Demographic Blues

The Federal Reserve Bank of San Francisco published a fascinating piece of research on Monday relating U.S. stock market performance to demographic trends. The results are not encouraging for long-term 'Buy and Hold' type investors.

Boomer Retirement: Headwinds for U.S. Equity Markets?

By Zheng Liu and Mark M. Spiegel

Historical data indicate a strong relationship between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. Statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades.

Historical data suggests a strong relationship exists between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, Boomers are likely to shift from a bias toward saving and buying stocks, to selling their equity holdings to finance retirement. Statistical models suggest that this shift could substantially depress equity valuations over the next 15 years or more.

Without belaboring the mechanics of the study, the researchers analyzed trends in the proportion of middle-aged workers in the U.S. economy relative to the proportion of retired workers to forecast future stock market valuations. This research follows other studies which found that the booming markets of the 1980s and 1990s were largely attributable to the bulge bracket of baby boomers who were entering their prime saving and investing years during those decades.

In contrast, the current Federal Reserve study finds that, as the ratio of middle aged workers to retired persons is forecast to fall persistently through 2025 as the bulk of baby boomers retire, these same boomers will be withdrawing savings from stock and bond markets, thereby exerting slow but steady downward pressure on prices of financial assets, including stocks, for the foreseeable future.

The specific demographic ratio analyzed in the study is the M/O ratio, which is the population ratio of those aged 40 - 49 to those aged 60 - 69. This ratio broadly captures the number of people in prime saving and investing years relative to the number of people who are beginning to withdraw from savings to fund retirement. From 1981 to 2000 this ratio increased from 0.18 to 0.74 at the same time stock valuations rose from roughly 8 times earnings to almost 30, and the main U.S. stock market index exploded from 150 to almost 1500.

Source: Stockcharts.com

Sadly, the U.S. Census Bureau is forecasting exactly the opposite dynamic to play out over the next 15 years as boomers retire. As this demographic scenario unfolds, the Federal Reserve Bank's model suggests that stock prices will enter a persistent decline until 2021. Further, stocks are not expected to exceed their 2010 levels until 2027, after adjusting for inflation.

Key findings:

• The M/O ratio explains about 61% of the movements in the P/E ratio during the sample period. In other words, the M/O ratio predicts long-run trends in the P/E ratio well.
• Given the projected path for P/E* and the estimated convergence process, we find that the actual P/E ratio should decline from about 15 in 2010 to about 8.3 in 2025 before recovering to about 9 in 2030.
• The model-generated path for real stock prices implied by demographic trends is quite bearish. Real stock prices follow a downward trend until 2021, cumulatively declining about 13% relative to 2010. 
• Inflation adjusted stock prices are not expected to return to their 2010 level until 2027.
• On the brighter side, as the M/O ratio rebounds in 2025, we should expect a strong stock price recovery. By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010.

Source: Federal Reserve Bank of San Francisco

Interestingly, the conclusions from the Federal Reserve paper mirror the conclusions from our own proprietary 'Estimating Future Returns' models, which suggest investors should expect near zero returns after inflation for at least the next 15 years.

Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)

While this outcome may appear inconceivable to many, I would urge you to examine the path of Japanese stocks from their peak in 1989 at almost 40,000 to their current price under 10,000. Japan suffered from too much debt and an unhealthy property sector, but these headwinds were amplified by another challenge which we in the West share (though not quite as badly): a declining share of working persons relative to retired persons.

Source: Stockcharts.com

Perhaps not surprisingly, U.S. stock markets have been tracking the performance of Japanese stocks since U.S. stocks peaked in 2000. When we overlay the two stock market indices and align their respective peaks, the resemblance is uncanny (and not a little bit shocking for 'Buy and Hold' investors). If we continue to track the Japanese experience, we may be setting up for another major drop, perhaps to new lows.
Source: Bloomberg, Ritholtz.com

You probably aren't hearing this message from pundits on TV or in the papers, or economists at the major banks or investment firms. However, I urge you to keep three thoughts in mind when you hear these experts speak:

1. If a person's job depends on them not knowing something, then they won't know it.

2. Investment firms make much higher margins from clients who hold or trade stocks or stock mutual funds than from clients who hold bonds or cash instruments like GICs or money market funds. As such, they have a strong incentive to keep clients invested in stocks and stock mutual funds at all times, per the 'Buy and Hold' approach.

So what is a person to do when long-term Canadian bonds are yielding 0.64% after inflation, and developed market stocks are likely to yield no returns (but probably typically high volatility) for the next 15 years or more?

At Butler|Philbrick & Associates, we have a plan. At its core, our approach embraces two major areas of differentiation:

1. Broaden the investment opportunity set for portfolios to include international and emerging market stocks, real estate, commodities,etc. Cash is an asset class!
2. Apply a proven process to decide which asset classes to own (including cash when markets are risky), and when to own them.

As a proof of the effectiveness of our approach in difficult markets, we published a study on how to profitably trade the Japanese bear market back in February (see here for full study). We have suspected for some time that the Japanese template was the most likely trajectory for developed stock markets over the next several years.

In the study, we applied our trend following approach to the Japanese stock market to see how it would have performed over its 21 year downhill roller coaster ride.

