Contents

Cover

Preface

Introduction

Opening Moves: Life-cycle Theories from A to Z

Fama-French: The Alternative to Leverage-Early

The Endgame (Relax. I’ll get to the middle later)

A Few Real-World Endgames

The Middle Game

Acknowledgments

About the Author

Notes

Copyright

The Ages of the Investor: A Critical Look at Life-cycle Investing is intended to be the first installment in the Investing for Adults series. Just as grown-ups do not believe in the Tooth Fairy, the Easter Bunny, or Santa Claus, “Investing adults” know that there is no such creature as the Stock-picking Fairy or the Market-timing Fairy. Further, there is no Risk Fairy who will write you cheap options that will protect your stock holdings against loss. Investing adults are familiar with Gene Fama, Zvi Bodie, Jack Bogle, and Burton Malkiel, and understand that a mean variance optimizer does not blend vegetables. In other words, this series is not for beginners. Future topics will, with luck, include the limits of market efficiency and diversification in increasingly non-segmented global markets.

Introduction

In As You Like It, Shakespeare famously listed the seven ages of man—the crying babe, the reluctant schoolboy, the sighing lover, the honor-seeking soldier, the judge dispensing wisdom, the foolish pantaloon, and, finally, the sad dependent in the throes of that second childhood called senility, “sans teeth, sans eyes, sans taste, sans everything.” Seven investment ages are several too many to easily digest, so I have defined only three much more prosaic ones: beginning, middle, and end, each with its own theory and strategy. This booklet has its origins in several practical and conceptual strands of thinking that have been woven into finance theory over the past few decades. First, I realized that by 2007, many investors had in fact “won the game”—that is, accumulated enough assets to successfully retire—then lost it during financial meltdown of 2007–2009, perhaps forever. The second strand of thinking, most forcefully propounded by such authorities on investing as Zvi Bodie, Robert Arnott, Barton Waring, and Laurence Siegel, stressed the importance of accumulating a portfolio of risk-free assets or the equivalent in an annuitized stream of income that would secure an investor’s retirement years. A third strand of thinking, originating with Paul Samuelson in the late 1960s and later amplified by two of his students, posited that most periodic investment strategies are far too cautious.

The Ages of the Investor endeavors to reconcile these disparate and, at times, contradictory concepts. We’ll find, among other things, that young people should, in general, invest far more aggressively than they do, although it may take them some time to achieve the risk tolerance necessary to do so; that older people, on the other hand, should, in general, aim at an investment strategy heavy on “defeasing assets,” that is, fixed annuities or a laddered bond portfolio that matures throughout their retirement years; and that the trickiest and riskiest part of the process is the transition from the first phase of investing to the second. This booklet’s aim, then, will be to use these concepts to cheat, ever so slightly, the destiny laid out in Shakespeare’s monologue, so that you won’t find yourself, in the end, sans assets.

Opening Moves: Life-cycle Theories from A to Z

Of all of investing’s most hallowed principles, few command as much respect as the “Age equals bonds” rule of thumb that states, for example, that the 30-year-old should own a 70% stock/30% bond portfolio, and the 75-year-old a 25/75 portfolio (or the slightly modified, the “Rule of 110,” which dictates the addition of 10% to those stock exposures).

Those rules are not bad ones, and most investors would be well advised to follow one or the other. That said, it’s worth examining just how well the Age equals bonds rule or the Rule of 110 serve over an investing lifetime. We’ll find that while they may or may not make good sense during the middle of the cycle, say between ages 40 and 55, they may not be appropriate in youth and in old age. To wit, it’s virtually impossible for young workers to deploy their investment capital too aggressively, because their human capital overwhelms it. Contrariwise, in later years aggressive investing may place an otherwise secure retirement at risk. As one approaches the end of one’s human capital and hopefully has accumulated enough investment capital to safely offset the expense of retirement living, it makes little sense to put at risk the funds earmarked for retirement living expenses. In other words, once the game has been won by accumulating enough safe assets to retire on, it makes little sense to keep playing it, at least with the “number”: the pile of safe assets sufficient to directly provide or indirectly purchase an adequate lifetime income stream.

Let’s start with the young investor. Consider the relative sizes of her human capital and her investment capital. We can define human capital in a number of ways, but for our purposes we’ll call it the present real value of her future wage stream. Let’s assume a 1% real annual wage rise that is discounted at a rate of 2% per year (or, more simply, a 1% discounting of a constant inflation-adjusted income). Let’s further assume that she saves 20% of her salary and earns a 2% real return on it. Finally, let’s assume also that she retires at age 65. Figure 1 displays her mix of human and investment capital over the course of her investing lifetime.

On the y-axis I’ve plotted wealth as a multiple of annual earnings. Note how at age 25 she has only 48 years of human capital and no investment capital. This seeming shortfall is illusory. First, she is saving and, thus, living on less than her income. Second, she is discounting her future earnings. Were she to contract with the cunning Mephistopheles at age 25 to exchange all of her human capital for investment capital, she would do just fine because she’d earn a positive real return on her nest egg. (I could also have chosen to define her human capital as her discounted stream of savings. This would have flattened out the plot on the left side, but it would not change the logic of the analysis.) Figure 1 is a schematic drawing. It ignores the risks, fortunately relatively uncommon, that imperil human capital: severe illness or accident when young, economic catastrophes, and so forth.

An old investment chestnut states that young people should invest heavily in equities because they become less risky with time. In the case of a lump sum invested over decades, this is patently false, the artifact of calculating returns in annualized fashion. For example, since 1926 the extremes of 12-month rolling monthly returns of the S&P 500 have been +162.88% and -67.57%, while the high and low extremes of annualized returns for rolling 360-month (30-year) returns were 14.78% and 7.80%, respectively. However, when the 30-year returns are converted to total returns, we get high and low extremes of +6,153% and +851%. The latter set of high/low returns is far scarier than the first two. Let’s say that you require a 3,000% total return on your lump sum over a 40-year investing career in order to meet your retirement needs. Let’s also assume that you get only 1,000% in the first 30 years. There’s an excellent chance you won’t be able to make up the 2,000% shortfall over the final 10 years. Or, as financial economist Wade Pfau puts it, “The probability of semi-bad outcomes decreases over time, but the probability of very bad outcomes increases.”[1]

Another reality check: If stocks really were less risky over increasing time horizons, put options would become cheaper with longer expiration dates. But they most certainly do not. Or said yet another way, risks experienced in multiple time periods over a long horizon multiply, not cancel out.

That said, there are two important reasons why young investors should invest aggressively. First, as will be discussed later, when investing a relatively constant stream of real income, as opposed to a lump sum, stocks probably do become less risky with time, or at least do not increase their risk. Second, and more important for our purposes, as Figure 1 shows, the investment capital of a young person constitutes only a small portion of her total capital. Even a devastating loss of investment capital hardly affects her total capital. Figure 2, which uses the same savings and investment assumptions that Figure 1 does, shows that a 50% loss of investment capital early in life produces only a small decline in total capital.

Although I am generally enthusiastic about this approach to life-cycle investing, it does have one major flaw. The theory assumes that human capital is, at any point in time, riskless. But in a severe economic downturn in the real world, human capital may suddenly disappear along with investment capital.

About 40 years ago Paul Samuelson and Robert Merton formulated a theory of life-cycle investing that mathematically integrated human capital and investment capital. They concluded that a rational investor maintains a constant risk tolerance, and thus a constant percentage of exposure to stocks, throughout his or her lifetime.[2] More recently, two Yale finance academics, Barry Nalebuff and Ian Ayres, revisited that theory. They posit that investors should strive to maintain not only a constant percentage allocation to equities but also a constant dollar amount.

In order to better appreciate this admittedly jarring insight, we’ll need to back up quite a bit, to my first book, The Intelligent Asset Allocator, and Uncle Fred’s coin toss.[3] For those unacquainted with him, Uncle Fred is a mythical employer who offers a retirement scheme with a most curious set of annual returns, determined by a coin flip that yields either a +30% or a -10% result. This simple paradigm provides a useful shorthand for the long-run behavior of equity investing: Its expected return is 10%, that is, the arithmetic average of +30% and -10%. But the more relevant number for most investors is 8.17%. This is the median return of a fair 50/50 sample of coin tosses, as well as the geometric average of +30% and -10%. Finally, the 20% standard deviation of the coin toss is similar to the volatility of the broad U.S. stock market.

Imagine that on December 31 in each of 40 consecutive years, you contribute $1,000 to a retirement account, and that Uncle Fred’s coin toss determines what happens to your account. Let’s further assume that your yearly returns sequence defies the laws of probability, and you enjoy 20 consecutive years of positive returns first, followed by 20 consecutive years of negative returns. The 40-year result? Your account has an ending value of $159,960. Not too bad, you might say. But if we are calculating in nominal terms, your total return is not far from flat after adjusting your contributions for inflation.

