Two weeks ago I recommended a 6-step model for managing investments through retirement. Today we test the model with data from the last 11 years, one of the most challenging periods for investors in modern history.
In the spring of 2000, stock markets started to fall, and by the autumn of 2002 the total value of U.S. stocks was cut about in half. Retirement accounts sank as well, and many near retirees decided to continue working.
Meanwhile, the seeds of the housing bubble were already in the ground. Massive amounts of money were channeled into mortgage financing. Home values skyrocketed as lending practices turned fraudulent.
Real estate markets began to fall in 2006, and there is still some doubt about whether they have bottomed. In 2008 large-capitalization stocks dropped 37%, then rose sharply (26%) in 2009, and more modestly since.
The 11-year period from the end of 2000 to the end of 2011 has been a turbulent and dangerous decade for stock owners, but a consistently good one for owners of bonds. Most periods of similar length show stock ownership to be more profitable. Any investment model showing reasonable results from 2000 to 2011, and during other 10-year periods, is likely a good candidate for retirees managing their own portfolios.
The 6-step model involves equal investments in diversified stock and bond portfolios, along with annual rebalancing and an annual, constant withdrawal of 4% of the initial investment. In the examples below, the initial investment is assumed to be $100, which makes the results easy to convert to percentages. Also, readers can easily scale the results to their own portfolios.
Stocks are invested in the Vanguard 500 Stock Index Fund Investor Shares, a mutual fund designed to track the Standard & Poor’s 500 Stock Index. The index tracks 500 leading companies traded on U.S. stock markets.
Bonds are invested in the Vanguard Total Bond Market Index Fund Investor Shares, a mutual fund designed to track the Barclays Capital U.S. Aggregate Bond Index. That index includes corporate, mortgage-backed, and U.S. government securities.
I chose two Vanguard funds because Vanguard is a reputable, low-cost provider of mutual funds. Mutual funds were selected because they are widely understood among retirees and offer an easy way to diversify among securities. I receive no compensation or other benefit from using these example investments.
The basic result is reported in the table below. After 11 years, withdrawing $4 at the end of each year for the next year’s living expenses (including a withdrawal to live on during 2012), a retiree ends the period with $99, just $1 less than her starting amount. If she had started with a $400,000 portfolio, she would have $396,000 at the end, immediately after having rebalanced and withdrawn $16,000 for living expenses in 2012.
Rebalancing involves buying and selling securities to restore a desired balance. Stocks and bonds grow at different rates (sometimes negative). If an investor wants to maintain a 50/50 balance, and if stocks grow at 10% in a year when bonds grow only at 2%, then at the end of the year, the investor will sell stocks and buy bonds until she achieves again the 50/50 balance.
If a retiree had invested only in bonds, she would have done better, ending with $126; and if she had invested only in stocks, her results ($63) would have been low enough to put the remainder of her retirement at serious risk.
Stocks usually perform better than bonds, especially over 10- or 11-year periods, so the results in this latest period are unusual. Looking forward, of course, no one knows whether stocks or bonds will fare better, hence advisers almost always recommend a mix.
The last result ($90) shows the effect of incorporating a small increase in annual withdrawals to compensate for inflation. Inflation averaged 2.5% annually over the period, and an annual inflation adjustment would have increased her annual withdrawal to $5.25 by 2011. The $90 result is worrisome—the withdrawal has risen to nearly 6% of the portfolio’s ending value. Many advisers would recommend reduced withdrawals going forward to give her investments a better chance of lasting the full 30-year period.
In future posts, I will build in different investments and more explanations. For now, however, readers have a simple model that works reasonably well. Over 11 years of unprecedented volatility in stocks, the 6-step model supported retirement withdrawals and ended at 99% of the original portfolio. The model includes a diversified portfolio, periodic rebalancing, and low costs. It represents a cautious approach to investing at the beginning of retirement, just when a retiree needs confidence that her strategy will hold up over time.