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Raddr's Early Retirement and Financial Strategy Board
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Norbert Schlenker
Joined: 11 May 2005
Posts: 92
Location: The Dry Side of the Wet Coast
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 Posted: Wed Feb 08, 2006 1:56 pm Post subject: Re: Hypothetical Y2K retiree update |
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| Michael wrote: | | Norbert Schlenker wrote: |
The 4% figure was hypothesized as safe (i.e. no portfolio failure) for a 30 year period. But six years have already gone by. The question is no longer whether a 75:25 portfolio of $600k can stand $40k withdrawals - all $ figures inflation adjusted - for the next 30-40 years. It's whether the portfolio will fail within the next 24.
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Just because 6 years passed doesn’t mean that the people involved will shorten their horizon by that amount. This is rational in a mathematical sense, but in real life people behave differently. |
I can't agree with this. If six years have passed and the real value of the portfolio has fallen by 40%, you're undoubtedly in trouble and you can be awfully bummed about unfortunate timing. But what gives you the right to get even more upset about the water under the bridge because NOW you want to move the goalposts? If you're reevaluating your position with respect to time frame from the present, then you may as well reevaluate with respect to financial resources at present. Faced with a tenuous situation, how many people would insist on an adjustment that would make things even more tenuous?
| Quote: | People age but they don’t necessarily shorten their financial planning horizon as a consequence. In other words, a plan designed to sustain withdrawls for 30 years, after 10 years, may still need to last for 30 years. In fact, as people age they become more concerned about running out of funds. Perhaps this is because their options (back to work, etc) decrease as they age. Either way, the need to extend seems to increase, not fall off, as time passes.
In addition, as their horizon becomes less quantified (more indefinite) they may lose physical and mental capacity – and possibly the very skills needed to assure sustained safe withdrawls.
I also think the proposition that the elderly will spend less is not true. They may not have much to spend, but health care spending alone – the part not covered by medicare or most retirement plans – has the potential of taking over all of their disposable income and growing much faster than inflation. |
All good points, but what does this have to do with whether a model that says "A 4% SWR will last 30 years" is correct or not.
| Quote: | | The folks in this example are screwed. |
Investments are all about probabilities. I don't think you should be nearly so definite. I think we'll have to wait and see.
| Quote: | | Even worse, they know it and will spend their final years worrying about their finances and therefore depriving themselves of a comfortable life. |
This remark puzzles me. Can you explain what you mean? |
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KenM
Joined: 23 Jun 2004
Posts: 988
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| Posted: Wed Feb 08, 2006 10:47 pm Post subject: |
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hi raddr
| Quote: | | Until all assets become perfectly correlated and have the same return you will always (my emphasis added) be better off with diversification. |
...... but surely correlations can only be relied upon as long term averages. In the particular case of a 2006 retiree where, as usual, portfolio success/failure will depend on performance in the first 5 years or so, he should be careful not to rely on the correlation effect in the same way that the thread's 2000 retiree should not have relied on Trinity etc ...... for example, in the 3 years since 2003 everything has gone in one direction - up .... LC up about 50% and EFA, SCv, REITS all up roughly 100%. Therefore if we take the particular case (instead of long term averages) of where we are in 2006 and if (a hypothetical if) there were to be a bad 3 year bear starting now, I'd suggest the probabilities are that a 75/25 diversified portfolio starting distribution in 2006 might well perform significantly worse than a 75/25 LC portfolio.
I wasn't around internet boards in 2000, but I get the impression there was a general air of complacency that a retiree could set a Trinity style LC 75/25 4% SWR retirement portfolio on autopilot with, as the Aussies say "No worries, mate." whatever the market circumstances were at the start of withdrawals. It now seems there's a similar "No worries, mate" undercurrent that a Coffeehouse portfolio will always solve the problems and eliminate the potential failures of a Trinity retirement portfolio at whatever particular point in time a retiree retires and starts taking income from the portfolio . I've not entirely convinced myself of this view, but I tend to wonder whether a 2006 retiree wanting something like a 75/25 4% SWR portfolio might not be at lower risk of failure if veering towards Trinity rather than Coffehouse under the current particular market circumstances .......... for accumulation I'd still agree that Coffeeshop is the way to go.