Now assume the opposite sequence: 20 consecutive years of negative returns, followed by 20 consecutive years of positive ones. Result? Your account grows to an ending value of $4,307,437.

Figure 3 displays the simplest way to understand the superiority of the negative-results-first sequence, in which you bought at significantly lower average prices than with the positive-results-first sequence. If stocks sold for $1.00 per share at the beginning of the negative-results-first sequence, they declined in price to just $0.12 per share after 20 years, before rising over 20 years to $23.11 at the end of the 40 years. Factoring the reinvestment of dividends into the share price, your average purchase price over the full 40 years was just $2.69 per share. With the good-results-first sequence, by contrast, the purchase price never fell below $1.00 per share, then rose as high as $190.05 at 20 years before falling back to the same final value of $23.11 at 40 years. The average purchase price over the whole period was $58.04.

There’s an even more profound interpretation of why the second sequence was better: The investor had a higher dollar exposure to stocks during the 20 good years with the second sequence (bad returns first) than with the first.

One lesson here is that bad returns may not always be bad—if they lead to higher good returns in the long run. But imagine another scenario, in which instead of investing a stream of savings, you have just inherited a lump sum of money at age 25 from Uncle Fred that is large enough to fund your retirement at age 65 if you invest it at the 8.17% return rate. Uncle Fred, of course, has forbidden you to spend any of the money until you reach age 65. In other words, you will neither add to nor withdraw from this investment for 40 years. What could be better? You won’t have to save a dime. All you will have to do in the meantime is meet your living expenses with a working salary.

Assume that the usual annual coin toss determines your returns. Assume also that the gods of chance treat you fairly, with 20 heads and 20 tails. Does the precise sequence of heads and tails matter with this lump sum? No, for without withdrawals from or additions to the portfolio, the commutative law of multiplication applies. For the same reason, at least to a first-order estimation, a traditional IRA and a Roth IRA yield the same result if tax rates do not change. A 28% tax bite at the beginning with a Roth or at the end with a traditional IRA gives you the same number of dollars. There are a lot of potential reasons why one or the other might be superior, but we’ll leave that for another book.

This concept, I’ve found, causes people no end of confusion. When I discussed it in The Intelligent Asset Allocator, I was inundated with emails and letters from folks who were convinced either that sequence does not matter with periodic investment or that it does with a lump-sum investment. Both errors pop up not infrequently in personal finance columns.

What we have learned here is that investing all of your money up front in stocks avoids “sequence risk.” That is, with a lump sum, a particularly good or bad sequence of returns will not affect your final result one bit. Of course, unless you began your adult life as a wealthy heir, you don’t have that option. But the corollary still holds. Investing as much as possible in stocks and other risky assets up front maximally mitigates sequence risk.

This is the essence of Nalebuff and Ayres’ insight: Inheriting money from your Uncle Fred is the optimal scenario—and not solely because you don’t have to work and save. It’s optimal for a second reason: The lump sum of an inheritance provides a much more level dollar exposure to equities throughout your investing life cycle than having to work and save, which gives you almost no exposure, relative to the size of your total capital, to stocks when you’re young.

Nalebuff and Ayres took that concept as far as the U.S. securities laws allowed. But even our hypothetical young person with near-zero initial investment capital can’t come close to the sort of lifetime equity exposure that an inheritance would give her. She can at least increase her equity exposure when young through leverage. Nalebuff and Ayres figured that the maximum leverage that can be legally and inexpensively obtained for a standard brokerage account is 2:1. They proposed a complex allocation trajectory that maintains 2:1 stock leverage until an investor is in his or her late middle age, followed by gradual deleveraging to a low stock exposure in retirement. They then compared that strategy to two others: the first an allocation path similar to the Rule of 110, the other a strategy of a constant 100% stock exposure.

Using Robert Shiller’s securities return series going back to the nineteenth century, Nalebuff and Ayres found that in almost all cases, their leverage-early strategy did better than a strategy of 100% stocks. The strategy of 100% stocks, in turn, did much better than the traditional Rule of 110 strategy. In fact, even the worst returns for the leverage-early strategy were better than those for the Rule of 110.[4]

But, you might ask, didn’t leveraging at 2:1 “margin out” during the catastrophic three-year bear market from 1929 to 1932 or even in the 2007–2009 one, which saw a loss of more than 50%? No. The constant stream of contributions prevented younger investors from being sold out, while older ones had by that point eliminated their leverage. During severe bear markets, as the authors point out, investors who are leveraged but young will lose “a large percentage of a small amount.”[5]

But isn’t the success of their strategy just an artifact of the high historical returns of U.S. stocks? What if the stock market delivers lower future returns? Nalebuff and Ayres also ran their simulations using the returns of British stocks, which had lower returns, and with Japanese stocks, which suffered a brutal bear market—they’re still in it—after 1989. In both cases, leverage-early still beat both the constant 100% equity exposure and the more traditional Rule of 110 strategy.[6]

Figures 4 and 5 illustrate in schematic fashion the ideal and real-world lifetime dollar exposure to equities, while Figure 6 illustrates the best that can be done with a leverage-early strategy.

So what’s not to like with the leverage-early strategy? Plenty. For starters, its implementation presents almost insurmountable problems. We can quickly dispense with one route: an Ultrabull-type fund with 2:1 leverage. It is burdened with high expenses, the constant need to rebalance, and variance drag. Take, for example, the Profunds Ultrabull Fund. Its return trailed that of the Vanguard Index Trust 500 fund by 6.33% per year for the decade ending November 30, 2011. Admittedly, this was a particularly unfavorable environment for leveraged ETFs, which suffer badly during volatile, trendless markets. They do better, and can even yield excess returns, during strongly trending markets. Needless to say, excepting the post-1970 behavior of Japanese stocks, markets do not strongly trend, up or down, for decades at a time.

That leaves the purchase of deep-in-the-money long-duration options (LEAPS), a relatively cheap strategy that effectively produces 2:1 leverage. While certainly preferable to purchasing a leveraged mutual fund, this strategy also has its drawbacks. For starters, it effectively limits stock exposure to the S&P 500. A few long-duration options on some foreign ETFs are available, but they are subject to very large spreads and only occasionally offer the deep-in-the-money strike prices needed to produce 2:1 leverage. This is too bad. In this day and age, an equity portfolio consisting only of large-cap U.S. stocks is almost comically underdiversifed.

Although the past few decades have seen the correlation of stock markets around the world move inexorably towards 1.00, diversification across national boundaries and across investment styles still provides real long-term protection to investors. Table 1 shows the returns of various asset classes over the decade from 1999 to 2008. This period encompassed not one, but two of the worst bear markets in history of U.S., and world, equity markets. It was also a time of very high asset-class correlations.

Table 1.

The Long-run Value of Diversification

Asset Class

Jan 1999–Dec 2008

S&P 500

-12.99%

U.S. Large Value Stocks

+23.71%

U.S. Microcap Stocks

+86.63%

U.S. Small Value Stocks

+102.63%

Real Estate Investment Trusts

+107.14%

Int’l. Large Cap Stocks

+13.23%

Int’l. Large Value Stocks

+59.02%

Int’l. Small Cap Stocks

+97.34%

Emerging Markets Large Cap Stocks

+147.67%

Emerging Markets Value Stocks

+251.38%

Emerging Markets Small Cap Stocks

+196.43%

Lehman 1-10 Year Treasury Bonds

+73.64%

Lehman 1-10 Year Corporate Bonds

+60.41%

Treasury Bills

+37.39%

Source: Dimensional Fund Advisors, Barclays/Lehman Brothers

Yes, on a day when the U.S. market is down 5%, the rest of the world will follow, usually with even larger losses, and in a year that the S&P 500 is down more than 40%, most other asset classes will likely do even worse. But long-term returns are the only ones that matter. As Table 1 vividly demonstrates, diversifying widely can save your long-run bacon. Just ask someone who retired in 2000 on an S&P 500-heavy portfolio or in 1990 with Japanese stocks.

Back, now, to the subject of leverage-early. The strategy has a much larger problem than lack of proper implementation and underdiversification. No matter how theoretically and empirically appealing it is—and I’ll admit, it scores high on both points—there are no sentient beings in this quadrant of the galaxy capable of executing it.

In the first place, leverage-early confines all of the investor’s risk within a derivatives wrapper, and there are few investment environments more psychologically toxic than an options account.

Second, only the rare investor can tolerate a 1.0 beta, let alone a 2.0 beta. My experience is that young investors have lower tolerance for risk than older investors do. I’ll admit that the academic literature on risk tolerance and age is a tad ambiguous. But the data are crystal clear on one point: Risk tolerance increases with wealth. A 50% fall in the value of a 401(k) plan whose $25,000 balance represents the major liquid asset of a young saver will devastate her. She’ll likely be gun-shy about stocks in the future, her multimillion-dollar human capital notwithstanding.[7]

Fama-French: The Alternative to Leverage-Early

The problem, then, of asset allocation for the young saver can best be described as a three-way collision involving an irresistible force (the psychological difficulties of a 2.0 beta portfolio), an immovable object (the low risk tolerance of young investors), and a lack of appropriate investment vehicles. What to do? Let’s start by dealing with the last factor, the inappropriateness of both leveraged mutual funds and options-based strategies for the average saver, as well as the current inability of these vehicles to provide adequate stock asset-class diversification. Where else can the young saver take risk?

