May 14, 2017

Surprises, the good, the bad and the ugly. When we are in retirement, we are less resilient when the bad or ugly surprises happen. There are event surprises and process surprises. An event surprise might be the damage and loss from a weather related event. A process surprise can be even more deadly because it happens over time.

Misestimates and unrealistic expectations are two types of process surprises. Let’s look at the first type – misestimates. In a recent survey, Boomers were asked to estimate the percentage of income they would have to spend on healthcare. The average estimate was a bit less than 25%. The actual average is a third of retirement income. Let’s say a couple gets $4000 in monthly income from Social Security, interest and dividends. If they had budgeted $1000 (25%) of that for healthcare costs, then discover that they are spending over $1300 a month, that extra cost will slowly eat at their savings base.

A good rule of thumb is to estimate that, in the first few years of retirement, we will spend as much if not more than we spent before we retired. If we are wrong and we spend less, that’s a good surprise. In those first years we may find that we are spending more in one area of our lives and less in another.

The second type of process surprise – unrealistic expectations. Let’s say I expect to make 8% per year on my savings with a small amount of risk. People with a lifetime of experience in managing money struggle mightily to accomplish this and all but a few fail. Either they must take on more risk or lower their expectations of return.

Vanguard and other financial companies provide the expected risk and returns of several different allocations over many decades. Here‘s a chart at Vanguard that does not include a cash allocation in its calculation.  These long term calculators have another drawback: they include rather unusual times in history – the 1930s Depression era and World War 2.

We could use the last twenty years of actual returns to guide our expectations for the next twenty years. In past articles, I have linked to the free tools available at Porfolio Visualizer and there is a permanent link on the Tools page.

I select 1997 for the starting year and 2016 for the ending year. I leave the default settings at the top of the screen alone for now. If I input 40% into the U.S. Stock Market, 40% into the Total U.S. Bond Market, and 20% into Cash, I have chosen a conservative allocation – 40/40/20. I click the Analyze Portfolios button and see that the return was a bit over 6% in the CAGR (Compound Annual Growth Rate) column. How likely am I to achieve 8% over the next 20 years? Not very likely.

I’ll input a moderate allocation of 60% stocks, 30% bonds and 10% cash. The result is an almost 7% annual return so I am getting close to my 8% but there was a nasty time when I lost 1/3 of the value of my portfolio. If I am 70 years old, how comfortable would I be if I watched my portfolio sink almost 33%? I think I would have some restless nights worrying whether I would have to go back to work. How up to date are my skills? Would my prospective employer allow me to take a short nap in the afternoon? I feel so rested and ready to rock and roll after a nap. Well maybe not.

Wait a minute, I tell myself. The past 20 years included the busting of a tech bubble, 9-11 and the 2008 financial crisis. Two of those were rather extraordinary events. So I pick a different 20 year time period, 1987 – 2006. That still includes some serious shocks like the tech bubble and its pop, as well as 9-11. My conservative allocation of 40/40/20 made 8-1/2% CAGR and the moderate allocation of 60/30/10 made 9-2/3%.

But I’m not happy with the risk. I could even decrease my risk and make my 8% return by choosing a very conservative allocation of 30% stocks, 50% bonds and 20% cash. My portfolio lost less than 10% in its worst year ever – the maximum drawdown. If I go to Vanguard’s risk return chart they estimate a 7.2% average return over 90 years, which included a horrible depression that lasted a decade and a world war. It’s to be expected that my 20 year period 1987 – 2006 would do a bit better than the 90 year average because the catastrophic shocks are not included.  I think my 20 year period is more representative of the risks I will face in the next 20 years.

I could have picked the 20 years from 1981-2000 and that would have been unrealistic. The conservative allocation earned more than 10% and the annual return on the moderate allocation was almost 12%.

So I have now set what I think is a realistic 20 year time frame that gave me the historical risk and reward that met my expectations. But that’s not realistic. Not yet. I am going to be taking money from this portfolio to supplement my retirement income. So now I go back up to the top of the screen where the defaults are and under “Periodic Adjustments” I select the “Withdraw fixed percentage” option and under that I input 4.0%. This is supposed to be the safe withdrawal percentage. The next row is the “Withdrawal frequency.” I’ll select Annual.

Since I am now taking cash out this portfolio, I will turn to the IRR column of the results because the Internal Rate of Return calculation considers cash flows. My very conservative allocation of 30/50/20 has an IRR of almost 8.5% with a drawdown of less than 15%. The column that says “Final balance” shows that I have more than double the money I started out with and I have been able to withdraw 4% per year. I would have liked to get the drawdown below 10% but I think I can live with 13-1/2%. I’ll be worried but I don’t think I will lose sleep over it. So now I have made what I think is a reasonable expectation of risk and reward based on historical returns.

There’s one last thing I need to do. I know that the 20 year period from 1929 to 1948 was bad but I can’t check that in Portfolio Visualizer because the year selection only goes back to 1972. So I select a really bad ten year period, 2000 – 2009. This was from the heights of the dot.com boom to a short time after the financial crisis. After taking 4% per year, the IRR on my very conservative allocation was 4% and I still had the money I started out with at the beginning of the ten year period. I could probably withstand a 20 year period like this as long as I stay true to my allocation.  But, the maximum drawdown (see here) was 21%, something that I am not comfortable with.

I am left with some hard choices.   In the case of another bad ten year period, I can lower my withdrawal percentage a bit or I can learn to have faith in the allocation process and accept the drawdown.  I have done this with a free tool. I could pay for more sophisticated tools that gradually transition from one allocation to another allocation over a 20 year period.  That would be more realistic still since I will probably get more risk averse as I get older. At least this gets me started.

We often can’t avoid the suprise events. Some surprises are both event and process like the diagnosis of a  life-threatening illness. We can understand and be alert to the process surprises that we may inflict on ourselves. Understanding involves some frank self-assessment and difficult questions. Am I prone to wishful thinking? Do I overestimate my tolerance for risk? How well do I live with the consequences of my decisions?

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CAPE

A few weeks ago I mentioned that I might calculate a 20 year CAPE ratio. The CAPE that Robert Shiller uses is a ten year period. As of the end of 2016 the 20 year CAPE was 31 vs the 70 year average of 21. Whichever calculation we use, the market is priced a good deal above average. The 20 year CAPE first crossed above the average in the late summer of 2009.

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California

Over the past 5 years California’s economy has grown faster than any other developed country except for China. Bloomberg article