 

Source: Butler|Philbrick & Associates 

You can see in the chart that by taking advantage of both positive and negative trends using a simple timing system over this period, our technique delivered over 16% annualized investment performance, while never dropping more than 22.9% from any peak to trough (see "CAGR%" and "Max Total Equity DD" respectively in the table above the chart).

Pretty good results generally, but especially when they're compared with the 75% cumulative loss that most Japanese investors experienced by holding stocks over the past 20 years.

We are following a proven trend following model like the one above to deliver prospective returns for clients no matter what happens in markets. What are you (or your Advisor) doing to prepare for this potential investment outcome?

Time to Row

We have discussed at length the merits of our “Estimating Future Returns” model and its history of providing more accurate forecasts of future returns to stocks than traditional methods (for more on our real returns model click here).

It is essential to consider the myriad potential outcomes and the likelihood of each outcome occurring when determining whether your current investment strategy is appropriate, or whether an alternative strategy is warranted.

Considering the expected returns for the foreseeable future allows the wealth management process to be more adaptive to market conditions, a characteristic that can add tremendous value to a portfolio and a wealth plan over time. One of the single greatest failings of the traditional wealth management approach is its inability to integrate these ever changing projected future returns into the portfolio management process.

In fact investors almost never receive the very long-term rate of return that the dominant investment theory would predict (Dalbar, 2011). Instead, investors have historically received a random mix of very low and very high returns year in and year out. Worse, these high return and low return periods often cluster together over many years at a time. This is problematic if you happen to retire during a period of sustained below average returns.

These types of multi-decade bull and bear markets exist and are driven by market regimes where economic and psychological forces compel prices to move broadly higher or lower over many years at a time. If you refer to Figure 1 below you will see that retiring in a regime of persistent low returns is just as likely as retiring in a period where markets experience sustained above average returns.

The question becomes: What type of market are you retiring in? Further, what can you do to maximize your chance of a successful retirement?

Our “Estimating Future Returns” model allows us to better inform investors about where they sit today and what their likely prospects are for the medium term. As Ed Easterling of Crestmont Research puts it, valuation models allow us to more accurately gauge whether investors will need to ‘row’ for the foreseeable future or whether they can ‘sail.’

Over the last 100 years there have been four extended periods during which investors were forced to ‘row’ and three periods where investors could ‘sail.’ There was the raging bull market of the roaring twenties, which seemingly defied Washington’s policy makers. The brutal bear market of the Great Depression followed the ‘Roaring Twenties’, and lasted until the end of World War II.

The end of the Second World War preempted the post-war economic boom and concurrent long-term bull market that raged from the late 1940s to the late 1960s. The almost decade and a half long stagnation that followed was sparked off in earnest by the 1973 OPEC oil crisis and the subsequent dramatic rise in inflation expectations which pushed interest rates to their century highs by 1981.

This period was followed by the longest sustained bull market in the history of the United States, from the early 1980s to the ‘Tech Bubble’ in 2000. We have subsequently experienced the current decade’s financial turmoil which has seen financial markets recover from the depths of the Tech Bubble only to be met with substantial difficulties stemming from the collapse of the U.S. housing market in 2008; a state from which the market still has yet to fully recover.

Figure 1

   Source: Butler|Philbrick & Associates (2011)

What this should illustrate is that markets come in all shapes and sizes, and that the traditional ‘Buy & Hold’ approach to investing may not be the optimal strategy in all market environments.  Additionally, sustained bear markets inevitably follow sustained bull markets. Unfortunately, no one knows precisely when the switch will flip from one market regime to the other.

This creates the need for a strategy that is not only effective during both rowing and sailing environments, but which can also be effective during the transition between these two market regimes.

Rowing requires a dynamic and adaptive approach with periodic readjustments, while ‘sailing’ only necessitates letting the prevailing wind propel you toward your financial goals, while making minor adjustments once in a while to stay on course. Passive strategies like ‘Buy & Hold’ work adequately, but only in ‘sailing’ markets. In ‘rowing’ markets the only positive returns that investors receive are necessarily taken from someone else, as it is a zero sum game.

If you look at Table 1 below, you will notice that our “Estimating Future Returns” model very accurately estimated the forward fifteen-year market environment for both bullish and bearish market regimes of the past century. While traditional Advisors would have you believe that the best estimate of portfolio returns is always the very long-term average of 6.5% after inflation, our model has historically delivered much higher levels of accuracy. You can see in Table 1. that in sailing environments this 6.5% estimate is usually too low, while in rowing environments it is much too high.

Table 1

Source: Shiller (2011), Doug Short (2011), Butler|Philbrick & Associates (2011)

If the model’s past success is any indication, then we observe a high likelihood that investors will face a rowing environment over the next fifteen years. During these types of market regimes, it is essential to have a strategy that is adaptable to many different market environments, and can scour the globe for the best opportunities. In our next installment, we discuss a strategy that has the potential to deliver substantial risk-adjusted returns in all market environments, and demonstrate how it managed to deliver positive returns, even during one of this decade’s most challenging years.