With other risk factors, of course. Tables 2 and 3 display the returns and SDs of the small and value risk factors over the three and a half decades between 1975 and 2011, as well as the correlation grids of these factors, including the U.S. returns factor. (The Fama-French international market factors are regional and are too messy to deal with. The small and value factors are long-short portfolios: the small factor, 100% long the CRSP 6 through 10 deciles and short the 1 through 5 deciles; the value factor, long/short the top/bottom book-to-market tertiles, respectively.)

Table 2.

The Returns to Small and Value Exposure in the U.S. and in Foreign Markets

Factor

Ann'd Return

SD

US Small

3.13%

10.83%

US Value

3.86%

10.56%

Foreign Small

1.66%

9.89%

Foreign Value

2.56%

5.87%

(Source: Dimensional Fund Advisors)

Table 3.

The Correlations of the U.S. and Foreign Small and Value Factors with U.S. Returns

US Market

US Small

US Value

Foreign Small

Foreign Value

US Market

1.00

US Small

0.28

1.00

US Value

-0.29

-0.25

1.00

Foreign Small

-0.22

0.07

0.15

1.00

Foreign Value

0.01

0.08

0.36

0.30

1.00

(Source: Dimensional Fund Advisors)

These two tables demonstrate what we already saw in the 1999–2008 data. First, the reward to small and value exposure is substantial. Second, both in the U.S. and abroad, the correlations of these two factors, with U.S. market returns and among themselves, are quite favorable as well.

Let’s compare grazing the Fama-French risk factors with using the Ayres/Nalebuff approach. If the equity risk premium (ERP) is, say, 4%, and the cost of margin is 2%, then a 2:1 leveraged strategy should yield a risk premium of about 6%.

Now, let’s look at the return to tilting towards small and value. The DFA US Small Value fund has small and value loadings of about 1.0 and 0.6, respectively. This suggests that it should yield about 1.0 x 3.13% + 0.6 x 3.86%, or an extra return of about 5.4%. Subtract, say, 1.5% of that for fund fees and transactional expenses, another 1% to allow for some large cap and growth/market exposure, and perhaps another 1% for the Rekenthaler Phenomenon (“If the bozos know about it, it doesn’t work any more”). You’re now down to 2% more than the S&P 500, for a total equity premium of 6%. That’s about what a 2:1 leveraged S&P 500 portfolio should yield after expenses.[8] In addition, the imperfect correlation of domestic and foreign small and risk factors with overall market returns stands in stark contrast to the additional, perfectly correlated risk taken on by leveraging stand-alone U.S. market returns.

A highly tilted portfolio should thus be much less volatile than the 2:1-levered S&P 500. The annualized SD of the DFA Small Value Fund is about 23%, versus about 32% for the Nalebuff/Ayres leveraged approach (twice the 16% annualized SD of the S&P 500). The lower volatility of the small- and value-loaded strategy is a blessing and a curse, however: a blessing because it will be easier to stick with, a curse because lower volatility gives the investor less opportunity to buy low during times of financial distress.

Two practical questions face the young investor wishing to implement the small/value approach. First, how much market, small, and value exposure do you want? Second, how, do you distribute those exposures around the world?

The first question comes down to your ability to tolerate a portfolio that is 100% stocks—and highly risky ones at that—until you’re 40 or 50 years old. Are you willing to tilt it all the way towards small and value only? The value premium is fickle enough. Since 1926, it has yielded negative returns for as long as 15 years. The small premium is even worse. It has occasionally yielded negative returns for as long as 30 years.

This occasional long-lasting underperformance of both the small and value factors, though, is of more concern to lump-sum investments than to a stream of periodic investments, where because of ability to occasionally purchase small and value stocks at a low price the picture becomes more favorable. Let’s analyze the question of how much tilt towards small and value with the following paradigm. We start with the inflation-adjusted return for the longest data series we have for small-value stocks—the Fama-French small-value index, with utilities included, between July 1926 and October 2011. This index returned 10.50% real-annualized, which was 3.88% per year more than the 6.62% real-annualized return for the S&P 500. Now imagine that a real $100 per month (in 1926 dollars) was invested for 30 years—360 monthly purchases—for all of the starting dates between July 1926 and November 1981 (as of this writing, the last date for which a 30-year period is available).

Figure 7 illustrates the ending real dollar value for $36,000 of real dollars invested in each strategy for each starting date ($100 for each of 360 months): For every starting date, the small-value strategy beat the S&P strategy, sometimes by a huge margin. Note how it’s difficult, though not impossible, to come out behind with an aggressive periodic saving strategy early in life, no matter which asset class you’re investing in. The power of periodic investing is such that the worst-case final portfolio amount after investing $36,000 in inflation-adjusted dollars in the S&P 500 over the thirty years between August 1952 and July 1982 was $44,271. Over the subsequent three and a half years (ending December 1985), the S&P 500 index doubled.

Figure 7 is a fantasy, though, for many reasons. First, it excludes fees and transactional costs, which can be substantial in the small-value universe. Second, the higher returns of small-value stocks are hardly a secret today. The Rekenthaler Phenomenon bids up their prices and possibly lowers their expected returns.

Figure 8 factors in the transactional costs, fees, and other factors that detract from the actual returns that will likely accrue to small-value investing in the real world, nicking 2% from the small-value advantage by subtracting a constant amount from each of the index’s monthly returns. That’s a closer shave, but it still beats the S&P 500 strategy 96% of the time.

Finally, Figure 9 eliminates all of the small-value advantage by equalizing the returns of the small value and S&P 500 indexes, again, by subtracting a constant amount from each monthly return. Amazingly, even with a zero small-value advantage, the small-value strategy beats the S&P 500 strategy 71% of the time. The reason, once again, is the contradictory nature of both the Nalebuff/Ayres and small-value strategies: higher volatility than a conventional 100% S&P 500 strategy and, thus, more opportunity to buy at much lower prices. The excess returns of both strategies, of course, come with a double cost. There is much greater volatility and, thus, far greater emotional demands on the investor—in plain English, stomach-churning uncertainty.

Nonetheless, discipline has its rewards. Figure 10 shows that the long-term small-value return must be 0.64% below the return of the S&P 500 before the success rate of the small-value strategy relative to the S&P 500 strategy falls below 50%.

As I’ve already said, I seriously doubt that most young and inexperienced investors have the moxie to stick with either the Nalebuff/Ayres strategy or an all-small-value strategy through thick and thin. A good compromise, especially for the young investor with a small balance, would be a less aggressive mix of the DFA US and international vector funds, which have a tad more than half the factor loading of its small-value funds. For exposure to emerging markets, either the DFA Emerging Markets Core or Value portfolios would be appropriate.

The virgin investor probably should not start out with more than a 50% investment in stocks. Here, then, is approximately how I’d begin:

35% DFA US Small Cap Value/Targeted Value/Vector

10% DFA International Small Cap Value/Vector

5% Emerging Markets Value/Core

50% Short-Term Bond Index/Short Treasuries

If you don’t have access to DFA funds, things become slightly problematic. You’ll be able to obtain fairly factor-intensive exposure from either the iShares S&P SmallCap 600 Value Index (IJS) or Vanguard’s Small Cap Value Index (VISVX, or the Vipers ETF, VBR). Table 4 shows the beta and factor loadings for the full data series from August 2000 to October 2011.

Table 4.

Fama-French Factor Loadings for Small-Value Funds

Fund

Alpha (yearly)

Market Beta

Small Beta

Value Beta

DFSVX

0.0%

0.99

0.97

0.55

IJS

-0.9%

0.92

0.82

0.49

VISVX/VBR

-0.4%

0.96

0.72

0.51

Both IJS and VISVX/VBR have significant REIT exposure—a modest disadvantage if you later decided to add a discrete REIT component to your portfolio, but a modest advantage if you don’t.

Small and value exposure in both developed foreign and emerging markets is more difficult without DFA funds. The PowerShares fundamental index funds in these areas (PXF = EAFE large value, PDN = EAFE small value, PHX = emerging markets) look promising, but have too short a track record, with inception only in 2007, to allow one to judge how well they execute their respective strategies. The VSS, Vanguard’s international small-company offering, suffers from having no tilt towards value. Another issue with VSS is its inclusion of both developed and emerging markets in one vehicle. Despite these drawbacks, I think these ETFs go a long way towards giving the average small investor adequate exposure to the small and value factors in the U.S. and abroad.

