Retirement Income Perils
Where will you get income in retirement? Most people think: By cashing in the investments I’ve accumulated during my working life. But even if you have a lot of money saved, cashing in will not always work. You need to have an income plan. The notion that you can withdraw a fixed amount every month carries a lot of risk.
Imagine a scenario where two brothers, three years apart in age, both retire when they are 62 years old. The year they retire, both brothers have exactly $1 million in assets and the exact same investments. They each withdraw 5% or $50,000, adjusted for cost of living, each year, and live 30 years in retirement before dying. This story ends happily for the older brother who left behind a large estate, but unfortunately, not for the younger brother who ran out of money at 84. How can this happen?
In this case, the older brother had positive returns during the first couple of years in retirement, while the younger brother had losses. The older brother’s first two years’ gains were good enough to bolster him against the later downturns. The younger one had no such cushion against bad fortune. The older one was lucky. It could have been the opposite, as both brothers left their retirement in the hands of the stock market’s whims. Their withdrawal strategy was a version of dollar cost averaging, which is done to accumulate assets during your working years. This involves purchasing a constant dollar amount of stock on a regular basis. It allows you to take advantage of the ups and the downs of the market, smoothing out the cost curve. Withdrawing on autopilot like the brothers both did is dangerous. It risks dollar price erosion, the evil twin of dollar cost averaging.
When an investment is up, there’s no problem. You sell and reap the rewards. But if an investment is down when you sell, the loss is magnified. Between 1970 and 1999 the Standard & Poor’s 500 stock index’s average annual return was 13.66%. If you were retired during that three-decade span, it appears you could withdraw $136,000 each year without running out of money. That’s true if the market moved in a straight line, known as a linear return sequence. Unfortunately, when we factor in the market volatility that occurred then, an investor who withdrew $100,000 annually was left with just $119,111 after 15 years. Not much to live on. Given a yearly return of 13.66% over 15 years under a linear return sequence, the ending balance was $1,025,586. As we have mentioned in numerous past newsletters, market returns in any given year rarely match the long-term estimates and, in fact, are much bumpier on the high and low side of the averages. This is why income planning is so important.
There are many strategies for income planning, including a defined withdrawal strategy, purpose-based investing or a sequential income portfolio. Each income strategy has its good and bad side. Let’s look at defined withdrawal. Here, you create something called an income ladder, which minimizes the risks of
needing to sell stocks in a down market. You buy a series of quality fixed-income securities with staggered maturity dates. You meet income needs with money you get from matured principal and interest. On the negative side, you forego capital gains’ selling if bond prices go up because you are locked in until maturity. And when rates go up, you are stuck earning less in interest than you could if you had more flexibility.
Which alternative is right for you depends on how much income you require, your total assets and many other factors. Make sure you work with an advisor that understands the importance of providing income in all market environments.
Source: Financial Media Exchange
Third Quarter Market Update—Trade Tensions Will Impact Results
As the third quarter of 2019 ends, analysts are already looking well ahead to first and second quarter 2019 earnings estimates, which are projected to be much rosier than what we will likely see this quarter. Trade tensions have dominated the media throughout the summer, and we are beginning to see effects of the trade war filter through to corporate earnings. Pain is now being felt beyond the farm belt. Anecdotally, we recently spoke with a sizeable independent trucking firm that is experiencing a big slowdown in container runs from the Newark docks which they attribute directly to the trade war. We would expect this to spill over into railways and eventually higher prices for the consumer as retailers turn away from China to alternative suppliers.
This, plus a 2% increase in our domestic currency are negatives for the multinational companies that do a fair share of their business outside of the US. Factset recently took a closer look at the S&P 500 Index to see just which sectors have the highest global revenue exposure. What they found was that companies with higher global revenue exposure are expected to report year-over year declines in earnings and revenues for Q3 2019, while S&P 500 companies with lower global revenue exposure are expected to report year-over-year growth in earnings and revenues in Q3 2109. See below:
Third Quarter earnings expected to decline-Factset found that:
- For companies that generate more than 50% of sales inside the U.S., the estimated earnings growth rate is .4% and
- For companies that generate less than 50% of sales inside the U.S., the estimated earnings decline is -10.7%.
Valuation, Negative Interest Rates, and The Wall of Worry.
We like to focus on what we can control—staying disciplined through market dips and swings, diversification, creating an investment plan tied to risk tolerance, taxes and costs; and not on what we cannot control: Financial media noise and market timing. Our disciplined process always brings us back to asset valuations and the earnings outlook.
Valuation—The forward 12-month P/E ratio for the S&P 500 is (17.0)—slightly above the 5-year average (16.6) and above the 10-year average (14.8). For Q3 2019, the estimated earnings decline for the S&P 500 Index is -3.8%, which will mark the first time the index has reported three straight quarters of year-over-year earnings declines since Q4 2015 through Q2 2016. But that is already baked into stock prices and the market is looking ahead to forward estimates. Analysts are projecting 7.9% and 9% growth in Q1 and Q2 2019 respectively.
This lift in earnings along with current interest rate levels would call for even higher valuations, but as mentioned above, investors have much to worry about, including trade wars, slowing global growth, and monetary policy mistakes—all of which are intertwined and can be the trigger to the next recession. Policy response to trade and interest rates will dictate whether this expansion continues.
Stocks continue to climb the wall of worry, with these challenges, including domestic political upheaval, all weighing on investor sentiment. There has been much talk in the media around the length of what is often cited as one of the longest bull runs in history. It is not. Of the prior post war bull markets, 4 of the 9 bull runs have durations of 153 to 181 months with returns of between 815% and 936%. The current bull market has returned 319%. And that is if you take 2009 as the starting point. A strong argument can be made that this current bull market began in 2013 when the previous market high of 1565 was breached on May 30,2007 right before the financial crisis—the textbook definition of the start of a bull market. There may be more runway for this market to advance, but again, we are at a critical juncture where policy decisions will either extend or end this expansion.
Consistent Process and the Power of Dividends and Dividend Reinvestment
In the meantime, we will stick to our knitting and focus on investing in companies with strong cash flow and dividend paying ability and, importantly, the ability to increase dividends over the long term. We always love looking at an old position that has a very high cost yield as a result of patience and consistent dividend increases. Recently, we looked at AT&T as an example of the power of dividends and why the dividend reinvestment decision trumps taking a cash payment. See below.
What we found was that if you invested in T in 2009 and held it for 10 years, the total return attributable to price change was only 34.30% vs. 133% when dividends were reinvested to buy more shares. Even more telling of the power of dividend reinvestment is that if you did not choose dividend reinvestment, you would need to reinvest your cash dividend payment at 6.75% (shown above) to equal the 133% dividend reinvestment return! Our investment process is built around getting paid from the companies we invest in, but it is also grounded in not just higher dividend payers, but companies with the ability to consistently increase dividends and meet stringent quality criteria.
Stock investors will have their patience tested in the fourth quarter. A big wall of worry represents greater opportunity for strong equity returns versus a calm environment where all is good, it also represents greater risk for investors should policy decisions go the wrong way. Equity investors are paid to look through the wall of worry and collect the equity risk premium over time and thru the ups and downs of booms and busts. We are at a critical juncture with Fed policy and trade talks that will decide where we go from here.
Please let us know if you would to schedule a meeting to review your financial plan and investment portfolios. Stress testing your portfolio for a bear market scenario is always a good practice that can give you more visibility on future cash flows in a volatile market environment. We are always here to help.
John Klobusicky, CFA, CAIA
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