09 Mar 2012 Boomers Take Note

The week’s economic numbers continued their trend toward improvement with manufacturing store sales, consumer confidence, and jobs growth all moving ahead. Even Greece looks to end the week on a strong note as arm-twisting forced enough bondholders to swallow losses of more than 100 billion euros ($132 billion) and allow the beleaguered country to move forward with its next phase of debt re-structuring.

Jobs growth continued at a reasonably healthy pace in February, according to the government. The gain of 227,000 jobs followed gains of 284,000 in January and 223,000 in December. Jobs were produced primarily in the services industries of the private sector. By industry, job gains were strongest in professional and business services, health care and social assistance, and leisure and hospitality, according to Econoday. Average hourly earnings rose a modest 0.1% in February, following a 0.1% gain the month before. The average workweek for all workers in February was unchanged at 34.5 hours. According to the household survey, the unemployment rate remained steady at 8.3% as the pool of available workers rose as fast as new jobs were created.

Consumer confidence is on the rise as more Americans said the economy was improving, according to the Bloomberg Consumer Comfort Index. The index rose to a minus 36.7 in the period ended March 4th, the highest since April 2008 and up from minus 38.8 in the prior period. The gauge on the state of the economy reached a one-year high while the buying-climate measure climbed to a level last exceeded in December 2009. Joe Brusuelas, a senior economist at Bloomberg said consumers are much more comfortable about their own personal financial situations, which is largely negating the recent rise in gasoline prices.” But he also noted index remains at the low end of its historical range.

Consumers took their improved moods shopping last week according to Goldman Sachs and Redbook. Goldman’s weekly same-store sales index rose 1.3% in the week ended March 3rd, while Redbook’s index saw a 3.0% rise of year-on-year same store sales ended March 2nd. This rate compared to a 3.4% gain the prior week. Redbook sees stronger sales ahead for the month ahead.

The ISM reported that its non-manufacturing index rose 0.5% to 57.3. Econoday says the composite may understate underlying strength in the bulk of the nation’s economy where order levels are building with new orders up nearly two points to a very strong 61.2 vs. January’s already very strong 59.4. The index is comprised of agriculture, mining, construction, transportation, communications, wholesale trade and retail trade companies.

The manufacturing sector cooled modestly as factory orders fell back 1.0% following very strong gains in the prior months of 1.4% and of 2.2%. Weakness was centered in durable goods orders which fell 3.7%. Orders for non-durable goods, which always reflect price swings in commodities especially oil, rose 1.3%.

Boomers Beware

An article this week caught my attention as an example of how terrible financial advice can so easily be taken as sound simply by association with the presenter, in this case, the Wall Street Journal. The article was titled Testing the 4%-a-Year Retirement Rule and features Bill Bengen, a financial planner in Southern California who developed the 4% rule.

The following description of his rule is excerpted from the article: “In a study published in 1994, he said that if retirees withdrew 4% of their nest egg in the first year, and then increased the dollar amount by the inflation rate every year, their savings would easily last 30 years. He assumed that the portfolio was held in a tax-deferred account and was evenly split between large-company stocks and U.S. Treasury bonds. In a subsequent study, Mr. Bengen added U.S. small-company stocks to the mix, which increased the portfolio’s volatility and potential return. To adjust for this, he revised the withdrawal rule to 4.5%.”

The first problem is with the article itself. There was no testing to be found. The author merely points out that as stocks have become more volatile, many wonder whether Mr. Bengen’s rule still holds. The answer?: Well, Mr. Bengen says he thinks it does. However, he says the next five years could be crucial, particularly for individuals who retired in 2000 and have experienced two major stock-market downturns since then. He expects stock returns to be low for a while; if that is coupled with high inflation rates, “then retirees have a big problem,” he says.

In my view they have more than one problem. Mr. Bengen’s ‘rule’ has several problems. While it seemingly addresses inflation, it ignores capital market uncertainty. Uncertain returns (portfolio values) mean that spendable income (4.5% of portfolio plus inflation) will swing wildly from one year to the next. My experience is that people really don’t like their income to swing.

Take for example a couple with a million dollars to spend over their remaining 30-year retirement. Mr. Bergen’s examples use a deferred account invested in a balanced portfolio (60% equities and 40% fixed) so we will too. Using our Monte Carlo system to live our couple’s lives virtually 1,000 times through randomly generated capital market returns (against an allocation of 60% equities and 40% fixed) we find that their income would range significantly depending upon the kinds of market returns they would experience.

The graph to the right illustrates why so many throw their hands up and buy annuities, which are basically contracts which pay the insurance company to give you back your own money.

There’s another huge problem with Mr. Bengen’s rule of 4.5%. Look below at all the money our couple would have left over at their deaths that they may have wanted to spend. Even at the 75th percentile, the most pessimistic of our examples above, the couple left $783,832 in the bank, unspent. OK, they may have heirs to whom the money might have gone. But shouldn’t they get the chance say how much?

Here’s a better way.

Let’s take our same couple, assume the same portfolio with the same risk allocation of 60% stocks and 40% bonds. But this time, let’s suggest that instead of accepting a lifestyle dictated by their returns let’s give our couple the opportunity to do some dictating themselves. We might ask them what an ideal level of spending might be as well as what would minimally suffice if times required or in order to meet other more important goals. In this case our only other goal is to leave something for the kids.

Our couple says that it would be ideal for them to spend $45,000 (after-tax) annually (adj. for inflation) for the rest of their retired lives. If necessary their spending could be reduced to $40,000. They would like to leave $100,000 for their kids, but in no case less than $50,000.

We inform our couple that they could accomplish both goals at their ideals and have an 81% confidence of exceeding both goals. Our objective is to maintain, to the extent possible, our clients’ income and estate goals through the reality of market turbulence and the uncertainty of future markets. By continually measuring uncertainty in our clients’ plan we can make adjustments to their spending, estate, and portfolio risk (allocation) according to their priorities to maintain a comfortable level of confidence.

The table above illustrated the broad range of potential outcomes for a $1 million portfolio delivering an annual after-tax income level of $45,000 (adj for inflation) and ending with $100,000. There is a 75% chance the portfolio will be worth more than $300,000 at death and a 25% chance that it will exceed $2.1 million. It is a picture of why our couple needs professional assistance in managing the uncertainty ahead of them and why a simple 4.5% rule of thumb simply won’t do.

Have a nice weekend.