The young investor’s first encounter with a significant market decline serves mainly to ascertain her true risk tolerance. Her responses to the decline define the policy allocation that takes her to age 45 or 50. Does she panic and sell? Then certainly her long-term policy allocation to stocks should be less than 50%. If she holds fast but does not have the stomach to buy more, then 50% is likely about right. And if she piles in, then I say, “God bless.” Perhaps she can increase her policy allocation to stocks to 60% to 80%. The next few decades should allow her to test, adjust, and repeat the process at least a few more times.

One last point. It’s probably wise to factor your outstanding mortgage balance into the calculation as a negative bond. If you have a 50/50 investment portfolio worth $200,000 and a $150,000 mortgage, then in reality you have $100,000 worth of stocks and $50,000 of net debt, and are already leveraged 2:1. My advice: Pay the damned thing off. You’ll sleep better, and the interest rate on the loan is almost certainly higher than the yield you’ll get on the bond side of your portfolio. Don’t let the deceptive allure of the deduction tail wag your investment dog. And if you’re unlucky enough to lose your job in the next crisis, you’ll hug yourself for being so smart.

The Endgame (Relax. I’ll get to the middle later)

As we’ve just seen, in the savings phase there’s a large margin of safety. Absent a mass extinction in the world’s stock markets, it’s almost impossible to come out behind with rigorous adherence to a strategy of periodic investment in internationally diversified equity. To reiterate, this is not the same as saying that it’s impossible to lose real value over periods as long as 20 or even 30 years with lump-sum investing in a single national market. Such a long-term loss, however, becomes much less likely with periodic investment in a single nation and is nearly impossible, short of a global cataclysm, with an internationally diversified periodic purchasing strategy. In other words, the long-term risks (as well as the returns) of lump-sum investing are far greater than those of periodic investing.

The conflation of lump-sum and periodic investing is the source of no small mischief. I’ve seen this error made by some of finance’s most authoritative observers. This gets to an even larger point, which is the supposed “superiority” of lump-sum investing over periodic investing, either via dollar cost averaging (DCA) or value averaging (VA), the latter a clever technique pioneered by Michael Edleson.[9] In most cases, lump-sum investing does indeed yield higher returns than DCA or VA. For example, using the Ibbotson series, mathematician Bill Jones determined that a DCA process longer than one year usually did not outperform investment of a simple lump sum.[10] If you’ve followed things this far, the reason for this should be obvious: With lump-sum investing, you are investing more dollars in more years. In a world with a high equity risk premium, then, lump-sum investing is usually the best choice.

However, to the extent that lump-sum investing maximizes an investor’s “dollar-years,” it also maximizes risks. Thus, the continuum between lump-sum investing and DCA/VA is simply a journey from high risk/high return to low risk/low return. Of course, most savers do not have a choice in the matter. Not being heirs or able to leverage to any great degree, they are forced to DCA/VA. The bad news is that in most cases their expected returns will not be as high as they would have been if they had been bequeathed a lump sum and invested it. The good news is that the DCA/VA process is a good deal less risky. It is, in fact, nearly bulletproof, which is certainly not true of lump-sum investing, even over long periods.

Take, for example, the disastrous 12-year period between 2000 and 2011, which saw a 20.36% decline in total real return for the S&P 500. A theoretical investor who put an inflation-adjusted $100 into that index each month between December 31, 1999 and November 30, 2011 would have seen her or his inflation-adjusted $14,400 investment grow to $15,402 by the end date of December 31, 2011, as opposed to a decline to a real $11,468 had he or she made a lump-sum investment. Thus, periodic investing provides real downside protection in bad states of the world, at the cost of producing inferior returns relative to lump-sum investing most of the rest of the time. (Sharp-eyed readers may have noticed the seeming inconsistency between this paragraph and this booklet’s first pages, where I extolled lump-sum investing as a less risky process. My two statements, though, refer to two different risks. In the first instance, it is the savings sequence risk that is avoided by lump-sum investing. In the second instance, the risk of very low equity returns is mitigated by periodic investing.)

One more observation about the risk/return differences between lump-sum investing and DCA/VA. These differences are dependent on both the length of the period under consideration and the size of the ERP. The longer the period and the larger the ERP, the greater the “advantage” offered by lump-sum investing. Jones’ article, for example, was published in 1997 and looked at the U.S. market. Had he done the study in 2010 and looked at Japan, he would have reached the opposite conclusion. Similarly, even with a small (but positive) ERP, lump-sum investing over periods longer than a decade will almost always result in better returns.

Back to the subject at hand. By the end of the investment lifetime, human capital has disappeared. With it has gone the margin of error (and admittedly lower returns) afforded by periodic investment. At this stage of life, the stakes are high, indeed. A retiree heavily overexposed to equities can ill afford a bear market after she stops working. Sometimes, even holding longer bonds doesn’t help much. Take the years between the mid-1960s and the early 1980s, for example. In that period, both stocks and bonds got hammered. The theoretical retiree who began to draw down his or her nest egg at a real rate of 7% on January 1, 1966 ran out of money in about 13 years, no matter what his or her stock/bond mix was. At a real withdrawal rate of 6%, the money lasted about 16 years; at a 5%, withdrawal rate, it was gone in a little more than 20 years. Only at a 4% withdrawal rate did the nest egg survive more than 30 years. But even then, more than half of the principal was gone by that point.[11]

During the savings years, it makes good sense to consider all investible assets as a single portfolio. Not so, however, in retirement. Barton Waring and Laurence Siegel’s landmark article in Financial Analysts Journal addressed the issues facing a rapidly disappearing species: public and corporate defined-benefit plans, whose happy beneficiaries receive a guaranteed lifetime pension. Waring and Siegel’s conclusions apply just as well, however, to the individual retiree, who, according to the authors, should have two buckets of assets: a “liability matching portfolio” (LMP) that is structured to provide an adequate lifetime income and a “risk portfolio” (RP) of funds in excess of the LMP that serves for luxuries and bequests.[12]

Consider, first, the LMP. In a perfect world, this should consist of an inflation-adjusted, highly secure annuity. Annuities possess one major theoretical advantage over the individual nest egg: risk pooling. Many married retirees can count on at least one spouse surviving to at least age 90. With life expectancies continuing to improve by a few years per decade, this trend will only accelerate. Without risk pooling of some sort, every retiree has to save enough to sustain the possibility of a 40-year retirement—a near impossibility. With risk pooling by way of an annuity structure, those dying early subsidize those who live longer, increasing individual retirement checks and diminishing the risk of a retiree outliving his or her money.

So much for theory. In the real world, annuities have four large disadvantages: First, they do not allow withdrawals for emergencies. Second, they require the participant to give up ownership of his or her nest egg, a powerful psychological disadvantage that greatly curtails their popularity. Third, the companies that provide them must make a profit, which reduces payouts. And, last but certainly not least, these same companies may not survive.

Annuity enthusiasts are fond of pointing out that many states “guarantee” the payouts. An insurance company, of course, is most likely to go under during a systemic crisis that results in multiple failures. In that case the state guarantees will not offer so much as a speed bump on the way to default. Moreover, in some cases where the state guarantee kicks in, the annuity gets taken over by another company, which more often than not reduces the payout.

There is one “exception” to the insurance company profit/survival annuity problem. That is to “buy” a guaranteed inflation-protected annuity from the U.S. government. You say the government doesn’t sell annuities? Guess again. The cheapest and most secure “annuity” you can get can be had simply by deferring your Social Security payments until you reach age 70. Each year that you delay receiving it beyond age 62 increases your payout by an average of 7.32% per year.[13] You “pay” for this annuity by drawing down your nest egg in the absence of a Social Security check until you reach age 70.

There are multiple potential strategies for mitigating this cost. For example, a low earning spouse can begin receiving Social Security payments at age 62. When both wife and husband have reached age 66, the higher-earning spouse can “file and suspend,” allowing the lower-earning spouse to receive the 50% spousal check until the higher-earning spouse finally reaches age 70. (The 50% spousal benefit is available only at the spouse’s full retirement age. It is less if taken earlier, e.g., 35% at age 62.)[14]

If the Social Security “annuity” does not provide enough coverage and you don’t want to purchase a conventional annuity, a Treasury Inflation Protected Securities (TIPS) ladder can serve much—but not totally—the same purpose as the commercial inflation-indexed annuity and allow the retiree to keep control of most of his or her nest egg in an investment vehicle that is almost perfectly safe.

