Christine Benz, Director of Personal Finance at Morningstar, discusses what to consider for retiring in today’s environment.
Hosted by the Metro-Boston chapter. Recorded on January 22, 2022.
Slides from the recorded meeting can be accessed here.
Chat from the recorded meeting can be accessed here.
Bogleheads® Chapter Series – Christine Benz: What if this turns out to be a terrible time to retire?
Therese: Welcome to the Bogleheads Chapter Series. This episode was hosted by the Metro Boston Bogleheads Chapter and recorded January 22, 2022. It features Christine Benz, Director of Personal Finance at Morningstar discussing what if this turns out to be a terrible time to retire.
Bogleheads are investors who follow John Bogle's philosophy for attaining financial independence. This recording is for informational purposes only and should not be construed as personalized investment advice
Further, we are fortunate to have Christine Benz with us here today. Christine is the Director of Personal Finance and Retirement Planning for Morningstar and the senior columnist for morningstar.com. In that role she focuses on retirement and portfolio planning for individual investors. She also co-hosts a podcast for Morningstar, The Long View which features in-depth interviews with leaders on investing and personal finance. In 2020 and 2021 Barrons named Christine to its list of the 100 most influential women in finance.
Christine is a board member of the John C. Bogle Center for Financial Literacy. She's also a member of the Alpha Group, a group of leaders from the wealth management industry from across the country. In her free time Christine works with underprivileged women to improve their understanding of personal finance. Thank you Christine for joining us this morning.
Christine Benz:Thank you so much Therese for the kind introduction, and thanks to all of you for being here. I've been an active member of the bogleheads community for many years. You know, when I reflect on my career, so far I think of getting the chance to meet Mr. Bogle--and I still call him Mr. Bogle in my mind--getting to meet Jack Bogle and getting to interview him many times over the years was one of the great privileges of my career.
I’ve learned so much from this community, Jack of course, but also all of the people within the community, Taylor and Mel and people on our board, Rick Ferri, Bill Bernstein, Alan Roth, a former board member. So many of you have imparted knowledge that has helped me know what to write about, know what to think about, and so I appreciate that. And I appreciate you turning out this morning.
The presentation I've prepared today is something that I think is top of mind for a lot of people who are embarking on retirement or thinking about retirement. And naturally when we've had a great market environment like we've had for many years running now, people look at their enlarged portfolio balances and think, well is it time to hang it up. Is it a good time to hang it up? And that's going to be what I'll explore in this presentation.
So I'm just going to share my screen here and get my presentation going.
So in terms of what I'll cover in the presentation. I'll start by talking about some of the trends in retirement that we've been seeing. We've had this great resignation going on during the pandemic. I'll talk about that, and then talk about why the timing of our retirements matters so much, and unfortunately it's not a hundred percent within our control. Sometimes we may need to retire for reasons that are outside of our control. So I'll talk about that sequence of return risk, which many of you are familiar with, but the basic idea is it's a risk that you might retire into a market environment that isn't so great. And the problem is if you haven't planned accordingly for a weak market to materialize that can have lasting implications for the health of your plan.
So as you think about the timing of retirement I'll talk about some of the key things that should be on your dashboard, and also sort of how they're looking today. So we'll look at equity valuations. We'll look at bond yields, which even though they've been taking up a little bit recently are still very, very low. And then we'll look at kind of a newish risk factor-- of course it's been there all along-- but I think it's come on to the front burner very recently, and that's inflation. And I'll talk about how to think about inflation with respect to your plan as well as to your portfolio constituents.
And then we'll get into the implications from all of this for withdrawal rates, for in retirement asset allocation, sub-asset allocation for inflation protection for your portfolio, and then I'll touch briefly on the implications for non-portfolio decisions that you might make. So Social Security claiming strategies, annuities and so forth. And then we will have time to tackle some of your questions.
So this is something that if you've been paying attention you know that we have seen many people retire. We saw in 2020 double the number of baby boomers retiring. I don't have data for 2021 yet, but my guess is that this trend persisted into 2021. It may have even hastened in 2021. So we have a lot of people retiring. I think some of the resignations that we've seen may be sort of short-term, where someone may decide to go back into the workforce. But some baby boomers, many baby boomers are indeed deciding that it's time to retire. And one of the key reasons is that we have seen assets in investment portfolios perform really, really well.
