Retirement Income Planning Article

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Retirement income planning and investing has become much more complex since 2000, as that year marked the beginning of the worst decade for stocks in 200 years.

The last 30 years in the stock market have been a wild ride for investors and advisors. From 1982 through 2000 were heavenly for people accumulating wealth in stocks. The annualized return for that period was over 17%. From January of 1980 to December 31st 2000, if you invested $100,000 in the S&P 500 Index and left it alone, it became $2,314,512. That’s a 23 times multiple on the original investment. Everyone was excited, flush, and believed they were stock picking geniuses.

But, as we all know, it didn’t last. From 2001 until today has been more like Hell for those retired or planning for retirement. Between 2000 and 2003, we saw a decline of 41% in the tech wreck. The period of 2007-2009 saw a decline of 51% and a collapse of confidence in the world financial system and $12 trillion dollars evaporated in the investment portfolios of our nation. No individual or institution was “too big to fail.”

People have since reduced their retirement incomes or put off their retirement dates. Many people don’t really retire at all, choosing to work part-time jobs or keep part-time or on-call hours at their former places of employment.

The lessons shall not be forgotten by those of us who were intimately involved in the financial sector during this time period. What have we learned from this period of devastation and how will we use it, is the question. I can only speak from my experience and that of the clients who have trusted me with their wealth, but I will pass those lessons onto you.

First, we start with dividends and cash flowing investments, which you can think of as a well built ocean vessel at sea on a long journey. If a big storm hits, you will get tossed around and it won’t be exactly pleasant, but you will weather the storm. If you panic and leave your vessel, your chances of survival are slim at best.

According to a study by Ned Davis Research from Sept. 30,1980 until Dec. 31, 2011
dividend paying stocks returned 8.61% while non-dividend paying stocks returned 1.35%.

The risk as measured by standard deviation was almost 50% higher for non-dividend paying stocks. I’m not a fan of standard deviation as a measure of risk but that is what’s commonly used. To return to the ocean journey as a analogy, high risk is a small vessel in a big storm and low risk is a large vessel in calm water. I want to get where I am going the smoothest way possible so I don’t mind taking a bit longer.

Retirement income management

Retirement income management is a whole different world versus pure wealth accumulation and investing for growth. A retirement income portfolio is not about investing solely based on forecasts and probabilities. It is more about delivering specific outcomes.

And the most important of those specific outcomes is dividends and cash flow to spend on living. This is why I build a wealth management plan for my retired clients based on investments that provide predictable cash flow. It makes perfect sense to me to match the investments and their characteristics to the cash flow needs of the family that owns them. Cash flow and dividends are a powerful equalizer in a portfolio to the headline risks and ups and downs of the stock market. Dividends are responsible for over 40% of the historical returns in the S&P 500 going back almost 100 years.

The average return for stocks from 1926-2012 was 9.7%.

  • 5.6% Capital Appreciation
  • 4.1% Dividends

Why would we ignore a factor that is 40% of the reason for success in any endeavor? Would a company fire a salesman who is responsible for 40% of the companies revenue?

There is a story I really like about a champion wrestler with a legendary coach. The wrester was undefeated through his career but had a horrible accident and lost his right arm. There was only one other wrestler in the land who was also undefeated and it was his burning passion to wrestle and beat this foe. He was giving up but the coach told him that he could beat this guy if he would listen to him and do exactly what he said. He agreed to try as the coach was a legend. They worked on one move only for 12 weeks before the match over and over. The day of the match the wrestler was questioning the coach and his sanity on only working on this one move. The coach said trust me, execute the move and you will win the match. Sure enough, he went out executed the move perfectly and won the match with just one arm. Afterwards he went to the coach and asked him quizzically how in the world he knew he would be able to beat this opponent of the highest ranking with that one move. The coach told him “the only defense for that move is to grab your right arm.”

You could say dividends and cash flowing investments are “one of the moves.”

I have had the good fortune to find and invest with a number of companies and management teams that have long histories of success in strategies that pay predictable dividends. They vary in industries and philosophies but the one constant is a focus on predictable, repeatable execution of a strategy that produces cash flow to investors that they can count on.

Sequence of Returns with Systematic Withdrawals

Retirement income from a portfolio has a very different impact on the results depending on the when withdrawals are taken and the corresponding returns at the time. If an investment portfolio is hit with negative returns early in a retirement, it can wreak havoc with the results.

Take a look at the following example. Portfolios one and two are both based on an initial investment of $500,000 in the S&P 500 from 1969-1994 with an annual withdrawal of $30,000. Both increase the withdrawal at 3% a year for inflation. The returns are identical. They are just reversed in exact order. Both portfolios have the exact average return, yet Portfolio 1 ends with $19,369 and Portfolio 2 ends with $2,555,498. The reaction when seeing this is shocking at first. How could the same yearly returns yield such an incredible difference? This shows how delicate a retirement income portfolio can be when looking at how the sequence of returns fall in retirement.

[needs illustration from book here]

The impact of this can me dampened by investments that come as close as possible to providing cash flow at the 6% level while having characteristics that will raise the dividend over time. An example would be a commercial real estate lease that has a 3% per year increase to the tenant in the amount they pay the landlord. Energy MLPs also have this embedded increase with a PPI plus 2.65% increase every year to the investor. These are just examples of possibilities for consideration.

Interest Rates and Impact on Retirement

The current interest rate environment is bouncing off historic lows. Large amounts of money have been pouring into bond funds even at these very low rates and the risk in this investment class may not be fully understood by many investors. I won’t get into an academic discussion, but a simple explanation of what could happen if rates rise will be useful.

A 1% increase in the 10 year treasury results in a 8.9% loss in principal value on paper. If the rate were to drift back to the historical average since 1958, it would result in an approximate loss on paper of over 30%. It is unlikely this will happen any time soon but it is good to be aware of the possibility.

The federal government is artificially manipulating rates to keep them low to spur economic growth. This may be good for housing and automobile sales but it is hurting conservative retirees in a big way.

Retirees who were investing in 6-month CDs in 2006 were receiving $5,240 per $100,000. Now it is $419. If you were using 6-month CDs for a $1,000,000 portfolio you had an income of $52,400 per year and it is now $4,190. Now that’s a devastating blow to annual income. The bottom line is these retirees are being forced out of their comfort zone into areas such as bonds and they may or may not understand the potential risk of rising rates. This is the “bond bubble” that is currently making headlines regularly in the media. My opinion is that these investors need to be educated on other options available to them so they don’t get caught off guard by a potential inflationary scenario in the future.