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raddr
Site Admin
Joined: 22 Jun 2004
Posts: 4728
Location: Texas
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| Posted: Thu Feb 09, 2006 9:38 am Post subject: |
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Hi Ken,
| Quote: |
Therefore if we take the particular case (instead of long term averages) of where we are in 2006 and if (a hypothetical if) there were to be a bad 3 year bear starting now, I'd suggest the probabilities are that a 75/25 diversified portfolio starting distribution in 2006 might well perform significantly worse than a 75/25 LC portfolio. |
I feel just the opposite. First of all, reasonably diversified portfolios always have had a higher sustainable long-term SWR historically. I see no reason for this to change. Second, IMHO large caps are still way overvalued as opposed to mild/moderate overvaluation of most of the other asset classes. I think that it is folly to have all equity exposure in one basket whether it be LC, SC, EAFE, etc. And I think that for the forseeable future the worst place to have most of your money is in US large caps where the expected return is only about 1-1.5% more than the risk free rate (TIPS). I think the assumption you are making about LC being due for a rebound is not a good one since it is still so overvalued, even after a substantial decline. Personally, I won't allow any one asset class to comprise more than about 1/3 of my total portfolio since, if you guess wrong, you are screwed.
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"I brew therefore I am." 
-raddr |
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Michael
Joined: 28 Sep 2005
Posts: 253
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| Posted: Thu Feb 09, 2006 12:58 pm Post subject: Re: Hypothetical Y2K retiree update |
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| Norbert Schlenker wrote: |
Investments are all about probabilities. I don't think you should be nearly so definite. I think we'll have to wait and see.
This remark puzzles me. Can you explain what you mean? |
Let’s sum up where we are.
On 1/1/2000, a 55 year old couple retire with $1M in retirement savings. They build a safe financial plan – a 75:25 mix of S&P500 stocks and 6 mo. commercial paper. This will allow them to withdraw 4% ($40K) per year, adjusted for inflation, over a 30-40 year range. Their funds will provide for them ‘till they are 95 with a probability of success greater than 95% (their opinion).
Real life does not evolve according to plan. After 5 years, their nest egg has now fallen to $600K in real terms. Their spending needs have not decreased, and their life expectancy has increased by about 1.5 years. So at age 61, to generate the $40K they originally needed, now for another 26 to 36 years, they would need close to their original nest egg. Seen another way, if they continue with the original withdrawal amount, the probability of portfolio survival falls from the high 90’s to the low 60’s.
What are their alternatives?
1. Reduce the withdrawal from $40K to somewhere between $25-$30K in order to recover to the original portfolio survivability . If their lifestyle is “average”, their total budget is pretty evenly split between fixed and discretionary. The fixed is, well, fixed and quite hard to reduce, so the difference comes from discretionary. They have to eliminate most of their discretionary spending.
2. Live with a much lower probability of success. Another way of saying this is: live with the constant fear of running out of money.
For the people in the example, probabilities and statistics are meaningless. Now, faced with reality, they choose some of each alternative, deprive themselves of harmony and material well-being, and for the rest of their lives, are aware of it and suffer as a consequence.
Michael |
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Norbert Schlenker
Joined: 11 May 2005
Posts: 92
Location: The Dry Side of the Wet Coast
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| Posted: Thu Feb 09, 2006 2:36 pm Post subject: |
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| Quote: | What are their alternatives?
1. Reduce the withdrawal from $40K to somewhere between $25-$30K in order to recover to the original portfolio survivability . If their lifestyle is “average”, their total budget is pretty evenly split between fixed and discretionary. The fixed is, well, fixed and quite hard to reduce, so the difference comes from discretionary. They have to eliminate most of their discretionary spending.
2. Live with a much lower probability of success. Another way of saying this is: live with the constant fear of running out of money.
For the people in the example, probabilities and statistics are meaningless. Now, faced with reality, they choose some of each alternative, deprive themselves of harmony and material well-being, and for the rest of their lives, are aware of it and suffer as a consequence. |
This may sound a bit smartass but it's not intended that way.