The Fee Delusion

Fees are perhaps the most frequently discussed, and least well understood, factor in financial product marketing. Financial organizations that serve professional groups often focus on low fees to obscure the fact that their investment arm is understaffed, under qualified, and generally delivers poor service and performance. The simple reality is that in the field of investments, as in many complex fields, differentiated value isn't free, but mediocrity can come very cheap.


To illustrate, consider the following 3 proposed investments:


Advisor A proposes an investment in a fund with a history of performing in-line with stock markets. The manager performs slightly better during really poor periods in the market, slightly worse in really good markets, and averages returns of 1% better than stocks over the last 10 years, after accounting for fees and costs. Note that this performance would place the fund in the top 95% of all funds, as most funds don't come close to this track record. This fund has dropped by more than 35% from its peak twice in the past ten years. This fund charges a fee of 1%.


Advisor B proposes an investment in a systematic strategy, with a history of performing very differently than stock markets over time. The performance of this fund is largely independent of the direction of stock markets, and the fund has never been down more than 25% from its peak. It has performed about 10% better than stocks over the last 3 years, after fees and expenses. This manager charges a fee of 2%.


Advisor C proposes an investment in a fund with a history of exactly tracking the performance of stocks over the very long-term. This fund does well when markets to well, and poorly when markets do poorly. This fund has also been down more than 35% from its peak twice in the past 10 years. This fund charges 0.4% in fees.


All other things equal, which Advisor's proposal would you go with?

Mutual Funds: A Low Probability Bet


Before answering, I urge you to consider the following chart, which illustrates the probability that a fund which ranks in the top 25% of its category will even be ranked in the top half of its category four years later. Remember that funds selected at random would, on average, be in the top half of their category about 50% of the time. However, we see that top funds in one year have, on average, only about a 40% chance of being in the top half 4 years later. That is worse than random chance.

Source: Gene Hochachka, February 2008

http://ssrn.com/abstract=1094246

The Passive Option


Given the chart above, one could be forgiven for believing that it is not possible to deliver differentiated performance, and in fact there is a very large and credible contingent of the investment community that operates on that basis. This way of thinking is called 'passive investing', and I am willing to concede that for the majority of investors, this is probably the way to go. I concede this for most investors because it is actually very hard to find an Advisor or a fund manager who actually does add value over time, especially after fees and commission. Hard, but certainly not impossible, and potentially highly rewarding for those who do.


If you embrace a passive approach, the only logical strategy is indexing. This is a low-cost strategy which involves purchasing a diversified basket of broad-market Exchange-Traded Funds and holding them forever, with periodic rebalancing. A buy and hold strategy that emphasizes a diversified basket of global asset classes is almost certain to outperform cash in the bank over periods longer than 10 years. However, investors are vulnerable to behavioral biases that will make it hard for them to stick with this strategy when things inevitably turn ugly. Further, the unpredictable path of returns may have a substantial negative impact on your ability to achieve, or maintain, financial independence.


For investors that choose this route, we would be delighted to provide guidance on how to construct a well diversified portfolio of ETFs that will benefit from the ebb and flow of capital and opportunity in global stocks, commodities, real estate and bonds. Under IIROC guidelines, I am not allowed to provide specific investment advice here without first knowing your long-term objectives and risk tolerance. A fairly quick phone call can establish these basic parameters (believe it or not), and we will provide this quick advice at no cost, and with no further obligation.


One final thing on passive investing: there is no conceivable reason to use mutual funds for a passive approach. If you embrace this philosophy, you acknowledge, quite legitimately, the low probability that a manager will add value over time. So why are you investing in mutual funds which charge you 1% or more for the slim chance that the manager will do just that, when you can open an account at a discount broker and purchase Exchange Traded Funds or index mutual funds for as low as 0.25%? It's madness!


Where an Active Approach Can Add Value


I made the case in the previous section for most investors to apply a passive approach to their investments. This means taking your money out of mutual funds and putting them into a basket of very low cost Exchange Traded Funds. However, while a passive approach is likely the best option for most investors, who lack the time, motivation, or acumen to find quality active managers, smart, motivated and open-minded investors who take the time to learn the nuances of different active styles can realize tremendous value. This task is difficult, but certainly not impossible.


Managers that deliver consistent returns over time generally possess some combination of the following 4  qualities:

• Insider information - yes, this happens all the time, and is quite illegal. No, your mutual fund manager doesn't have any. If he did, he would be making 2% plus 20% of the fund's profit at a hedge fund.

OR

• A systematic approach with very little qualitative interference based on manager ‘intuition’
• A focus on asset allocation, not stock-picking
• A rigorous strategy for risk management

There are some superb talents in the investment industry who have demonstrated incredible performance persistence through time: George Soros, Steve Cohen, John Paulson, and a few others. So far as I know, these managers do not use any specific system to manage money, but instead are able to see into the future via a black box in their heads. Notably, none of these managers is available for average investors, though they charge extremely high fees (5% plus a percent of total portfolio growth). Further, I could count the number of consistently successful investors of this type on two hands. I don't include Warren Buffet because he is not an investor in the contemporary sense. Rather, he is a business man who purchases companies and then adds value through extraordinary management. This is an important distinction!