So stocks, US stocks, have outperformed everything else. But commodities have finally left reasonably well. Bonds have not been terrific during this period but they've kind of flatlined except until 2021 we saw some small losses in high quality bond portfolios. So these have been accelerants for retirements, where we've seen people looking at their enlarged portfolio balances thanks largely to the strong stock market, and they've decided to retire.
Home prices have gone along for the ride. This is the Case-Shiller home price index. You can see that we've had a really strong set of gains in home prices. This has been another catalyst, I would think, for some pre-retirees to think that perhaps they might retire. They might cash in some of that home equity, trade down into a smaller home. So I think that this has been a contributor as well.
The key point I would make in all of this is that the timing of our retirements matters a lot. So I'll just describe what we're looking at here on the screen. And on the left hand side of the screen is a simulation of an individual who would have retired in the early ‘70s with a portfolio that was 50% stock/ 50% bond. So a $500,000 portfolio at the outset of that retirement, and that person was using a 5% withdrawal rate, and you can see that within 20 years that individual would have burned through all of his or her funds using that five percent withdrawal system, sticking with that 50 /50 portfolio.
So from a retirement planning standpoint we consider that a fail because we typically like to think of retirement planning, retirement plans, being durable over a 25 or 30-year time horizon at least. So in this particular era, this particular 20-year period, we had the bear market that started out in the early ‘70s, so in ‘73-’ 74. We had runaway inflation after that. We had rising bond yields which damaged bond prices. So a lot of things were working against retirees in this era.
On the right side of the screen is what that same system of portfolio withdrawals and that same 50/50 portfolio that same $500,000 starting balance. How that would have behaved if we flipped that sequence of returns. So we assume in this slide that the great returns of the early ‘90s and of the ‘80s actually occurred early in the retiree’s sequence. Well you can see this is a completely different outcome. So not only did that particular time period, in part because it featured rising equity markets as well as declining bond yields, for a portion of that period the person not only was able to meet his or her withdrawal rate, but was actually able to grow that portfolio balance quite significantly over the time period.
So the tricky part of all of this is that it's luck of the draw. Really, we might have a little bit of control over the timing of our retirement but for many of us it's not within our control. So the sequence of return risk is super important and it's definitely something to be thinking about, especially if you are a pre-retiree who is thinking about retirement within the next couple of years.
So the ideal sequence of returns would be that you are buying low during your accumulation years and then you're selling the stuff when the market is going up in your decumulation years. So you're selling it to higher bidders as you decumulate and as you withdraw from your portfolio. The opposite sequence can prevail, like we saw in that period, the retirement period that began in the early ‘70s where someone may be accumulating assets at higher and higher levels and then be forced to sell them off at lower levels into a declining market.
So you can respond to a bad sequence in a couple of different ways.The key thing to think about if you are concerned about sequence of return risk and concerned that perhaps the next decade or two for the markets might not be that great is that you can adjust your asset allocation, or at least acknowledge that market returns might not be great and so put in place some safe assets that you could draw upon in retirement.
And I think there are also implications for withdrawal rates. So one of the key takeaways we have from some of the great withdrawal rate research that's been done over the past decade is that if retirees are willing to be flexible, and able to be flexible in terms of their withdrawals, that is one of the best responses that you could have to a weak market environment materializing early on in your retirement. If the person encounters a bad sequence of return risk and doesn't make those adjustments, that's where you run into retirement failures, where someone burns through his or her money quicker than he or she expected. And that can happen if the withdrawal rate is too high or if that portfolio is too aggressive.
So one of the issues in all of this is that while we might like to think we have control over our retirement dates, and many of us indeed do, in reality people tend to not be great at predicting when they might retire.
So this is a slide that I think is super interesting. The awkward bars represent pre-retirees who were asked when they anticipated that they might retire and the green bar represents when they actually did retire.So one thing that jumps out at me is that many people expected to retire in the sort of 65 to 69 year period, or even the 70 to 79 year period. And many fewer people were able to do so than thought they would be able to do so.
And then on the flip side we saw fewer people saying that they would be retiring in that 50 to 59 range, or in the 60 to 64 range. So when they were asked in pre-retirement when they might retire very few people said in those years. In reality much larger numbers of people did retire in those years.
So some of that certainly may have been voluntary. Perhaps people had a good market experience, any number of positive reasons why someone may have been able to retire early but there are also other less positive reasons why someone may not be able to continue working. I often quote my Morningstar colleague Mark Miller. Mark is a contributor to morningstar.com and writes a lot about retirement and sort of encore careers in retirement and Mark always says that “working longer is a worthy aspiration but it's not a plan.” And that's one reason why I always feel a little fearful when I talk to people who say, yeah my plan, my retirement plan is just to continue working as long as I possibly can.