A word or two about TIPS. They are surely one of the most peculiar assets in the investment world. They are a marvelous way of protecting one’s cash flow against inflation, but they do so only when held to maturity. Before then, they can prove quite risky, in large part because their secondary market is thin. This was vividly demonstrated during the recent financial crisis, when, instead of benefiting from the instinctive “flight to safety,” the longest-dated year 2032 TIPS, which had a maturity of 24 years at that point, lost nearly a quarter of its value between January and October of 2008. Thirty-year TIPS are once again available at auction, and had one been trading in 2008 it would have lost about 30% of its value. The message here is clear: When using TIPS to fund your retirement, do so with a ladder whose maturities at least approximately match your projected needs; do not do so with a TIPS mutual fund, which may suffer capital loss just when you need the funds the most. In addition, the costs of owning a ladder of individual TIPS purchased at auction is near zero (and actually is zero for some brokerage accounts), far cheaper than even the thriftiest mutual fund or ETF.

Each of the three vehicles/strategies mentioned—fixed annuities, deferring Social Security, and a TIPS ladder—has pros and cons. Commercial inflation-indexed annuities can at least theoretically provide a safe lifetime flow of real income, but they are vulnerable to crisis-related and company-specific default. Purchasing annuities from several different companies mitigates the latter problem, but not the former. In addition, these annuities are not “actuarially fair.” That is, the companies that market them need to make a profit, and so they do not pay out the full actuarial amount to the beneficiaries. As we shall soon see, this actuarial unfairness comes at a high cost.

Deferring Social Security does provide a payout that is more than actuarially fair, and it is highly secure. But, unfortunately, it allows the “purchase” of only a relatively small amount of income stream, whose actual amount is dependent on a retiree’s work history.

A TIPS ladder, in contrast, is also highly secure and inflation protected, but it does not allow for risk pooling. Ideally, the retiree does not need the stream from the TIPS ladder until age 70 or so and still has enough assets to buy a full 30-year ladder sufficient to pay for retirement needs in each year. Left-over assets can be invested in the “risk portfolio” (RP). Few investors, however, will be able to completely take care of their living expenses to the outer limits of their potential survival, say, age 100 or so. Table 5 summarizes the advantages and disadvantages of these three different approaches to a secure retirement LMP.

Table 5.

Pros and Cons of Major Liability Matching Portfolio Strategies

Buy inflation-adjusted fixed annuity

Pros: Inflation-protected income stream for duration of one or joint lives

Cons: Default/failure, particularly in the event of systemic financial crisis. Adverse “adjustment” of inflation formula. Company profit motive detracts from actuarial fairness

Defer Social Security to age 70

Pros: Secure, inflation-protected income stream for duration of joint lives

Cons: Adverse “adjustment” of inflation formula. Benefit available to each retiree limited by work history

Buy TIPS ladder

Pros: Secure, inflation-protected income stream

Cons: Absence of risk pooling requires either a very long ladder or purchase of “longevity insurance.” Adverse “adjustment” of inflation formula

A TIPS ladder protects the retiree from a severe financial crisis in a way that commercial annuities cannot, and it comes fairly close to providing a lifetime income. Table 6 sets out the tradeoff between the risks of a commercial annuity and a TIPS ladder.

Each cell of Table 6 shows two figures: the percentage payout for an inflation-adjusted annuity for joint survival with a 100% spousal payout, a single male life, or a single female life; and a second number, the age at which a TIPS ladder with a 1% yield with the same payout would run out. Consider, for example, a husband and wife, both age 65, shown in the first data column of Table 6. For $1,000,000, the couple can purchase an annuity with income of $3,233 in the first month. (The 3.88% annual payout figure is the product of $3,233 times 12 months, or $38,800 per year.)

Table 6.

Commercial Annuity versus TIPS Ladder

Age

Joint Annuity with 100% Survivorship versus TIPS drop-dead at a 1% Yield

Single Life-Male Annuity versus TIPS drop-dead at 1% Yield

Single Life-Female Annuity versus TIPS drop-dead at 1% Yield

60

3.35%

Age 95.6

4.18%

Age 87.5

3.82%

Age 90.5

65

3.88%

Age 95.0

4.94%

Age 87.7

4.46%

Age 90.5

70

4.44%

Age 95.7

6.08%

Age 88.1

5.43%

Age 90.5

75

5.62%

Age 94.7

7.57%

Age 89.2

6.76%

Age 91.1

80

7.20%

Age 95.0

9.82%

Age 90.8

8.89%

Age 92.0

Source: Online quotes from Income Solutions, Hueler Investment Services Inc. State of Residence is California, average of all quotes.

This monthly payout rises with inflation and continues until the death of the second spouse. Were they to put the same money into a TIPS ladder with an average real yield of 1% and withdraw the same inflation-adjusted $3,233 per month, reinvesting the coupons also at 1%, the couple or the surviving spouse would run out of money at age 95.

Which is worse, the risk of running out of money with TIPS at age 95 or the risk of a severe financial crisis or company failure that would crater the annuity income stream? Your guess is as good as mine. A reasonable person has at least three options in this situation: the TIPS ladder, the commercial annuity, or some combination of the two. Best of all would be to completely avoid this dilemma by being able to purchase at age 75 a supplementary 30-year rung that would take them to age 105 or to have the equivalent in risk-free assets to do so. Such a comprehensive real coverage of retirement living expenses would constitute a liability-matching Full Monty (or, perhaps a, ahem, “Full Bodie”).

A Few Real-World Endgames

To illustrate how the Liability Matching Portfolio and the Risk Portfolio fit together (assuming that a retiree is lucky enough to have both), let’s consider four fictional cousins from the Frick family who demonstrate how the choices in this table play out in the real world.

The first, Fenwick, has just retired at age 62 from his school superintendent position in rural Kansas. He has a superb health-care package to supplement his Medicare coverage and $850,000 in an IRA rollover from his 403(b) plan. He has also made nearly the maximum in Social Security contributions. His house is paid for, and he and his wife enjoy a secure but spare lifestyle. Current living expenses, including taxes, amount to just $36,000 per year.

Social Security will pay him and his wife $1,705 per month right off the bat at age 62, $2,273 at the full retirement age of 66, or $3,000 at age 70.[15] It’s important to note that Social Security payments contain a cost-of-living adjustment and thus represent a stream of inflation-adjusted income. Fenwick did the math and has decided to spend down approximately $288,000 (8 times $36,000) of his IRA to get to age 70, at which point his Social Security checks will cover his modest living expenses for the remainder of his life and his wife’s.

He should invest the $288,000 of his IRA dedicated to paying his living expenses from ages 62 to 70 very conservatively—a ladder of plain-vanilla Treasuries, TIPS, or CDs. For the purposes of this analysis, I’ll assume that the short-term vehicles in which he’ll invest this 8-year stream keep pace with inflation. At present, this may be a generous assumption.

The approximately $562,000 (again, in 2012 dollars) left over in his IRA at age 70—his RP—can be tailored to whatever purpose Fenwick designates. If, for example, he wants to help his son with a down payment on a house in the next few years, he should invest conservatively. And if he’s thinking of using it for bequests to his old school system, it can be invested fairly aggressively, perhaps even mainly in small-value equity.

His RP should at all times hold a modest amount of cash for both emergencies and to pay the taxes on the required minimum distributions (RMD) that will begin after he reaches age 71 or 72, depending on his birth date. Because of the cumulative effects of the ever-increasing RMD share, bequests should not be deferred too long. In 2010 and 2011, taxpayers could make charitable contributions of up to $100,000 tax-free directly from their IRAs, thus doing away with this problem. (Whether this particular deduction survives future tax legislation is uncertain.)

To show the advantage that deferring Social Security until age 70 has over buying a commercial annuity, consider what would have happened if Fenwick opted instead to begin receiving Social Security payments at age 62, as a majority of Americans do. In that case, he would have to spend $1,295 per month from his IRA to take up the slack left by his $1,705 Social Security check. This totals only about $124,000 over the eight years until he reached age 70, as opposed to the $288,000 he would have to spend down from his IRA if he used IRA distributions to meet all of his living expenses between age 62 and age 70.

So starting Social Security at age 62 does, indeed, leave him with $164,000 more in his IRA at age 70 than starting Social Security at age 70 will. But from then on, it’s all downhill. This strategy leaves him with the same initial inflation-adjusted monthly shortfall of $1,295, or about $15,500 per year, a permanent ongoing deficit that would cost him about $349,000 to replace with an inflation-adjusted annuity at age 70. Thus, at age 70, having benefited for 8 years from the reduced outflow from his IRA but then being forced to purchase the annuity to cover the shortfall, he’d have only $377,000 left in his RP ($850,000 minus $124,000 minus $349,000), versus the $562,000 he’ll have by deferring Social Security until 70. The whopping $185,000 gap between the two strategies highlights both the government’s generosity to late retirees and the actuarial unfairness of commercial insurance companies.

All in all, Fenwick can’t complain. He’s in pretty good shape. Next, consider his twin brother Frank, who also wound up a school superintendent, but in California’s Sonoma Valley. His rollover IRA size and Social Security and health-benefit profile are identical to Fenwick’s, and he is just as frugal. But, fortunately or unfortunately, depending on your perspective, he lives in Northern California, with its much higher living expenses, of $56,000 per year. He, too, would be a fool to refuse the cheap, but partial, longevity insurance offered him by Uncle Sam. So like brother Fenwick, Frank elects to start the full $36,000 annual Social Security “benefit” at age 70.

