Script for November 25

THIS MORNING WE’RE GOING TO DISCUSS RETIREMENT PLANNING AND A BIG PROBLEM THAT MOST PEOPLE FACE IN PLANNING FOR THEIR RETIREMENT ….BUT AND ALMOST NONE ARE AWARE OF IT…

IN FACT MANY PEOPLE ARE RELYING ON ADVICE FROM ADVISORS WHO AREN’T AWARE OF IT.

THE PROBLEM IS PEOPLE RELY ON INACCURATE ASSUMPTIONS ABOUT RATES OF RETURN…

OUR GUEST THIS MORNING CALLS ONE ASPECT OF THIS THE “FLAW OF AVERAGES”

HIS NAME IS MR. JIM OTAR, HE’S A CERTIFIED FINANCIAL PLANNER WITH AN ENGINEERING BACKGROUND, IN FACT HE HAS HIS MASTERS DEGREE IN ENGINEERING, HAS WRITTEN TWO BOOKS, AUTHORED EXTENSIVE RESEARCH AND PAPERS, AND NUMEROUS PRESENTATION S TO PRESTIGIOUS GROUPS ABOUT THIS TOPIC …REFER TO BIOGRAPHY

Jim, people are often presented with, rely on, and make important decisions based on, investment information that that talks about “average rate of return”.. a broker or online mutual fund site may tell someone that the average rate of return of an investment has been 8% or 12%.... What is the problem with relying on that information?

Why do you call this the “flaw of averages”?

Before I went into the financial planning business, my wife and I had a financial planner. During our first meeting with him in 1991, he asked us many questions and he tried to find out about us as much as possible. That is good, because before he can give us advice, he should get to know us.

In our next meeting, he came with a retirement plan. This was great; it showed that we would have gazillion dollars for our retirement. Both my wife and I felt great.

However, one thing he said struck me as very strange: he said something like “well, historically a portfolio of this type should grow ON THE AVERAGE by 12% per year over the long term. And then he used a portfolio growth rate of 10% going forward, just to be on the safe side.

As an engineer, that was the strangest thing I could hear, because when you design something you don’t design it for the AVERAGE, you design for ADVERSE events. Let me give you an example: the average wind speed on an average day in Birmingham may be 5 miles per hour. However, when you look at the glass walls at the front entrance of the Birmingham Museum of Art, I have no doubt that the civil engineers designed these glass walls to withstand storms with wind speeds higher than the average 5 miles per hour.

We can use the same analogy for retirement planning, if you use the average historic portfolio growth rates, the chances are, your portfolio will run out of money a lot sooner than you think. If you want to design your portfolio to withstand adverse market conditions, you must not use “averages”.

Unfortunately, to this day, far too many advisors still use the average growth rates when they make retirement projections. To put it in perspective, if you assume an 8% average portfolio growth rate and you are taking out $6,000 each year indexed fully to inflation from a portfolio worth $100,000, then there is 88% chance based on market history that your portfolio will run out of money sooner than your projection. We are talking about huge failure rates, 80 percent, and 90 percent. Yet the financial industry still keeps making big promises and offers little substance, except a handful of advisors and a few insurance companies.

Are knowing mathematical “average rates of return” on investments of any value?

So the sequence of return is more important than the average?

When we are talking about retirement planning, average rates of return has pretty well no value. Averages are for a population of numbers, you cannot use averages for an individual. If you are lucky, you may catch a 20-year secular bull market, then your average portfolio growth will be 15%, give or take. That is wonderful; you can’t do any wrong. But, if you happen to catch a secular sideways trend for 18 to 20 years, like we had between 1900 and 1920, or between 1966 and 1982, then average portfolio growth will be 2% to 3%, you will likely run out of money during your retirement.

If you are using a standard retirement calculator, you need to use adverse – not average -growth rates, just to make sure that your portfolio can survive.

And the adverse growth rates depends on how much money you are taking out of your portfolio: for example if you take out 6% out of your portfolio, then use 4% growth rate in a retirement calculator. This will give you a projection which has about 90% survival rate, based on market history. Or even better, you can go to my website and download my calculator which is based on market history and it will do the all calculations for you.

My purpose of using the past performance is not to predict the future, but to give my client the range of outcomes that happened in the last 106 years, which covers most imaginable market events. I don’t care if 1982 was a better year than 1956, but when I look at the whole envelope of outcomes since 1900 it gives me a lot of information. So, what I am presenting to my client is not a forecast, but a snapshot of historic outcomes.

Then the client decides for himself when to retire, how much more to save, how much can he spend after retirement and all that.

