Your Ideal Retirement Number Is Zero
The neglected subject of liability management.
You've surely seen ING's advertising campaign, “What's your number?” It features actors toting giant orange signs that represent the amount of money they will need at the time of their retirement. The commercials are goofily memorable and effectively deliver the company's message: Plan for retirement.
They do, however, ask the question from the wrong perspective--at least according to Michael Falk, keynote speaker of one of last week's Morningstar Investment Conference sessions. ING inquires about assets. Falk argues that the better approach is to begin with debt. The ideal retirement number for liabilities is zero--no mortgage, no credit card rollover, no unpaid loans.
Doing so means that the retiree may be able to fund basic needs (food, utilities, taxes, automobile, insurance, clothing, etc.) solely from Social Security payments (and/or other guaranteed pensions). In such cases, ING's numbers would therefore apply only to the retiree's discretionary spending.
They therefore can be substantially cut. ING's signs range from $600,000 to $3 million, with the median figure being roughly $1.5 million. At a 4% withdrawal rate*, those lump-sum amounts translate to from $2,000 to $10,000 monthly, with a median of $5,000. For comparison's sake, per this report, the median American household has $1,100 month for discretionary spending.
(*Whether a 4% withdrawal rate is realistic given current market valuations is open for discussion. For the purposes of this column, we'll assume the answer to be yes.)
To state the matter in reverse, the lump-sum at retirement that is required to fund $1,100 of monthly spending, assuming a 4% withdrawal rate, is $320,000. For the millions of households that currently have almost no savings at all, retirement or otherwise, that number will look daunting. But a lot less daunting than what is currently being shown to them.
Moreover, argues Falk, retirees can shrink even these lowered lump-sum amounts. Consider, for example, a worker who retires at age 70 and buys a deferred annuity that begins 15 years later. This annuity, which would cost pennies on the dollar, will be used to pay discretionary expenses from age 85 onward, thereby slashing the investment time horizon to 15 years. The investor can therefore safely increase the withdrawal rate (although carefully and cautiously in the first few years, to defend against the possibility of an early bear market).
The effects of eliminating liabilities spill over into asset allocation. If required spending is fully covered by guaranteed payments, then the "number" can be more aggressively invested. After all, even a steep market decline would only moderately alter the retiree's lifestyle. Also, the investor without liabilities can adopt flexible withdrawal policies, to avoid selling assets into weakness during down markets. Such an approach effectively increases the acceptable withdrawal rate. The combination of more stocks leading to higher returns, and a flexible policy leading to a higher withdrawal rate, is powerful.
None of this, of course, is particularly deep. Eliminating debt entering retirement to free up obligations for the investment nest egg, and to avoid potential catastrophe should everything simultaneously go wrong, is a simple and natural concept. It would be the first thing to come to mind if financial-services companies were liability managers. As they are asset managers, however, those firms--and their advertisements--frame the discussion otherwise.
Which is fine. Of course companies will view the matter according to their business needs. There's nothing wrong with that. It would be a mistake, however, to move into ING's orange-signed world without recognizing the existence of valid and reasonable alternatives.
Let me start with a couple of classic Buffett-isms:
"First, many in Wall Street--a community in which quality control is not prized--will sell investors anything they will buy."
- Warren Buffett
"A pack of lemmings looks like a group of rugged individualists compared with Wall Street when it gets a concept in its teeth."
- Warren Buffett
With these aphorisms in mind, let's review the case for low investing as it exists today. It goes like this:
(A) Within an asset class, the low vol assets outperform the high vol assets, on average.
(B) Therefore, investors should buy the low vol assets within an asset class.
Well, (A) appears to be correct, at least historically, but the key phrase that so often gets overlooked is the magic “on average.” And (B) does not logically follow from (A). The only way (B) does follow from (A) is if an investor has only two choices, a portfolio of randomly chosen high vol stocks or a portfolio of randomly chosen low vol stocks. In that case, low vol is better.
But of course investors aren't faced with just these two options.
I think my paper with Tim [Riley] shows pretty conclusively that high-volatility investing is not bad per se. Further, low volatility is low beta, which is low expected return.
So, in my view, the jury is out on passive, mechanical low-volatility investing, as used by exchange-traded funds. For me, for now, the evidence supports intelligent stock picking.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.