Why can't they just pick #1 or #2?
If it's #1, yeah, their material well being is substantially impaired, but them's the breaks. Life is not a bowl of cherries, financially or otherwise.
If it's #2, then they've made a knowing choice that current lifestyle trumps long term safety. That may not be for everybody but there is no shortage of people who act this way every single day of their lives. (Not FIREes, so there aren't many hanging around here.)
If you're suggesting that people will do both simultaneously, i.e. cut their spending and still be scared to death, I suppose that's possible. I would counsel them otherwise. Make a case that I shouldn't talk them out of what I consider baseless fear.
An analogy: I have clients all over the risk spectrum. I have some clients who are so conservative that tell me they cannot take a hit of any sort to their portfolio in a given year. If that belief is firmly held, and yet a money market rate is insufficient, I tell them I can't really help them. The choices are to cut income - in your terms, cuts in discretionary spending follow - or to assume some risk - in your terms, live with the constant fear of losses.
There is no happy middle, where fear is allayed and income is higher as well. That particular combination is not on offer, not now, not ever, not in portfolios pre- or post-retirement, not even if there's a slick sales pitch that promises it.
Every investor has to learn that. Why would raddr's example be exempt? Why should raddr's example be exempt? |
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tmeri
Joined: 08 Mar 2005
Posts: 167
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| Posted: Thu Feb 09, 2006 8:22 pm Post subject: Re: Hypothetical Y2K retiree update |
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| raddr wrote: | | raddr wrote: | I've finally gotten around to calculating the 2004 year end balance of the portfolio of a hypothetical investor who retired at the end of 1999 with a 75:25 mix of S&P500 stocks and 6 mo. commercial paper. This was the type of portfolio that was being touted as "100% safe" on some investment boards based on historical backtesting at the time. The following numbers assume a 0.2%/yr. expense ratio, 4%/yr. withdrawal, and are stated in constant (real) dollar amounts:
| Code: | Year Return CPI Withdrawal Balance
1999 1000
2000 -9.1 3.4 40 869
2001 -9.9 1.6 40 743
2002 -18.8 2.4 40 564
2003 19.7 1.8 40 635
2004 5.3 3 40 628
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It's clear that this person would be in real trouble, particularly if he is an early retiree with possibly 30-50 years of life remaining. He would be taking withdrawals of about 6.4% at the start of 2005 because of the severe hit that the portfolio has taken. Using MC analysis this portfolio would have a greater than 50:50 chance of failure during the next 40 years IF you assume that returns will be as good as in the past. Using Gordon equation predictions the chance of failure is about 80%. |
2005 update:
Following 2005's lackluster returns, the hypothetical portfolio has now shrunk to 599K which means a cumulative drop of over 40% in real dollar terms. Chances are very good that this portfolio will fail sometime in the next 30-40 years. |
Well, it would be nice if people would supply data when they make claims like this. By not doing that, it forces me to back-calculate.
When I back-calculate, I get that the performance of the 75/25 portfolio must have been roughly 2%. That seems to be at odds with what I've seen elsewhere.
Someone is confused. Probably me. Could you supply the actual data you used to arrive at 599K? |
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tmeri
Joined: 08 Mar 2005
Posts: 167
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| Posted: Thu Feb 09, 2006 8:43 pm Post subject: Re: Hypothetical Y2K retiree update |
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| tmeri wrote: |
Well, it would be nice if people would supply data when they make claims like this. By not doing that, it forces me to back-calculate.
When I back-calculate, I get that the performance of the 75/25 portfolio must have been roughly 2%. That seems to be at odds with what I've seen elsewhere.
