With spiking volatility, toppy markets and memories of the 2008 financial crisis indelibly imprinted on investor psyches, it can be tempting to try to avoid market risk and hide out in the relative stability of cash or bonds. This can be a mistake, however, especially for those in or nearing retirement. As Craig L. Israelsen, PhD, points out in a study published in the recent Forbes magazine article "How Safe Is Your Retirement Portfolio?" the avoidance of short-term volatility can actually increase the likelihood of running out of money in retirement.
Cash and Bonds Seem Safe
According to Israelsen's study:
- U.S. bonds averaged 5.41% from 1926 to 2014 with the worst one-year return of -2.92% in 1994. Over the 89-year period, only nine years had negative returns-about 10% of the time.
- 90-day U.S. Treasury bills (a proxy for cash) averaged 3.60% with a worst one-year loss of -0.02% in 1938.
- Meanwhile, the S&P 500 (a proxy for U.S. large cap stocks) had an average annualized return of 10.12% but suffered a worst one-year loss of -43.34% in 1931. Of the 89-year period from 1926 to 2014, large cap U.S. stocks had negative returns in 24 years, or about 27% of the time.
Given the extent and frequency of negative returns, it's easy to see why investors might be tempted to forego the higher overall returns of equities for the lower, but more stable returns of cash and bonds.
The Best Portfolio Allocation?
A retirement portfolio needs to accomplish the somewhat conflicting objectives of controlling downside risk and achieving a reasonable rate of return. Ultimately, though, it needs to allow an investor to withdraw an income that increases yearly with inflation while minimizing the chance that the portfolio will run out of money before the end of the retirement period.
To determine the best type of portfolio to achieve this objective, Israelsen constructed a number of different portfolio allocations subject to withdrawal rates ranging from 3% to 7%. (The withdrawal rate is the percent of the portfolio that is withdrawn each year to fund retirement expenses.) The retirement period was assumed to be 35 years. This may seem long, but the average retiree will spend 20-25 years in retirement. This means that half of all retirees will spend longer than the average in retirement; we just don't know which ones.
Some key portfolio allocations included in the study:
- All-cash portfolio
- 100% U.S. bond portfolio
- 40% stock/60% bond: Represented by the S&P 500 and U.S. bonds rebalanced annually
- Four-asset portfolio: 25% S&P 500, 25% U.S. small cap stocks, 25% U.S. bonds and 25% cash rebalanced annually
The study assessed the ability of each portfolio to sustain withdrawal rates of 3%-7% over a 35-year period with the withdrawals increasing by 3% yearly to account for inflation. The time period for the study spanned from 1926 to 2014 for which there were 55 rolling 35-year periods.
So, if we looked at a $1 million portfolio, the withdrawal rates would range from $30,000 to $70,000 per year starting in year one and then increase each year by 3%. The first 35-year period would start in 1926, the second 35-year period in 1927 and so on.
All-Cash and All-Bond Portfolios Don't Hold Up
The results may be surprising, especially for those trying to avoid risk.
- The all-cash portfolio lasted the full 35-year period only 56.4% of the time for a withdrawal rate of 3%. At withdrawal rates of 6% and 7%, the all-cash portfolio never lasted.
- The 100% U.S. bond portfolio lasted 69% of the time at a 3% withdrawal rate. It lasted only 30.9% of the time at a 5% withdrawal rate and 9.1% at a 7% withdrawal rate.
- The 40% stock/60% bond portfolio lasted 100% of the time at a 3% withdrawal rate, 89.1% at a 5% withdrawal rate and 43.6% at a 7% withdrawal rate.
- The four-asset-class portfolio lasted 100% of the time at a 3% withdrawal rate, 89.1% at 5% and 50.9% at 7%.
There are a number of important points highlighted by the study. Perhaps the most important is to understand that the goal of a retirement portfolio is to last through retirement, not avoid short-term market volatility. Some others are:
- The higher the withdrawal rate, the higher the risk that the portfolio won't last, regardless of the allocation. Withdrawal rates of 2%-3% are fairly safe for most diversified portfolios but don't produce much income. Withdrawal rates of 4%-5% are reasonable compromises between income and safety.
- All-cash portfolios are the riskiest, despite the appearance of stability. Even at very low withdrawal rates, an all-cash portfolio rarely lasts. The reason is that returns on cash generally don't keep up at the rate of inflation. Based on today's cash rates, many investors are earning a negative return after inflation.
- A 100% bond portfolio is not much better than cash, especially where rates are today. Bond yields are at historic lows, and when interest rates rise, bond prices will fall. Bond returns can also remain low for extended periods of time. From Israelsen's study, U.S. bonds only averaged a 2.19% return over the 29-year period from 1941 to 1969.
- The addition of higher return, but more volatile equities significantly increases portfolio survival rates across all withdrawal rates. Short-term portfolio volatility increases, but the chance of running out of money during your retirement decreases significantly.
- The addition of asset classes increases portfolio survivability rates for all withdrawal rates above the simple stock/bond split. The study looks at a simple four-asset-class allocation, but numerous studies have shown the benefit of adding additional asset classes. Diversification adds value.
Some Additional Considerations for Expats
Inflation: Most portfolio studies are based on developed market data where inflation rates tend to be lower and more stable. For those retiring in emerging markets or places such as developing Asia, inflation can be higher and more volatile. This can be mitigated to an extent by holding more resident country fixed income (if it is available), but those in high-inflation environments will have to consider lower withdrawal rates to ensure portfolios last.
Currency: As anyone who has watched the impact of a rising U.S. dollar on global exchange rates can attest, currency movements can have a big impact on expat portfolios and income, especially if there is a mismatch between your assets and liabilities. Developed market currencies tend be more stable, but as the U.S. dollar/euro shows, that is not always the case. Again, holding more fixed income in the currency of your expenses along with a global mix of equities and lowering your portfolio withdrawal rate can help reduce risk.
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About Creveling & Creveling Private Wealth Advisory
Creveling & Creveling is a private wealth advisory firm specializing in helping expatriates living in Thailand and throughout Southeast Asia build and preserve their wealth. The firm is a Registered Investment Adviser with the U.S. SEC and is licensed and regulated by the Thai SEC. Through a unique, integrated consulting approach, Creveling & Creveling is dedicated to helping clients cut through the financial intricacies of expat life, make better decisions with their money, and take the steps necessary to provide a more secure future. For more information, visit www.crevelingandcreveling.com.