It's a good aspiration. There are a lot of knock-on benefits of working longer if someone can. So not only financial ,but we see some connection between some health benefits of working longer, certainly social benefits, and sort of engagement and activity benefits come along with working longer. But people may not be able to do so and there are a few reasons why. One is that ageism is a thing in our culture so someone may have a goal of working longer but for whatever reason may not be able to stay within the workforce. Some people have jobs with physical demands that they're no longer able to do later in life. And then health issues can get in the way, either an individual's own health issues, spousal health issues, parental health issues, any number of things can get in the way of someone being able to work longer.
So there are certainly risks for the viability of someone's retirement plan and someone's income replacement if they are forced out of the workforce earlier than they anticipated. So essentially it's just the inverse of all of the great attributes, financial attributes we know that you achieve by working longer. So you can't make any additional portfolio contributions. You won't benefit from additional market gains with the amount that's coming out of the portfolio. At least, fewer years for the portfolio assets to compound prior to drawdown. And then importantly, withdrawals over a time horizon that's longer than 25 or 30 years need to be lower.
And I worry that some people aren't aware of this fact. In fact I am really interested in the whole FIRE community [Financial Independence Retire Early], and I think there's a lot of positive stuff going on in the FIRE community, but my concern is that for some of the financial independence retire early folks that perhaps they're not as knowledgeable as they should be about the trade-offs between withdrawal rates and very long time horizons. and the short answer is that if you have a very long time horizon your portfolio withdrawal rate should be, in my view, in the neighborhood of two percent, two and a half percent.
Retiring earlier than one expected may also tie one's hands with respect to Social Security filing. So we all know, or many of us know that there are great benefits to be had by delaying Social Security if you possibly can. The person who retires earlier than expected may not be able to benefit from delayed Social Security.
So three key factors for your retirement dashboard is your kind of sizing up sequence of return risk and whether that's going to be potentially an issue over the next decade: equity valuations, bond yields, and inflation.
So just a quick look at equity valuations and where we are currently. This is the Shiller P/E. This is a cyclically adjusted P/E ratio. Robert Shiller was the creator of the Shiller P/E. It's sometimes called the CAPE ratio. This has been flashing warning signals for a while. You can see that it's quite elevated relative to market history, so this is concerning. But it also has been looking like a danger zone for a while, and yet we've continued to have really strong gains from stocks. So the timing of Shiller P/E in terms of predicting a big equity market downdraft is inexact. But nonetheless this is kind of a data point to be monitoring, and we've all experienced great results in the equity market at least until very recently and so this is just kind of food for thought.
Another thing I like to look at is our Morningstar equity analysts view. So we have a deep team of analysts at Morningstar who cover individual companies and do analysis on individual companies. I know many of the bogleheads are all index funds all the time, and I think that's perfectly fine. But we do have a deep equity research effort and the team of researchers when they cover individual companies we task them with coming up with an estimate of the company's fair value. What do you think it should be worth based on discounted cash flow analysis? So the fair value can be compared to the current price to arrive at a price to fair value. So if a company's trading at eighty dollars and the analyst thinks it should be worth a hundred the price to fair value would be 0.8. If the company is trading at 120 and the analyst thinks it should be worth 100 the price to fair value would be 1.2.
So what I like to do is look at this bundled view of all of those price to fair values for our global coverage universe just to try to get my arms around whether the market is cheap or expensive at any given point in time. And so what you can see is that the market in aggregate, our coverage universe in aggregate, is a little bit overvalued today, not egregiously overvalued. I would say that this is sort of a more tempered view than what Shiller P/E would suggest, but nonetheless I think it's aligned directionally, where we do see a little bit of overvaluation.
It's interesting to look at this historical slide that looks at how these price to fair values kind of ebb and flow over time based on what's going on in the market. So back in 2020 you remember we had that teddy bear market where we had a very sharp downdraft in stocks that turned out to be very, very brief. You can see that stocks based on our analysts' bottom-up work looked very very cheap to them and then at other points in time that was the case as well. So back in the great financial crisis we saw several periods where stocks remained cheap, looked cheap and remained cheap really even after the market had begun to recover. In 2009 our analysts felt that there were still pockets of value.