Thankfully, there are far more examples of true systematic approaches with very long track records of adding extraordinary value to investors. Here is a list of some of these funds, along with their December 2010, and calendar year 2010 returns, and total assets under management, courtesy of Jez Liberty of Au.Tra.Sy blog:

Organisation / Fund	Return	YTD *	AUM **
Abraham Trading1	8.28%	8.30%	$456M
Altis Partners2	5.66%	11.52%	$1,609M
Aspect Capital3	6.16%	15.35%	N/A
BlueTrend4	6.71%	15.98%	$8,000M
Campbell & Company5	N/A	N/A	N/A
Chesapeake Capital6	13.90%	10.86%	$835M
Clarke Capital7	9.08%	42.62%	$38M
Drury Capital8	9.05%	0.63%	$305M
Dunn Capital9	10.95%	30.75%	$275M
Eckhardt Trading10	8.87%	21.08%	$418M
EMC Capital11	5.90%	6.72%	$180M
Hawksbill Capital12	11.79%	57.58%	$83M
Hyman Beck & Co.13	12.82%	8.49%	$512M
JWH & Co.14	-5.18%	5.20%	$25M
Man AHL Diversified15	4.80%	11.60%	$1,223M
Millburn Ridgefield16	5.58%	12.65%	$1,090M
Rabar Market Research17	10.51%	24.59%	$179M
Saxon Investment18	1.18%	6.10%	$89M
Superfund19	10.93%	12.93%	N/A
Tactical Investment Mgt20	10.60%	68.99%	$66M
Transtrend21	3.60%	14.88%	$5,826M
Winton Capital22	3.73%	14.43%	$17,010M

Many of these systematic managers charge hefty fees, but have delivered remarkable long-term performance. For example, Jim Simons’ Renaissance Medallion Fund (not shown) charges 5% management fees and a 44% (!!) performance fee. Despite these burdensome costs, Medallion has consistently returned 35% per year in performance after deducting all fees. Unfortunately, Medallion fund has been closed to new investors since 1993. MAN Group’s AHL Diversified Fund has been open to new investors since its inception in 1990. This fund has returned 15.4% per year for investors after charging a 3% management fee and a 20% performance fee. It has reported fund losses over a calendar year only once: in 2009.


There are several Canadian systematic funds, most notably Acorn Diversified in Oakville, and Auspice Capital out of Calgary. Of course, Butler|Philbrick & Associates applies a systematic approach for its clients as well.


Conclusions


Unfortunately, high fees do not necessarily guarantee superior service or investment performance. You are, however, unlikely to receive superior service or performance for low fees. Investment advisors and funds who rely on low fees to capture and keep clients generally fall into 3 categories:

1. They are in the early stages of building their businesses, and with few qualifications
2. They have a focus on client volume instead of performance and/or superb service
3. They do not offer differentiated value

Highly qualified professionals that deliver differentiated value to their clients are confident charging a reasonable fee for their services. For other professionals, this should not come as a surprise.


Perhaps the main point of this essay is to demonstrate that there is no logical basis for investing in traditional actively managed mutual funds, no matter how low their fees are. Given that your probability of choosing a strong traditional mutual fund which will remain in the top half of its category just 4 years from now is worse than random, an average investor should ALWAYS prefer a diversified basket of passive Exchange Traded Funds.


Investors with the acumen, motivation and perseverance to investigate active managers will discover that there are phenomenal managers and strategies out there that have the potential to fundamentally alter the trajectory of their investments, and the landscape of their retirements. These managers do not compete on price - but smart investors won't care.


Notes

<sup>* YTD: Year-To-Date performance.
** AUM: Assets Under Management.
1. Abraham Trading was founded by Salem Abraham, after he was introduced to Managed Futures and Trend Following by Jerry Parker. He is considered as a “second-generation” Turtle.
2. Altis Partners started trading in 2001 and now manage over a $1B with their Altis Global Futures Portfolio. The figures referenced in the performance table are not provided by Altis Partners and no reliance should be taken as to their accuracy, and as a consequence the figures may not be in accordance with any CFTC / NFA performance reporting requirements.
3. The four founders of Aspect (Eugene Lambert, Anthony Todd, Michael Adam and Martin Lueck) were significant members of one of the most succesful funds in managed futures – AHL (Adam, Harding and Lueck).
4. BlueTrend, from BlueCrest Capital, is one of the largest Trend Following funds – headed by Ms. Leda Braga
5. Campbell & Company is one of the oldest Trend Following firms, operating for around 4 decades.
6. Chesapeake Capital was founded by Jerry Parker, a former Turtle.
7. Clarke Capital was founded by Michael Clarke in 1993. The programme tracked here is Millenium.
8. Drury Capital, Inc., was founded in Illinois in 1992 by Mr. Bernard Drury.
9. Dunn Capital was founded by Bill Dunn.
10. Eckhardt Trading is the firm managed by William Eckhardt, who co-led the Turtle experiment with Richard Dennis
11. EMC Capital was founded by Liz Cheval, a former Turtle.
12. Hawksbill Capital was founded by Tom Shanks, a former Turtle.
13. Hyman Beck & Co. main principals are Alexander Hyman and Carl Beck.
14. JWH & Co. was founded by John W. Henry, Owner of the Boston Red Sox.
15. Originally ED & F Man. Became a succesful CTA under Larry Hite and went on to form part of The Man Group plc, which subsequently bought AHL to form the Man AHL: the systematic trading division of the Man group.
16. Millburn Ridgefield have been trading Trend Following models since the early 1970’s.
17. Rabar Market Research is the company of Paul Rabar, a former Turtle.
18. Saxon Investment was founded by Howard Seidler, a former Turtle.
19. Superfund founder and CEO: Christian Baha.
20. Tactical Investment Management was founded by David Druz, a student of Ed Seykota.
21. Transtrend is a Trend follower CTA based in Netherlands
22. Winton Capital is a London-based CTA founded by Dave Harding (also co-founder of AHL).</sup>