After his Social Security kicks in at age 70, he’ll still have a shortfall of $20,000 in inflation-adjusted money per year, and about $402,000 left in his rollover to cover it with ($850,000 minus [$56,000 times 8 years]). Frank could simply buy a 20-year TIPS ladder with that money. But whether or not it lasts is critically dependent on the overall interest rate he gets. In practice, he would spend an inflation-adjusted $20,000 each year and let the coupons pile up for spending money after the last rung matures. At a zero percent real yield, it, of course, lasts just over 20 years. At a 1% rate it lasts 22.4 years. At 2% it lasts 25.7 years. That’s until ages 90, 92.4, and 95.7, respectively. Did I mention that both of the brothers’ parents lived past age 90? Even at the 2% TIPS payout, either Frank or his wife could outlive their money.

Alternatively, Frank could invest in a mixed stock/bond portfolio. That courts disaster even more than the possibility of running out of money with the TIPS ladder or by way of an insurance company failure. A fast Monte Carlo run, with assumptions of a 2% real return and 9% SD, shows a 20-year (age 90) success rate of 80% and a 25-year (age 95) success rate of 51%. Both the TIPS ladder and the conventional portfolio might not last Frank and his spouse long enough.

Still, these are not bad odds. But given the longevity running in his and his wife’s families, Frank would like to see other options. He could use the $402,000 remaining in his IRA to buy an immediate single-premium inflation-adjusted annuity that would pay out nearly $20,000 in inflation-adjusted dollars per year at age 70, guaranteeing him and his wife a secure retirement if the two or three companies he buys them from all survive. Even then, Frank will have to be able to watch his IRA balance plummet—without flinching.

Finally, there’s a scheme devised by Stephen Sexauer and his colleagues and published in Financial Analysts Journal. As a form of “longevity insurance,” Frank could purchase a combination of a TIPS ladder and a deferred annuity that would not pay out until age 85. The authors suggested a strategy of allocating 88% of a nest egg at age 65 to a 20-year TIPS ladder that would be consumed by age 85, and 12% towards a deferred annuity, also purchased at age 65.[16] Theoretically, this is very attractive.

In Frank’s case, different numbers apply, since he’ll be buying the deferred annuity at age 70. Let’s see how the Sexauer approach works out for him. At age 70 he purchases a 15-year TIPS ladder that will pay him the needed $20,000 per year. A 15-year ladder yielding $20,000 in monthly payments of $1,666.67 would cost Frank $279,000 at TIPS yields of 1%. Starting with his $402,000 nest egg at age 70, this would leave him with $123,000.

This $123,000 remaining after the TIPS ladder purchase is then used to pay for the deferred annuity that will kick in when Frank reaches age 85. Things get a little murky at this point, for several reasons. First, although a lot of finance academics and practitioners toss around the phrase “longevity insurance” (i.e., deferred annuity) as if it were an off-the-shelf item, few deferred annuities actually exist in the real world of insurance products. It’s also very difficult to get direct quotes from the companies for deferred annuities. Frank will have to go through multiple agents to compare quotes. Second, it is not possible at present to obtain an inflation-adjusted deferred annuity, so he’ll be taking on about three decades of inflation risk. Third, legal issues surrounding RMDs make it impossible at present to actually purchase a deferred annuity that begins paying out much after age 71½ with IRA money. (As of this writing, the government is looking into safe-harbor-type rules that might allow the purchase of a deferred annuity with a defined portion of IRA money). Fourth, it’s also very difficult to purchase a joint-lifetime deferred annuity. Finally, he will be taking an incredible default risk. If the insurance company goes under before he reaches age 85, he's vulnerable to a 100% loss.

Frank has made a few phone calls and has found that if he withdraws the $123,000 not used for the TIPS ladder and is left with, say, $100,000 after taxes, he’ll be able to buy a single-life policy paying out about $45,000 per year, or $22,500 for separate policies for him and his wife, at age 85. At first, this seems too good to be true, until Frank remembers that this is $45,000 of nominal income. At an inflation rate of 3%, it will be worth just $28,900 of inflation-adjusted spending, 15 years later, when he and his wife both will be 85. If both of them make it to age 95, the pay out will amount to just $21,500, or a meager $10,750 per year in today’s (2012) purchasing power. If inflation is higher, things look even worse.

Again, to summarize Frank’s choices:

- A simple 20-year TIPS ladder, which would provide at least 20 years of retirement income, perhaps more if Frank can buy it at a higher yield. While a TIPS ladder eliminates the risk of default or bankruptcy, it leaves open the possibility that the taps will run dry if he and his wife live much past age 90.

- A conventional stock/bond portfolio: While offering potential upside, it is far too dangerous, with a significant chance of failure even by age 90.

- A selection of inflation-adjusted annuities purchased from different insurance companies. While this theoretically eliminates the risk of Frank’s running out of money, it replaces that threat with the risk of getting wiped out in a severe financial crisis.

- The Sexauer approach: a combination of a 15-year TIPS ladder with a deferred annuity beginning at age 85. The advantages and disadvantages meld those of the first and third approaches above and add two new risks: the lack of true joint-survivorship coverage and the deferred annuity’s lack of inflation adjustment, which in the event of extreme longevity or high inflation (or both), seriously erodes future spending power, a problem that would only worsen as Frank and his wife grew older.

My opinion is that the first course, a simple 20-year TIPS ladder, is the best choice. It eliminates default risk, which I think is the most important consideration. The financial crisis of 2007–2009 occurred, in no small part, because of the systemic risk inherent in a financial market that is dominated by a few huge banks. Now, several years later, there are fewer still, and the resultant Dodd-Frank reform has been so watered down that it does little to diminish the likelihood or severity of the next financial crisis.

While we may well avoid another crisis, particularly one that might devastate the insurance industry, I would not want to bet my retirement on it with either an immediate annuity or a deferred annuity. The possibility of running out of money with my preferred choice, the TIPS ladder, should also concentrate Frank and his wife’s thinking on making some minor adjustments to their living standard. Were they to reduce their expenses by just $2,000 per year—from $56,000 to $54,000, they would have $418,000 left in their IRA at age 70. At TIPS yield and reinvestment rates of 0%, 1%, and 2%, an $18,000 burn rate would last them to ages 93.2, 96.4, and 101.3, respectively.

And just to reiterate, the success of all of these strategies hinges on deferring Social Security until 70. The only reason not to do so would be ill health and shortened life expectancy for both spouses.

In the end, none of these alternatives appealed to Frank. He realized that without additional assets, retirement at age 62 was a dicey affair. Recall that at age 70, when he finally would begin receiving Social Security, he would have only $402,000 left in his IRA, just a tad over 20 years of supplemental living expenses—right on the borderline.

Frank, though, has an ace up his sleeve. Retired school superintendents are eminently employable. He ultimately decides to supplement his income with the odd interim administrative position in a neighboring district, a consulting job for the state education department, and a teaching gig at the local community college—just a few months a year, as long as the work doesn’t interfere with fishing season. He figures that his part-time work will enable him to sock away another $200,000 by age 70, more than enough to put him over the top, so that when next February rolls around he’ll be able to needle Fenwick, without a twinge of regret, about the weather in Kansas.

The major remaining issue might be the potential need for high out-of-pocket medical expenses or long-term care, which is a major risk for both twins. Long-term care insurance, in particular, is expensive (up to several thousand dollars per year), is often unreliable, and carries very high deductibles. Faced with unexpectedly high losses from this line of coverage, insurance companies are bailing out of the field, and those that are left are rapidly raising their rates. We are likely not far from the day when, if you can afford long-term care insurance, you can probably afford to pay for long-term care on your own. Such is life in a country with a dysfunctional health-care system and an inadequate safety net.

Fenwick and Frank, it turns out, have a pair of 62-year-old twin cousins, Frasier and Fritz, both of whom were inventors, and both of whom spend, inclusive of taxes, $200,000 per year. Both contributed negligible amounts to Social Security. Neither of them will count on monthly retirement checks.

Frasier struck it rich with his robotics company, which was bought by a larger firm, a purchase that left him with a lump sum, after taxes, of $10,000,000. Consequently, he has no sheltered assets. It is not being too flip to say that Frasier really doesn’t need much of an investment or retirement strategy. Although TIPS ladders are a good way, in general, of protecting against inflation, they are problematic in a taxable account. The gain in the inflation component of the price is taxable each year, which is a real accounting headache. Almost any prudent mix of indexed global stocks and, on the bond side, short-term Treasuries, munis, and CDs will last Frasier nearly forever.

