know your risk tolerance level.

Disclosure: The author is long SPY, EWC, EFA, VIG, ENB, TRP, AAPL. Dale Roberts is an investment funds associate at Tangerine Investment Funds Limited. The Tangerine Investment Portfolios offer complete, low-fee index-based portfolios to Canadians. Dale's commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process. The views expressed are personal and do not necessarily represent those of Scotiabank.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.