Retirement at the Casino

Clients and others who have seen us speak, read our material, or know us at all, understand that we at Butler|Philbrick & Associates don't make any investment decisions without a proper understanding of the odds, and the range of possible outcomes. We are optimists, but err on the side of caution.

The Quantitative Wealth Management Analytics Group, or QWeMA Group, based out of the Fields Institute near the University of Toronto, also embraces this focus on probability, and has applied it to the field of retirement planning in a novel way.

Traditional retirement plans have no way of accounting for the range of possible future outcomes, in the markets, with inflation, or in your own lifespan. The QWeMA Group's solution, on the other hand, accounts mathematically for the full range of possible outcomes, and assigns a probability to retirement success. As you will see in some of the videos produced by QWeMA's founder, Dr. Moshe Milevsky, a closer inspection of traditional plans shows that they will fail up to 50% of the time. For an in-depth case study about the vulnerabilities in traditional retirement plans, please see our article in Dental Practice Management's December issue, starting on page 36.

The following video by Dr. Milevsky explains the tradeoffs facing retirees, and how they can effectively plan for their future by finding an optimal mix of retirement income, product mix, and investment strategy. The video is over 17 minutes long, but grab your spouse, a glass of wine, and invest in your future. Be sure to return to this article after watching by hitting your browser's 'Back' button.

Welcome back!

Dr. Milevsky demonstrated how you can alter the sustainability of your retirement by reducing your income and altering your product mix. He also illustrated how different income levels and product mixes affect retirement sustainability and the legacy you leave behind.

There are other ways to improve your retirement options that Dr. Milevsky did not discuss in the video. One of the ways is to broaden your investment opportunity set to include international stocks, commodities, REITs and alternative strategies, in addition to domestic stocks and bonds. If you are like most Canadian investors, your portfolio is focused almost exclusively on Canadian stocks. While this has worked out well over the past ten years, investors may be missing important future opportunities by sticking so close to home. Further, adding even a very simple risk management system, such as the timing system we described in our Ontario Dentist article, can improve your sustainable retirement income by over 50%.

As an example, for a couple with a $1,000,000 retirement portfolio, following this simple system would have increased sustainable income from less than $50,000 per year for a traditional balanced portfolio, to over $90,000 per year. The same applies to expected legacy, where this simple investment approach would have more than doubled the amount left behind at the end.

Chart source: Ontario Dentist (2010)

Volatility Gremlins

The term 'Volatility Gremlins' was coined by Ed Easterling of Crestmont Research to describe how volatility impacts the growth of investment portfolios. The term is perfect. Gremlins are annoying, but not particularly dangerous - unless there are a great many of them. They might take food while you aren't looking, or throw your laundry on the floor. Maybe they'll play little jokes on you, like hiding your keys, or your wallet. You wouldn't want one as a pet, but neither would you be frightened if you encountered one on a hike.

Volatility Gremlins play similar tricks with your portfolio. You may hear that markets have gone up by 8 percent per year, but you've only seen 5%. Your financial plan might say you can safely take $70,000 per year in retirement income, but your nest egg is shrinking more quickly than expected. What's going on?

Volatility Gremlins work by tricking you into thinking average returns are the same as compound returns. Let's work through an example.

If you experience returns of 5%, -15%, and 25% over three years, your average return over the 3 years is 5% per year. However, your compound return is just 3.7%. Those sneaky Volatility Gremlins snatch away 1.3% per year, or over 25% of your returns! Not so harmless now, eh? Table 1. and Chart 1. show more examples of how a wider disparity (or volatility) in returns results in lower compound returns, even while average returns are constant at 5%. The example above is 'Case E' below.

Table 1. Volatility Effect on Average and Compound Returns

Source: Crestmont Research, Butler|Philbrick & Associates

Chart 1. Volatility Effect on Average and Compound Returns

Source: Crestmont Research, Butler|Philbrick & Associates

Volatility Gremlins really hit above their weight class when you are taking money from your retirement portfolio to meet living expenses. In this case, the nasty critters can make off with a very substantial portion of your annual income, if you aren't careful. This is because of the impact of taking money from your portfolio during periods when it has declined in value. Money that is withdrawn when markets are down can not be used to help the portfolio recover.

So how much of your annual retirement income might Volatility Gremlins be snatching from your wallet when you aren't looking? The amount could be quite substantial. Chart 2. illustrates the impact of increasing levels of volatility on the retirement income of an average retiree.