Only if he rolls big dice with an all-stock portfolio and comes up with the snake eyes of prolonged Depression-level returns on his holdings does dying poor become a possibility for him. Frasier aims for a 25-year supply of riskless assets, in his case, $5,000,000. Thus, a 50/50 stock/bond mix provides him with an LMP and an RP of equal size. Note that, at least at the short end, there’s little difference between risk-free assets and TIPS. Both should be priced to yield the same real return. In the long run, unless the U.S. suffers the hyperinflation that plagued Germany in the 1920s and Zimbabwe over the past decade, short-term rates should keep up with “normal” inflation. The uncertainty over whether this will prove to be the case in the future is, I believe, small enough not to outweigh the tax disadvantages of holding TIPS in a taxable portfolio.

Fritz also succeeded, after a fashion, but not as well as Frasier. The sale of his Internet startup netted him “only” $4,000,000 after taxes. Clearly, Fritz has a problem. Even if he completely annuitizes his new $4,000,000 nest egg at age 62, he’ll only receive about $142,000 per year in inflation-adjusted annual income. To the extent that he employs any of the strategies considered by his cousin Frank involving TIPS and deferred annuities, he’ll have even less annual income, albeit with more control and perhaps greater safety of his money. The optimal solution for Fritz, alas, likely involves some combination of fixed annuities purchased somewhat later in life, part-time work to supplement his income, and a reduction in his standard of living.

This discussion, then, in no way mandates that all investors should immunize their retirement income with annuities, TIPS, or even a delay in Social Security draw until age 70. As we’ve already seen, health status, the absolute level of assets, personal preference, and the tax status of the nest egg all enter into the analysis. But this exercise does provide a rough rule of thumb. By age 70, the investor should have accumulated enough safe assets, including Treasury bills and notes and CDs, to fund, at a bare minimum, 20 years of the cash-flow needs remaining after Social Security and pension payments. An LMP of 25 years of living expenses would be even better. Further, with today’s historically low TIPS and annuity payouts, it might not be a bad idea to hold off purchasing TIPS for a while.

Finally, note how thus far the word “stocks” has not entered into our discussion of the LMP. The reason for this is simple. Over the past two hundred years, U.S. equity market indexes have at times declined as much as nearly 90%. You should assume, therefore, that at some point in your retirement, you’re going to be kissing most of the value of your stock holdings good-bye for a while, and you should take no comfort from the fact that markets usually recover. A probably apocryphal quote from John Maynard Keynes has it that “the markets can remain irrational longer than you can remain solvent.” This goes double in retirement. If you’ve counted on your stock holdings to see you through retirement, you’re likely to be seriously disappointed. Yet, there is a small part of the equity portfolio that can be considered in the funding of retirement: the “safe dividend flow” from stock holdings. Although the value of stocks can fluctuate wildly, their stream of income is much more stable. At no point in the history of the U.S. stock market has its real dividend stream fallen by more than half, even during the Great Depression. During the most recent financial crisis, for example, although stock prices fell by more than 50%, dividends also dropped, but by only 23% from their peak, and only temporarily.

You can thus reasonably add into your retirement permanent income flow about half of the dividends from your stocks or stock funds. Let’s go back to Fenwick to see how this works. If he, for example, decides to invest almost all of his $562,000 “risk portfolio” in stocks, he’ll have an additional income stream of about $11,000 from dividends, so he should be able to count on an annual $5,500 through thick and thin. (There’d be nothing wrong with taking the whole $11,000, of course, as long as he would be willing to reduce his spending when dividends fall.) His wife has been bugging him for years to take her to Europe. Now, he’ll be able to occasionally indulge her hankering to see the world. While 1% of stock holdings per year may seem to be small beer, in the long-run retirement permanent cash-flow game, every little bit counts more than you might think.

A final word about retirement spending. If you found the above quantitative analysis tedious, take heart. Even the most sophisticated retirement projections contain so much uncertainty that the entire process can be summarized as follows: Below the age of 65, a 2% spending rate is bulletproof, 3% is probably safe, and 4% is taking chances. Above 5%, you’re taking an increasingly serious risk of dying poor. (For each five years above 65, add perhaps half of a percentage point to those numbers.) Frasier, who will be spending only 2% of his corpus per year, has no worries. But Fritz, who spends 5%, will find it difficult to make ends meet if he lives much past 80.

The Middle Game

Why have I placed the Middle Game—roughly, the period between late middle age and retirement—at the end of this booklet? Because you can’t really understand a midlife strategy without a grasp of the strategies of early and late life. Midlife is a most difficult and uncertain phase in the investing life cycle. It marks the transition between the aggressive investment of the early years and the conservative investment of the later years. Early in one’s investing lifetime, the focus is on rapidly building up assets. A rich wage stream and future human capital almost completely mitigate the risks of owning equity, but when, later in life, an investor’s human capital is depleted, there is little margin for error.

In the first place, you might ask why take any risks at all, even early in the process? Why not simply accumulate risk-free assets right from the get-go? Because, unless you are an Olympic-class saver and investor, you can’t get there from here. If you cannot save at least 20% of your pretax salary beginning at age 25 or obtain a high risk-free return on what you invest (or both), you will not be able to retire until shortly before you are pushing up the daisies. Oh, those lucky boomers, who for a while in the 1970s and 1980s vacuumed up double-digit CDs and Treasuries.

Consider this: At the present time (mid-2012), risk-free assets have an expected real return of less than zero. Over longer periods, 2% is the best you can do. Further, your “hedonic set point” will change with time. Worker productivity, wages, and per capita GDP all grow at a real rate of about 2% per year. So will your expectations. Would you be happy with a 1960 standard of living? When everyone else has or will soon have an iPad, could you stand to live without one? Thus, if the real return of a retirement portfolio invested in safe assets is, optimistically, 2%, then one dollar of earnings will buy exactly one dollar of hedonically adjusted retirement income. If you want 30 years of retirement, and you want to do it with CDs, plain Treasuries, and TIPS, you’ll have to save half of your salary during the three decades that you are working.

We can look at this problem another way. Ultimately, stocks and bonds are just media of exchange. In a world with a flat age distribution—already nearly the case in Europe and coming soon enough to the U.S.—and where everyone works from age 25 to age 55 and retires at age 55 and lives to age 85, there will be exactly one worker per retiree. Those working now are not saving mightily. In fact, they are barely saving at all. Look for trouble ahead.[17]

Unless you’re comfortable with such depressing retirement math, you’re going to have to take some risk, à la Age equals bonds, Nalebuff and Ayres, or Fama-French. A fast spreadsheet run shows, for example, that if you want to retire at age 70, you’ll have to start working at age 25, save 20% of your salary, and earn a 3.5% real return on your portfolio. If you want to retire at age 60, you’ll either have to earn a 6% real return or save 30% of your salary. What if you don’t start working until age 35? In that case, you’ll have to get a 3.5% real rate of return, save 30% of your salary, and be willing to retire at age 70. To start work at 35 and retire at age 60, you’ll have to save over half of your salary. And don’t count on a 6% real return, or even a 3.5% real return, by investing in safe assets. You’re not going to get it.

When, and how, do you transition from a risky young-investor strategy to the low-risk retiree strategy? One perfectly acceptable way would be to formulaically reduce your equity allocation as a function of age. Say by age 40 you’ve figured out that you’re comfortable with a 70/30 stock and bond mix. You might decide that by age 70 you want to be no more than 25/75. This entails lowering your equity allocation by 1.5% each year between ages 40 and 70. Yet another way would involve a gradual switch from a bond fund to a TIPS ladder, as detailed by Michael Zwecher in his book, Retirement Portfolios.[18]

Markets fluctuate, so I suggest another path. If, at any point, a bull market pushes your portfolio over the LMP “magic number” of 20 to 25 times your annual cash-flow needs beyond Social Security and pensions, you’ve won the investing game. Why keep playing? Start bailing. After you’ve put enough TIPS, plain vanilla Treasuries, and CDs into your mental LMP, you’re free to start adding again to your RP. If stocks continue their rise, you can slowly transfer even more assets into a separate low-risk pool earmarked for emergencies, RP equity purchases at lower prices, nice-to-have luxuries and travel, and purchase of the corner lot owned by your impecunious neighbor who suddenly sorely needs some cash.

As you might expect, just when this critical transition comes depends on the interplay of three factors: your savings rate, your asset allocation, and, critically, the market gods. There’s no way of predicting the event.

As a small thought experiment, I posited imaginary annual cohorts who began work on January 1 of each calendar year, and who then on each December 31 invested 20% of their annual salary in the real return series of the S&P 500. I then measured how long it took each annual cohort, starting with the one that began work in 1925, to reach a portfolio size of 20 years of salary (which constitutes 25 years of their living expenses, since presumably they were able to live on 80% of their salary). Figure 11 shows how long it took each cohort beginning work from 1925 to 1980 to reach that retirement goal.