Someone is confused. Probably me. Could you supply the actual data you used to arrive at 599K? |
Part of my problem is that I failed to account for inflation. I don't know what that was, but even if it was 4% last year, you still only get 6% for port performance. I think it was more like 8% or so.
raddr, I understand why you use inflation adjusted values, but it is not the way people think and it is confusing. You are careful to say "down 40% in adjusted dollars" but people don't naturally think back to what a dollar would buy in 2000. I personally have a much easier time with today's dollar for today's portfolio. I really do not see why you wish to make this more confusing, unless you are just trying to make the outcome look worse than it actually is. I know what it costs to buy a gallon of milk today. I don't have a ready grasp on what it cost back in 2000. When you say the portfolio has 599K in inflation-adjusted dollars, what is in people's minds, I suspect, is a feeling for what $599K would buy TODAY, not 6 years ago.
Sorry. I just strongly disagree with this presentation. It is hard enough to communicate without insisting on using a frame of reference that almost no one else uses.
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ben
Joined: 24 Jun 2004
Posts: 1434
Location: The world is not enough
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| Posted: Thu Feb 09, 2006 8:59 pm Post subject: |
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I fully agree with tmeri here.
But on a seperate note; the 2000 Firee also have option 3; to diversify out of the SP500/US bonds only portfolio - historically that has added about 1-2% to the SWR which might help in future years - especially if combined with option 1 (or 2). Cheers!
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90% of my money I intend to spend on wild women, booze, and good times and the other 10% I will spend foolishly. |
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raddr
Site Admin
Joined: 22 Jun 2004
Posts: 4728
Location: Texas
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| Posted: Thu Feb 09, 2006 9:16 pm Post subject: |
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Tmeri,
I'll recalculate the data in non-inflation dollars soon but I have to say that I strongly disagree with you here and don't appreciate the insinuation that I am somehow obfuscating the numbers. Sorry you don't like them but they are what they are. It is portfolio purchasing power that we are talking about and the only way to level the playing field is to use constant dollars. A dollar from 2006 does not buy what it did in 2000.
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"I brew therefore I am."
-raddr |
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tmeri
Joined: 08 Mar 2005
Posts: 167
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| Posted: Thu Feb 09, 2006 10:03 pm Post subject: |
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| raddr wrote: | Tmeri,
I'll recalculate the data in non-inflation dollars soon but I have to say that I strongly disagree with you here and don't appreciate the insinuation that I am somehow obfuscating the numbers. Sorry you don't like them but they are what they are. It is portfolio purchasing power that we are talking about and the only way to level the playing field is to use constant dollars. A dollar from 2006 does not buy what it did in 2000. |
I apologize. I did not mean to insinuate anything. My only point here is that I have a difficult time thinking in terms of dollars from some other year than now. While I cannot be certain, I suspect that the vast majority of other people also think in today's dollars.
The reference to making the numbers look worse than they are was simply showing that if someone wanted to do that, they might employ the presentation you are using. I did not mean to suggest that that was your reason for doing so, simply that the presentation effectively does so. It was a hypothetical, and actually, it was meant, rhetorically, to dispel any reason at all for the choice of reference of 2000 dollars, because I don't think anyone for a second would think that you are deliberately trying to deceive. Perhaps it was a poor choice of rhetorical device.
I believe you are trying to make the withdrawal constant ($40K) because that gives people a constant value to look at with respect to each year's portfolio. While it is true that if you use real dollars rather than inflation-adjusted dollars, the reader will have to adjust in their mind that they need more money today than they did 6 years ago to get the same buying power, I think people are more comfortable with that adjustment than the other.
One way or another, people are going to have to adjust something mentally.
Additionally, since virtually every other financial report anywhere uses real dollars, a quick comparison of facts from your table are never possible with other information elsewhere, unless it just happens to be information for year 2000.
I am frustrated. I have never once looked at your table without stumbling over the arithmetic behind it. And it generally takes me a good 15 minutes of study to re-grasp what it is trying to say, and even then I get it wrong. This does not happen to me with the financial tables that others make which are reported in real dollars. The fact that I keep making mistakes when I look at your table says I am tripping over it perhaps because of the choice of reference point.
But I might be unique in that. I sort of doubt it, but anything is possible. |
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lazyday
Joined: 24 Jan 2005
Posts: 1023
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| Posted: Fri Feb 10, 2006 12:54 am Post subject: |
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KenM, I do think it's very possible for most classes to drop at same time. For example, Asian recession could spread and hurt equity everywhere, especially EM, and the reduced demand could hurt commodities. A very deep recession might be brutal on small and value.