Chart 2. Higher Volatility in Retirement Portfolio Results in Lower Safe Portfolio Income

Source: Milevsky (2005), Faber (2010), Shiller (2010), Butler|Philbrick & Associates. For Illustrative Purposes Only

Astute readers will notice that Volatility Gremlins get very excited at the idea of pilfering income from retirement portfolios. In Chart 2. we can see the effect of increasing volatility on a $1 million retirement portfolio which:

1. delivers 7% per year growth after inflation;
2. for a retiree who expects to live another 25 years, and;
3. who wants to be 85% confident that he won't run out of money.

Observe that a retiree with a low volatility portfolio, at say 7% annualized volatility (green bar), can safely withdraw over $71,000 per year. In contrast, a retiree with a volatile portfolio, at say 17% annualized volatility (red bar), can safely withdraw less than $52,000 per year. The Volatility Gremlins make off with 36% of the latter retiree's income!

I have spilled much ink describing ways for investors to lower risk in portfolios, so I won't go into the details here. You will note in Chart 2. that I make reference to Faber's Tactical Asset Allocation portfolio as a lower risk alternative. Readers who are interested in methods to capture robust returns while dramatically lowering portfolio volatility are invited to visit our web site (http://www.macquarieprivatewealth.ca/specialist/butlerphilbrick/case-studies) for more articles and studies.

The Three Horsemen of Retirement Apocalypse

We have stated many times in past articles that the brain uses facts as factors, but makes decisions on emotion. This article will present some extraordinarily important facts for people approaching, or already in retirement. Unfortunately, the facts alone are unlikely to motivate readers to change their behaviour; for most of us, it generally takes substantial emotional trauma to compel us to change. For example, smokers may continue to smoke until someone close to them is diagnosed with lung cancer. Interestingly, it has been established that even doctors are vulnerable to this type of cognitive dissonance. To whit, the likelihood that a physician is a smoker relates directly to how much their individual specialty relates to the lungs. Respiratory and cardiovascular specialists are least likely to smoke, while psychiatrists and podiatrists are most likely.

In the same way, most investors will not come to grip with the new realities of retirement until it is too late. The investment industry spends billions every year to maintain the illusion of certainty about long-term market returns, and most investors buy into this because it supports their emotional need to feel like they are in control. As humans, we do not handle ambiguity very well, so most of us avoid it where possible, even when it means potentially sacrificing our future. It is not the policy of Butler|Philbrick & Associates, however, to tell our clients what they want to hear. There are thousands of Advisors across Canada who will be happy to accommodate you in this. Instead, we are committed to telling our clients the truth, so that we can make smart decisions today that provide the greatest likelihood of future happiness.

The 3 Threats to Retirement Success

In light of our continuing effort to promote a more scientific approach to managing wealth, this post will focus on the three biggest threats to retirement success. These threats are (drum-roll please):

• The threat of inflation eroding purchasing power
• The threat of living longer (or less long), than you expect
• The threat of poor or negative investment returns, especially early on in retirement

Most investors are aware of these threats, but most Advisors do not effectively address the tug of war that exists between them. For example, most investors would avoid the stock market roller coaster in favour of safe bonds and cash, if they felt this solution would deliver retirement success. Unfortunately, retirees have to deal with the fact that safe assets like bonds do not effectively protect them against inflation. At the same time, stocks carry a significant risk of losses, especially over short time periods like ten years. Chart 1. shows that stocks have delivered between -6% and +20% over 10-year periods during the past 140 years. So what is one to do?

Chart 1. Annualized 10-Year Stock Market Returns, 1870 - 2010

Source: Butler|Philbrick & Associates, Shiller (2010)

Risk #1: Inflation

Inflation occurs when the price of goods and services increases slowly over time. The mechanism by which inflation occurs is actually subject to some debate, but this is less important to retirees. What is important is how inflation can impose significant restrictions on lifestyle over time. 

Inflation can be a difficult thing to wrap one's mind around, so examples are helpful. Postage costs are one good example: in 1950, a 1st class Canadian stamp cost 4 cents. Today, it costs 57 cents + GST to send a letter in Canada. This represents 4.53% per year in inflation over that time period. If we apply the same rate of inflation to a $1.00 bottle of Coke today, that same can would have cost 7 cents in 1950.

The chart below shows how the purchasing power of income declines over time due to inflation. Put another way, the chart shows how a fixed retirement income can purchase fewer and fewer more expensive goods and services. Note that $100,000 will only buy $70,000 worth of goods and services after just 10 years; purchasing power is cut in half after 19 years.

Chart 2. Purchasing power of $100,000 erodes over time due to inflation

Source: Butler|Philbrick & Associates

Most Advisors incorporate some sort of inflation forecast into portfolio return expectations when creating financial plans. This is better than completely ignoring the effects of inflation, but it ignores that fact that inflation also impacts the returns to other asset classes, like bonds and stocks. For example, bonds do especially poorly during periods of high inflation, so a high allocation to bonds would have very negative consequences should inflation accelerate higher. Conversely, stocks do very poorly in periods of negative inflation, or deflation, such as during the Great Depression when stocks dropped almost 90%.