One of the most important things in retirement planning is not to make a forecast based on ridiculous assumptions. When I prepare a retirement plan for my client, I make no assumptions and I make no forecast: All I do is take clients financial information, plug that into my retirement calculator, and then I show my client what would have happened based on 106 years of market history. I show him or her the lucky and unlucky scenarios, and everything in between.

Monte Carlo simulations are the new fad. You see, the financial industry must keep inventing new things all the time to keep clients coming to them.

Several years ago, when I realized that one should not use average growth rates, I looked at Monte Carlo simulations. I knew about this technique in my engineering years, so it was not difficult for me to develop some interesting models. Later on, as I looked at it closer when I was writing my book “High Expectations and False Dreams – One Hundred Years of Market History Applied to Retirement Planning”, I discovered many of the weaknesses of Monte Carlo.

Its main flaw is that it generates random outcomes. In real life, markets are random in the short term, but they are cyclical in the medium term, and trending in the long term. So, basically, the glove does not fit the hand…

I was sorry to see that NASD recently approved use of Monte Carlo simulations for retirement planning. The projections that the Monte Carlo simulators generate are usually too optimistic.

Since my first brush with Monte Carlo simulators, I developed a retirement calculator based on actual market history.

PROBABILITY OF SUCCESS AND FAILURE

When it comes to retirement planning, yes, we are definitely talking about minimizing the probability of portfolio depletion or portfolio going to zero. In retirement portfolios, the two most important factors are how lucky you are with respect to long term market trends, and the withdrawal rate. If the withdrawal rate near age 65 is higher than 4% of the portfolio, then the probability of failure is high. If you are 65 years of age and retiring, have $500,000 for retirement, you should take out more than $20,000 each year, indexed to CPI for the rest of your life. If you catch a good secular bull market then the story changes of course, then you can take out more. But you should not count on luck during retirement.

I sure have listeners who have or will have millions of dollars to fund their retirement. For those there is perhaps less pressure to plan wisely because they have so much they think they can avoid or withstand most risks.

On the other end we have listeners who will have nothing but social security…. Their only option is to keep working as long as possible and hang on to a frugal lifestyle.

But most of our listeners are in between these extremes and their investment planning is very important to their future lifestyle. People want simple answers – but planning is very complex.

What kind of Advanced Retirement Planning do you recommend?

Dean, let me tell you one thing; advanced retirement planning is advanced only for the advisor. Let me make it lot easier for the average folk: Here are two simple tips I’ll share with our listeners:

First, figure out how much income you need after retirement. That is one side of the equation. Then add up all the income you expect from pensions, social security, rental income, whatever else. That is the other side of the equation. What is your shortfall? If you don’t have a shortfall you don’t need to worry about retirement.

If you do have a shortfall then ask the next question: If you were to take all your retirement savings and buy yourself a life annuity, or a variable annuity with guaranteed payments for life, would the monthly payments from this meet all your shortfall? The answer is either yes or no.

If the answer is no, then you do not have the financial capacity to generate income from an investment portfolio, because in most likelihood your investment portfolio will expire before you do.

So tip #1 is this: If a life annuity (or a variable annuity with life guarantee) cannot create the income that I need then an investment portfolio is a no-no, there is not enough assets to weather the adverse markets.

This brings us to tip number 2: At age 65, if you have at least 25 times the income you need in the your first year of retirement, then you can probably finance your retirement through an investment portfolio.

For example, say a client has $1,000,000. He is 65 years old and just retiring, and he wants his portfolio last until 95. He wants to take out $60,000 a year from his portfolio. The question is: Does he have enough savings? First thing to do is; get an annuity quote: I used a life annuity with 3% annual indexed payments. It pays, $55,000/year for life. If he were to cut back his expenses a bit, then he can have a life long guaranteed income. That is fine.

Should he invest his money, perhaps he can then take out $60,000 annually and maybe he’ll get lucky.

Well based on market history, depending on his portfolio expenses, there is about 88% chance that he will run out of money before age 95. So the odds are against this client, he should stick with the annuity.

Let me give you another example: If you have at least 25 times what you need in the first year of retirement, then you can finance your retirement through an investment portfolio. So, if you shortfall is $60,000 then multiply it with 25, which is $1.5 million. If you have more than $1.5 million, then you can the annuity route and finance your retirement with your investments. Of course these are just some rule of thumb numbers, each specific case is different.

TIME VALUE OF FLUCTUATIONS is the combined losses in a distribution portfolio due to factors beyond our control. They are the “friction losses” of a distribution portfolio. There are three big factors that shortens the portfolio life: The Luck Factor, Reverse Dollar Cost Averaging and Inflation

The luck factor refers to the timing of the start of your retirement. When you look at the market history, we see that there are long term trends that can last as long as 20 years. The most recent long-term bullish trend was between 1982 and 1999. Before then, between 1966 and 1982, there was a sideways trend.