So, I can easily imagine a scenario where LC outperforms slice and dice, particularly the type most people talk about which overweights small and value, and lately, EM.
Still, I think a slice and dice portfolio is safer than a simple LC US+bonds portfolio, as the diversification could help in many possible futures. My personal opinion, as a market timer/TAA type, is that a small or value overweight isn't a good risk today. But S&D can be done without that, such as Swensen's version.
I don't think S&D is enough to make 4% WR safe, for a young ER. I prefer barebones at something well under 4%, and if portfolio does well, eventually increase standard of living. |
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KenM
Joined: 23 Jun 2004
Posts: 988
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| Posted: Fri Feb 10, 2006 4:35 am Post subject: |
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| Norbert Schlenker wrote: | ....... them's the breaks. Life is not a bowl of cherries, financially or otherwise.
...... not even if there's a slick sales pitch that promises it.
Every investor has to learn that. Why would raddr's example be exempt? Why should raddr's example be exempt? |
As you said, this may sound a bit smartass but it's not intended that way.
Although I'd emphasise I've never seen a slick sales pitch promising a 4% SWR, a potential retiree would find on just about every sensible, well respected (the ones that I respect anyway, including your own) financial website and internet board something similar to the following which is from your own site at http://www.libra-investments.com/di08.htm :- | Quote: | | The historical evidence is that you can take roughly 4% from the starting value of an investment portfolio, raising it each year by the inflation rate, without running into disaster. History is not a perfect guide to the future, but barring nuclear war, natural disasters, or complete economic collapse, 4% should be your guide. |
..... and that was the sort of thing being said about a Trinity style portfolio and it appears people believed it and acted on it and a Y2K retiree now is at high risk of disaster even though nothing has occurred that comes anywhere near the severity of nuclear war or complete economic collapse. The naive (which covers just about 98% of us) but intelligent investor doing his/her due diligence would find noone mentions that every investor using 4% WR as a guide has to learn about bad breaks or bowls of cherries ...... just things like complete economic collapse.
Current conventional wisdom appears to be still high equity portfolios; TSM or diversified stock indexes and 4% WR as a guide but not the Trinity style S&P500 based portfolio ..... perhaps also mentioning that if things turn out not so well then a retiree may have to cut back expenditure for a couple of years while the portfolio returns to a reasonable level. A couple of rhetorical questions ..... am I the only one who, considering current market conditions, doesn't find it difficult to imagine a scenario where 2006 retirees with a diversified portfolio and 4% WR might not find themselves in 6 years time in a similar situation as Y2K retirees now find with a Trinity style portfolio? .... am I the only one who thinks that, in most cases, cutting back expenditure from 4% to, say, 2.5% for a couple of years in down years is a waste of time?
I like this thread  ..... it's one of the few cases I've seen illustrating the mechanism of one way in which a retirement portfolio might fail ....... it's made me think and perhaps I'm now slightly less naive than I was ..... 