Our methodology does not use a specific inflation forecast. Instead, we use monthly portfolio return numbers based on actual market returns that go back to 1870, and are already adjusted for inflation. This is an important difference, as this method explicitly incorporates the relationship between inflation and portfolio returns, rather than assuming that it doesn't exist. Traditional models assume that inflation rolls merrily along at 3% per year, even during the Great Depression. This assumption has serious implications for investors that are drawing retirement income.

Risk #2: Longevity

Longevity risk really refers to two related risks:

1. The risk that you save too little, or spend too much, because you end up living longer than you expect. In this case, you run out of money before you pass.
2. The risk that you save too much, or spend too little, because you end up living less long than you expect. In this case, you make needless sacrifices to lifestyle.

Traditional financial plans use a specific point estimate for lifespan; they usually assume death on a person's 86th or 91st birthday. This is tragically misguided however, as you can see from the table below. Table 1. shows the likelihood that a man, woman, and at least one person in a couple, will live to various ages, assuming that the person/couple has already reached age 65.

Table 1. Probability of Survival at Age 65

Source: The Society of Actuaries RP-2000 with full projection

You will note that the table indicates that 75 out of every 100 couples will see one person in the couple reach at least age 85; 50 out of every 100 couples will see one person live to age 90 or beyond! With this knowledge, it seems foolhardy in the extreme to rely on a plan in which between 50 and 75 couples out of every 100 will run out of money.

If you are uncomfortable with a 50% to 75% chance of retirement failure, imagine instead being able to tailor your plan to minimize your chance of retirement ruin, while maximizing your lifestyle. Butler|Phlibrick & Associates applies a different approach that accounts for the wide range of possible lifespans, and their respective probabilities. Our approach enables clients to tailor their plan to accomplish their individual level of comfort and confidence. As an example, some of our clients are comfortable with a higher chance that they will run out of retirement funds before they pass. These clients may be able to accept as much as a 30% chance that they will have to dramatically cut back on their lifestyle in their later years, in order to maximize current spending. On the other hand, more conservative clients require near certainty that their retirement funds will see them through with comfort to the end.

Of paramount importance, our approach allows us to update clients on exactly how their spending and portfolio performance during each year has impacted their chances of retirement success during annual review meetings. If markets have not cooperated, or if there was unanticipated spending during the year, we will discover that spending needs to be cut back, or portfolio risk needs to be adjusted, in order to move the plan back into an appropriate comfort zone. If on the other hand performance has been stronger than expected, clients may discover they have a surplus of cash. These fortunate clients have the option of maintaining their current standard of living, but enjoying a higher confidence in a successful retirement, or withdrawing a higher income to boost lifestyle expenditures. Image 1. below shows how retirement plans should be tracked over time to ensure clients remain in 'The Zone' to maximize their chances of balanced retirement success.


Image 1: Keeping clients in 'The Zone' during annual reviews

Source: Financeware.com

Risk #3: Poor or Negative Market Performance

You may have noticed that the first two risks are long-term risks. In the face of long-term risks like inflation, investors tend to behave like the proverbial frog in a pot of water that boils slowly. If you place a frog in boiling water, he will leap out quickly, grumpy but unharmed. However, if you place a frog in cool water and then boil it slowly, the frog will slowly die from the heat. In the same way, investors are unlikely to notice the effects of inflation over a period of a few years. Instead, they will wake up one morning many years from now to discover that their money only goes half as far as it used to. Perhaps they can no longer afford their membership at the golf course. Perhaps they are astounded at how much food costs, or how much of their monthly income is consumed filling the tank of their car with gas. Longevity risk manifests in the same way; slowly, and then all at once.

In contrast, market risk is often front and center in people's attention. They are bombarded with stock market prices every evening on the news, and every day in the papers. They receive a monthly statement and obsess over whether the value of their portfolio is higher or lower than in the previous month. Investors celebrate their peaks and grind their teeth at the troughs, mostly cursing the annoying roller-coaster ride of stock markets.

Strangely though most investors, and indeed Investment Advisors, fail to account for the volatility of stocks and bonds when they build retirement plans. Traditional plans are constructed with the inconceivable assumption that markets go up consistently every year. For example, many Advisors assume an 8% rate of return, and that investors will receive this 8% return every year, without fail. We have yet to meet an investor who has experienced the same return on their portfolio every single year. 


Rather, contemporary investors are used to seeing a wide range of returns, especially over the past ten years. Since June 2000, stock markets have lost over 25% of their value after accounting for inflation. This is catastrophic for people in or near retirement. Readers may be interested in reviewing some of our previous posts (click here for an explanation of our Gestalt Architecture), where we demonstrate how we strive to avoid these major long-term losses while still providing substantial exposure to growth assets.

Dr. Moshe Milevsky is a professor at York University School of Business, and sits on the boards of many Canadian and international life insurance companies. He may know more about retirement risks than any other person on the planet. In the following video, Dr. Milevsky discusses the importance of considering market risk, or what he calls 'Sequence of Returns Risk' when formulating retirement plans.