While the cohort that began work in 1980 took just 19 years to reach the 20-years-salary finish line, the one that began work in 1949 took 37 years. This makes sense. Remember the coin-toss sequence we discussed earlier? It’s far better to experience poor returns at the beginning of the savings path. Cohorts starting work in the decade after 1945 did so at the beginning of one of the most powerful, prolonged bull markets in the history of U.S. equity returns. Those who began work after about 1970, on the other hand, did so at the onset of a prolonged bear market. The latter cohorts, of course, did better.

Further, note the “waterfall” phenomenon. Successive cohorts take progressively less time to reach the goal line as the time to the next bull-market peak shortens, until the next cohort just misses at that peak and winds up taking much longer. You can see the first “waterfall” with the 1943 to 1945 cohorts, which just missed being able to retire with the mid-1960s market peak and had to wait another decade and a half for the markets to recover. The second “waterfall,” the cohorts that started work after 1980, fell just short in 1999. They are not represented in the graph, since they haven’t yet reached the LMP goal amount! The 1981 cohort, for example, is still plugging away, 31 years after beginning work. As has already been noted, the 1980 cohort was the luckiest one, having reached the goal during the 1999 peak. (The market did sail slightly higher in 2000 before plunging, but this paradigm looks only at year-end data.)

Figure 12, finally, shows how many cohorts reached the goal in each year. The goal-reaching years clustered in periods of high equity returns: 1955 to 1965 and 1985 to 1999. Those who missed in 1999 may have to wait a long time.

This paradigm rests on too many faulty assumptions to list, but it still illustrates a valid point: You just don’t know when you’re going to achieve your LMP, and when you do, it’s best to act.

This is why I left the middle years for last. The strategies for the early investing years and the years before retirement are relatively clear cut. But it’s extraordinarily difficult to know exactly when, or even if, the need to shift from the early strategy to the late strategy will occur. That shift depends on so many different variables: the amount of savings (more equals sooner, less equals later), the equity returns series (poor-returns-early equals sooner, good-returns-early equals later), the magnitude of the returns, and most important, the timing of the asset trajectory relative to long-run stock-market peaks. Some fortunate folks will fill their LMP while still reasonably young. Others who use the same strategy but begin a few years later may never do so.

This cohort variability not only carries momentous personal freight for the individual investor, it also has enormous implications for public policy. It’s becoming increasingly clear that the headlong rush into defined-contribution retirement schemes will not turn out well. At some point our whole system of retirement saving will need a major overhaul. Whatever new system emerges, and no matter how it is designed, some investing cohorts will still do better than others. Such is the nature of uncertainty in the capital markets, for the individual and society alike.

But, like so many things in finance, what is bad for the society is often good for the individual. This is the obverse of Keynes’ Paradox of Thrift, where saving that is good for individuals is bad for society. That most people do not save likely offers higher returns to those who invest liberally and aggressively when young, accumulate adequate assets for a safe retirement, then convert those assets to a safe stream of income against the day when their earning power is gone.

Figures 11 and 12 encapsulate an ugly reality that gets almost no attention. Anyone who saves to retire of necessity plays demographic roulette. The markets may be kindest, paradoxically, to those fortunate enough to find jobs and begin their working careers during periods of distress, such as the grim years of the 1930s and 1970s, while those who began to work in boom times often have not fared well. A short work career—think a fellowship-trained surgical subspecialist who does not begin his or her career until age 35—magnifies the chances of a poor demographic draw.

This paradox gets back to the major flaw in the human capital/investment capital paradigm. These two forms of capital are not independent. They are, in fact, strongly linked. Sadly, peaks and troughs in both tend to occur together.

Life, alas, is not fair. The gods occasionally reward the lucky but somewhat imprudent investor with a favorable draw of early low returns, later high returns, and a conversion to safer assets just before a market peak. The prudent but unlucky investor may do everything right and still never accumulate an adequate LMP, leading to a retirement that requires the investor to continue work of some kind and an old age that is underfunded and insecure. But by saving like mad and playing the life-cycle game as well as you can, you stack the odds in your favor.

Good luck.

Acknowledgments: I’d like to thank Susan Sharin, Mel Lindauer, Alan Roth, Albert Kinderman, Daniel Smith, and Wade Pfau for helpful comments and advice. John D’Antonio provided editing expertise and polished the final result to a high sheen. All errors are my responsibility.

William J. Bernstein is the author of The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk (2000), The Four Pillars of Investing: Lessons for Building a Winning Portfolio (2002), The Birth of Plenty: How the Prosperity of the Modern World Was Created (2004), A Splendid Exchange: How Trade Shaped the World (2008), and The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between (2009). His latest book, Masters of the Word: How Media Shaped History, a narrative treatment of the relationship among communications technology, culture, and politics, will be published in early 2013 by Grove/Atlantic Press.

Notes

[1] Wade Pfau, personal communication.

[2] Robert C. Merton, “Lifetime Portfolio Selection under Uncertainty: The Continuous-time Case,” The Review of Economics and Statistics 51, no. 3 (August 1969): 247–57, and Paul A. Samuelson, “Lifetime Portfolio Selection by Dynamic Stochastic Programming,” The Review of Economics and Statistics 51, no. 3: (August 1969): 237–46.

[3] William J. Bernstein, The Intelligent Asset Allocator (New York: McGraw-Hill, 2000), 1–5.

[4] Shiller’s series is available at http://www.econ.yale.edu/~shiller/data/ie_data.xls.

[5] Ian Ayres and Barry J. Nalebuff, “Life-cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk,” (NBER working paper 14094, p. 23), accessible at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1139110.

[6] Ian Ayres and Barry J. Nalebuff, Lifecycle Investing (New York: Basic Books, 2010).

[7] For a brief survey of the risk tolerance/age literature, see Nancy Ammon Jianakoplos and Alexandra Bernasek, “Financial Risk Taking by Age and Birth Cohort,” Southern Economic Journal 72, no. 4 (April 2006): 981–1001; William B. Riley Jr. and K. Victor Chow, “Asset Allocation and Risk Aversion,” Financial Analysts Journal 48, no. 6 (November–December 1992): 32–37, Hui Wang and Sherman Hanna, “Does Risk Tolerance Decrease with Age?” Financial Counseling and Planning 8, no. 2 (1997): 27–31; and R.A. Morin and A.F. Suarez, “Risk Aversion Revisited,” Journal of Finance 38, no. 4 (September 1983), 1201–16.

[8] John Rekenthaler, personal communication.

[9] Michael Edleson, Value Averaging (Hoboken, NJ: John Wiley & Sons, 2006).

[10] Bill Jones, “Do Not Dollar-Cost-Average for More than Twelve Months,” http://www.efficientfrontier.com/ef/997/dca.htm (September 1997).

[11] William J. Bernstein, “The Retirement Calculator from Hell,” http://www.efficientfrontier.com/ef/998/hell.htm.

[12] M. Barton Waring and Laurence B. Siegel, “Don’t Kill the Golden Goose! Saving Pension Plans,” Financial Analysts Journal 63, no. 1 (January–February 2007): 31–45.

[13] This annual increment is not uniform, ranging from a low of 6.45% between ages 69 and 70 to a high of 8.33% between ages 63 and 64.

[14]Such strategies are well beyond the scope of this booklet. (Note: The full retirement age is 65 for those born in or before 1942, 66 for those born between 1943 and 1954, and 67 for those born in or after 1955.)

For more information, consult Taylor Larimore et al., The Boglehead’s Guide to Retirement Planning (Hoboken, NJ: John Wiley & Sons, 2011).

[15] The ratios between $1,793, 2,273, and $3,000 will look slightly different than the ones on your Social Security statements. This is because the statement assumes that you will keep working until ages 62, 66, and 70, while the above numbers all assume retirement at age 62, as in Fenwick’s case.

[16] Stephen C. Sexauer et al., “Making Retirement Income Last a Lifetime,” Financial Analysts Journal 68, no. 1 (January–February 2012): 74–84. For a discussion of the expense of an all-TIPS portfolio, see http://wpfau.blogspot.jp/2012/03/safety-first-retirements-are-expensive.html.

[17] Robert D. Arnott and Anne Casscells, “Demographics and Capital Market Returns,” Financial Analysts Journal, 59, no. 2 (March–April 2003): 20–29. See also William J. Bernstein, “The Retirement Calculator from Hell, Part V,” http://www.efficientfrontier.com/ef/403/hell5.htm.

[18] Michael Zwecher, Retirement Portfolios (Hoboken NJ: John Wiley & Sons, 2010).

Copyright 2012 by William J. Bernstein

ISBN (epub): 978-0-9847060-4-4

ISBN (mobi): 978-0-9847060-5-1

Ebook design by Digital Bindery

Table of Contents

Preface

Introduction

Opening Moves: Life-cycle Theories from A to Z

Fama-French: The Alternative to Leverage-Early

The Endgame (Relax. I’ll get to the middle later)

A Few Real-World Endgames

The Middle Game

Acknowledgments

About the Author

Notes

Copyright