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Find a job you like and you add five days to every week - H. Jackson Brown jr |
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raddr
Site Admin
Joined: 22 Jun 2004
Posts: 4728
Location: Texas
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| Posted: Fri Feb 10, 2006 8:12 am Post subject: |
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| tmeri wrote: | | raddr wrote: | Tmeri,
I'll recalculate the data in non-inflation dollars soon but I have to say that I strongly disagree with you here and don't appreciate the insinuation that I am somehow obfuscating the numbers. Sorry you don't like them but they are what they are. It is portfolio purchasing power that we are talking about and the only way to level the playing field is to use constant dollars. A dollar from 2006 does not buy what it did in 2000. |
I apologize. I did not mean to insinuate anything. My only point here is that I have a difficult time thinking in terms of dollars from some other year than now. While I cannot be certain, I suspect that the vast majority of other people also think in today's dollars. |
Apology accepted.  As you know it is hard to read body language on the internet and I really doubted that you were accusing me of anything but I'm glad to know for sure that you were not. Here's the same analysis in nominal dollars:
| Code: | Commercial Composite
CPI S&P500 Paper Return Withdrawal Portfolio
2000 3.4 -9.1 6.8 -5.4 40 906
2001 1.6 -11.9 3.7 -8.3 41 789
2002 2.4 -22.1 1.8 -16.4 42 618
2003 1.7 28.7 1.2 21.5 43 707
2004 3 10.9 1.7 8.3 44 722
2005 3.4 4.7 3.3 4.1 45 706
2006 47 |
As you can see, the retiree is now withdrawing 47K from a 706K portfolio, i.e. the exact same as taking 40K from the 599K portfolio in the constant-dollar original example. This works out to about a 6.7% withdrawal rate for 2006 any way you look at it. The same dreary analysis applies to this set of numbers as it does the inflation-adjusted numbers that I prefer to work with. BTW, if you run the numbers yourself, and I encourage you to do so, remember to subtract 20 or so basis points for expenses. Hope this helps!
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raddr
Site Admin
Joined: 22 Jun 2004
Posts: 4728
Location: Texas
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| Posted: Fri Feb 10, 2006 8:30 am Post subject: |
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| Quote: | | ...am I the only one who, considering current market conditions, doesn't find it difficult to imagine a scenario where 2006 retirees with a diversified portfolio and 4% WR might not find themselves in 6 years time in a similar situation as Y2K retirees now find with a Trinity style portfolio? .... am I the only one who thinks that, in most cases, cutting back expenditure from 4% to, say, 2.5% for a couple of years in down years is a waste of time? |
Ken,
I'd say maybe and no.  As for the diversified portfolio, every bit of backtesting I've done shows that diversification raises the SWR a lot - at least 1% in most cases. The only way you'll ever convince yourself of this is to run the numbers yourself. It will be an eye opener for you, trust me.
I do agree that cutting back from 4% to 2.5% won't help much as I alluded to earlier in this thread. The key is to avoid a big hit to the portfolio in the early years and the best way to do this is - you guessed it - to avoid putting all of your eggs in one basket and instead diversify. Have you read Bernstein's two books? He'll convince you of this in more elegant fashion than I'll be able to.
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"I brew therefore I am."
-raddr |
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KenM
Joined: 23 Jun 2004
Posts: 988
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| Posted: Fri Feb 10, 2006 11:44 am Post subject: |
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raddr, with respect ..... I was beginning to think I'd explained my point clearly ...... and then you say .... | Quote: | | The key is to avoid (my emphasis) a big hit to the portfolio in the early years and the best way to do this is - you guessed it - to avoid putting all of your eggs in one basket and instead diversify |
...... which sounds to be an absolute - diversify and you avoid failure of a portfolio .... no caveats? no doubts? no possibility of failure?
I've read both Bernstein books and I agree most definitely that a diversified portfolio is better in all respects but from what I can remember it's all about averages over long periods of time - Trinity was about averages over long periods of time and a 4% SWR worked for an LC portfolio until we got to 2000 ...... there must be circumstances where a diversified portfolio can fail. The naive investor in me would like to believe I can be complacent with a diversified portfolio and 4% SWR for the next 30 to 40 years with no worries except nuclear war etc- the sceptical investor in me cannot accept any buy&hold diversified portfolio until I've got some idea of under what sort of scenarios failure might occur ......
From your previous figures the Y2K S&P500 portfolio is at high risk of failure after the S&P dropped about 50% over 3 years and went back up 50% over the subsequent 3 years. If I take Coffeehouse as a typical diversified portfolio - 10% each of LC, LCv, SC, SCv, REITS, Int'l and 40% FI - is anyone really willing to tell me that, short of nuclear war or complete economic collapse, this sort of portfolio can never drop 50% in 3 years and then go back up 50% for the next 3? I'd make an entirely arbitrary guess and say that the chances of that happening to Coffeehouse in 2006 is about 1 in 5 ..... anyone want to say that the odds are so low that they can be ignored? (Please note - lots of rhetorical questions - I don't really expect answers )
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