Video 1: Moshe Milevsky Discusses Sequence of Returns Risk

Source: ClientInsights.ca

In his presentations, Dr. Milevsky often performs a thought provoking exercise that illustrates how important it is to address 'Sequence of Returns' risk in retirement plans:

Sequence of Returns Example:

• Couple age 65 with $1,000,000 in retirement wealth
• Couple withdraws $7,500 per month in income from the portfolio
• Annual expected investment return of 7% after inflation

He then introduces the idea of a rotating sequence of returns, where investors receive 7%, -13%, and 27% returns in years 1 through 3, and then the series repeats for years 4 through 6, 7 through 9, etc. He then changes the order of returns to see how this impacts the age at which the couple will run out of funds. This is illustrated in the Retirement Merry-Go-Round below.

Image 2:The Retirement Merry-Go-Round

Source: The IFID Centre

There are 4 unique ways that an investor can experience the returns from the Merry-Go-Round. In the table below, we show how these 4 sequences of returns affect when the couple described above runs out of money (Ruin Age), and how the actual results differ from what would be expected from a traditional retirement plan (the +7%, +7%, +7% example below).

Table 2. Ruin Age Under Different Sequence of Return Assumptions

Source: The IFID Centre

It is important to understand that the couple receives a 7% average return under each of the scenarios in the table above. However, despite the fact that average returns are constant, the order of those returns can impact the age at which the clients run out of funds by as much as 14 years! Poor returns early on would cause the couple to run out of funds in their 81st year, while strong early returns would see them safely through to age 95. The sequence of returns in the example may seem extreme, but in fact the example assumes a volatility of 20%, which is comparable to the historical volatility of stock markets.

You may be wondering whether it is better to have higher returns, or a more predictable sequence of returns. The following example (Table 3.) shows that it is much more important to avoid poor returns early on in your retirement than it is to increase overall average returns. The investor on the right, which receives 8% average returns, but has poor early returns (-12% in the first year), runs out of funds before her 85th birthday. In contrast, the investor on the left earns 7% average returns, but her funds last through age 95 because of strong early returns (+27% in her first year).

Table 3: Is It Better to Receive Higher AVERAGE Returns, or Better EARLY Returns?

Source: The IFID Centre

Two things should be clear by now:

1. It is extremely risky to rely on a financial plan that does not account for 'Sequence of Returns' risk 
2. It is extremely important to avoid large investment losses, especially early on in retirement 

Fortunately, Dr. Milevsky has provided a framework that allows us to model the risk of poor or negative market returns. His model also enables us to account for the range of potential lifespans and inflation expectations. His framework differs from traditional financial plans in the following ways:

For illustrative purposes, we provide an example of our proprietary model, which is based on Dr. Milevsky's research papers, found here and here. Note the table of inputs in the upper right of the image. The 'Expected Real Return' input is the return we expect on the portfolio, after accounting for inflation. The 'Expected Portfolio Volatility' input allows the model to account for 'Sequence of Returns' risk, while the 'Median Remaining Lifespan' input is related to longevity risk.

Image 3: Sample Sustainable Income Model with Confidence Interval

Source: Butler|Philbrick & Associates

So what happens when we plug some numbers into our model, using assumptions based on actual market returns, and including very conservative fees? The chart below shows the safe withdrawal rate from an all-stock retirement portfolio assuming 4.6% annual average returns (see posts here and here for why we chose this return), and assuming 0.5% in management fees (about what you would pay for a diversified basket of ETFs if you were to manage the portfolio on your own).

Chart 3: Safe Rate of Withdrawal for A Diversified Global Stock Portfolio

Source: Butler|Philbrick & Associates


The chart above demonstrates that, if one were to create a pure diversified global stock portfolio through ETFs, and manage it on one's own, current assumptions would provide for a safe income of 3.1% of current portfolio value. This means that, for every $1million in portfolio value, an investor can take $31,000 per year from the portfolio, adjusted each year for inflation. This is interesting, but unrealistic as most investors would, quite rightly, feel that a pure stock portfolio is too risky in retirement. So what happens if we invest in a balanced portfolio, with 50% stocks and 50% bonds (See Chart 4.)?

Chart 4. Safe Rate of Withdrawal for A Balanced Portfolio

Source: Butler|Philbrick & Associates

Interestingly, the model arrives at the same 3.1% safe withdrawal rate for a balanced portfolio, despite significantly lower expected returns of just 2.18%. This is because we have reduced our 'Sequence of Returns Risk' input by almost 50% by introducing a 50% bond allocation, because bonds are generally much less volatile than stocks. This underlines the importance of accounting for sequence of returns risk, or the risk of poor returns early in retirement.

Conclusion

We hope this article has helped to drive home the importance of explicitly accounting for all three of the major threats to a successful retirement. To reiterate, a realistic and useful financial plan must account for the following three risks:

1. The risk that inflation erodes purchasing power from the portfolio over time 
2. Longevity, or the risk of living longer, or less long, than we expect 
3. 'Sequence of Returns Risk', or the risk of poor or negative returns early on in retirement

Most financial plans today do not account for the wide range of possible outcomes in either of the above variables. Please visit our web site to see how our Gestalt Architecture can deliver higher confidence, flexibility, and a substantially better lifestyle in retirement.