If your retirement coincides with the start of a long-term bullish trend, then in all likelihood, you will have a lifelong income from your investment portfolio. If you retire any other time period, then the chances are your portfolio will deplete between 10 years and 20 years, depending on your withdrawal rate.

The sequence of returns right after your retirement has a huge effect on the portfolio longevity. That is called the luck factor.

When we look at the market history, we observe that markets move in long- term trends. We call these “secular” trends, of “megatrends” or “generational “ trends. Some secular trends lasted 8 years like the roaring twenties, some last 18 to 20 years.

Then within these secular trends there are cyclical trends. These are generally the 4 year market cycles, or business cycles. They are the building blocks of the secular trends.

The shortest trends are the random fluctuations, which can last from a few minutes to a few months.

The secular trends create the luck factor, which can cut the portfolio life by as much as 60%.

The cyclical trends create the reverse dollar cost averaging effect, which can also cut the portfolio life by as much as 50%.

The seasonality and random fluctuations have no significant effect on portfolio longevity.

Many listeners may be familiar with the dollar cost averaging. You decide to invest a specific amount of money at specific intervals. Like you add each month $200 to your portfolio automatically.

Over the long term, your average cost of investments will be less than the average cost of the investment, because your money buy more shares at dips and less number of shares on tops. That works great for you during the accumulation stage.

Reverse dollar cost averaging is exactly the opposite: What happens when you retire is, you need to withdraw money from your investment regularly, perhaps every month. If you are taking out this money from a fluctuating investment, every time you take out money at a dip, this creates a permanent loss in the portfolio. That is the effect of reverse dollar cost averaging. It is bad for retirement portfolios.

The remedy is very simple: the withdrawals should be made only from non-fluctuating investments, like money market funds. Never take your regular withdrawals from equity funds, balanced funds, even aggressive bond funds.

If you follow this rule, and the portfolio-rebalancing rule, you can minimize, or even almost eliminate the effect of reverse dollar cost averaging.

Let’s say your optimum asset mix is 40% equity 60% bonds. Over time the value of these investments will change. Say at the end of the year you find that your asset mix has shifted to 46% equity and 54% bonds. You need to bring your asset mix back to 40/60 mix. So you sell some equities and buy bonds and you are back to 40/60.

In my research, I found out that for accumulation portfolios, where you might have for example 65% stocks and 35%, it is best to rebalance when the asset mix deviates by more than 4%.

However, in retirement portfolios, where you take money out, it is a little bit more complicated. The optimum rebalancing depends on your withdrawal rate. If you are taking out over 5%, then you should rebalance once a year. But if you are withdrawing less than 5% it is better to rebalance once every four years. That will give you a longer portfolio life, or a larger portfolio value.

So, for the retired folks out there who are lucky enough to take out only 3 or 4 percent from their investments, rebalancing once every four years on the Presidential election year, may work better. If you run my calculator, it tells you what type of rebalancing is best for you.

One thing about asset allocation: it is important , but it is far less important than the financial industry wants you to believe. The financial industry will tell you that asset allocation contributes over 90% to the differences in portfolios success. Well,; the folks who did that study looked at the largest pension funds, all in secular bullish markets, and ignored the luck factor entirely. This study does not apply to individual portfolios, it applies only to pension funds, and I don’t need to tell you the miserable state that many of those pension funds are in. If you feed garbage knowledge to an investment,, you’ll end up mostly with manure.

The luck factor influences the portfolio longevity by well over 50%, asset allocation only by 25% maximum. Of course these numbers depend on the withdrawal rate.

The decision for asset allocation is simple: It takes two steps: Step number one: what asset mix gives my client the most dollars in the portfolio, or the longest portfolio life. Step number two what is the tolerable asset mix for this client.

In my retirement calculator, you can push the “optimize” button, and the program tells you the tolerable and the optimum asset mix based on 106 years of market history.

SWR is the maximum amount of money you can withdraw periodically from your investment portfolio without the probability of depleting the capital before a predetermined time horizon. It is based on market history

The most important decision in retirement planning is not the asset mix, not what stocks or mutual funds to buy, not the choice of small cap / large cap, domestic / foreign, emerging / developing.

The most important decision is to figure out whether you have the financial capacity to be invested at all. If at the age of 65, you have retirement assets less than 25 times your annual income needs, then resist the temptation, don’t look at stocks or bonds, look for life annuity. If your savings are more than 25 or 30 times of your annual income needs, then you have the financial capacity for investments. Don’t let any advisor tell you otherwise.

Please keep in mind; I cannot give personal financial advice but can answer only questions of general nature.