An interesting dimension to this. The previous slide showed all of the stocks in that global coverage universe. This is the style box view. And I know many of you are familiar with our Morningstar style box, but I'll just describe what we're looking at here. The horizontal bands on this box represent company size. So at the top would be large companies. Middle would be mid-sized companies. And bottom would be small cap companies. And then from left to right we have the company's investment style, where we plotted on our value-to-growth spectrum. So on the left hand side of the style box we've got value stocks, in the middle we've got blend or core stocks, and on the right hand side we've got growth stocks.
And so the interesting thing when I look at this is based on these bottom-up views of individual companies. The value stocks still appear relatively undervalued to our analysts as do smaller cap stocks, and that dovetails with what we've seen go on in the market where, until very recently, we saw large cap growth stocks and mid caps growth stocks really pace the market. So you had companies like Netflix and Amazon and Apple really driving the whole market's gains and getting quite expensive along the way.
More recently we've seen a little bit of a rotation from that where the inflationary concerns have pushed down on valuations within that space. But nonetheless that was a pretty long running trend of more than five years with growth stocks outperforming so it's going to take a little while, I think, for that to work its way out of the system. But our analysts do think that if you take kind of a nuanced look at the style box, that value stocks appear to represent better value today as do smaller cap stocks.
So I know many vocal bogleheads use Total Market indexes, which is totally fine, but for investors who do have discrete value and growth exposure in their portfolio I think this is kind of a data point to think about, especially if you've been hands off with that portfolio. You've probably seen the growth side of your portfolio get larger at the expense of the value side. So that's something to think of from sort of an intra asset class perspective.
This is just a quick look at valuations by sector. You can see that there is some divergence based on sector with some of the most overvalued sectors, which are represented by the orange bars being industrials, technology. Generally, I think if I look at our analysts' coverage, I think there's some view that some of the more cyclical industries are a little bit overextended.
When I turn to capital markets forecasts, what firms like Morningstar and Vanguard and JP Morgan are saying about how the markets might behave over the next decade an interesting thing jumps out. That to a firm, these firms are expecting better results from non-US stocks versus US. I do this sort of compendium of capital markets forecasts annually and this is just a look at what our Morningstar team is thinking in terms of 10-year returns from the major asset classes.
So you can see for US stocks and US bonds it's pretty thin gruel for this say 60 /40 US stock and bond investor, where we have 1.6% returns for both US stocks and bonds and that doesn't factor in inflation. So even if inflation is at sort of a normal two, two and a half percent level over the next decade that'll take the investor with a balanced portfolio of just US stocks down into sort of the flatline or slightly below flatline over that period.
On the other hand our team and interestingly all of the firms in my forecast do foresee better results for non-US stocks than US over the next decade and that's largely a valuation story. So I would say that for investors who haven't rebalanced between US and non-US names, that's something to look at. And I know that there's some difference of opinion in the bogleheads community about whether to own non-US stocks at all. I would say that that was probably the one thing, one area where I disagreed with Mr. Bogle's great wisdom on so many topics, and that he generally didn't think foreign stocks were important for investors' portfolios. And I will just say his thinking was as always very clear on the topic which is that so many US companies have such significant exposure to non-US markets. But nonetheless I think on a valuation basis it's hard to argue with the view that non-US names are inexpensive relative to the US today.
Our team foresees particularly good results from emerging market stocks, which is not to say that someone should load the boat with emerging market stocks, we know that they're incredibly volatile relative to developed market stocks. But I think it is an argument for making sure that if you have non-US exposure in your portfolio, for making sure that you do have a decent amount of emerging markets exposure in there.
I mentioned that other firms kind of corroborate that view. So when you look across the capital markets forecast from Blackrock and Research Affiliates, JP Morgan was in my latest review as well as Vanguard, what you can see is that all of these firms are suggesting that non-US returns will be better than than US over the next decade and here I'll just offer a quick defense of these capital markets forecasts. In general, I think some investors quite reasonably say, why would I bother with market forecasts. No one can predict the future and that's a hundred percent true.
But also I would say that we need to plug something in if we're creating a financial plan. If we're creating an investment plan we need to know how much help we'll be able to get from the market. So if the answer is as I would suggest it is today, not a lot of help from the market. My view is that that calls for sober return expectations, which in turn call for a sober approach to withdrawal rates and a sober approach to asset allocation. So I do think that very short-term forecasts are ridiculous. So where people are saying what they expect the market will return this year or something like that. That's as good as useless. But I do think that if we are thinking about how to position our portfolios and how to deal with our savings rate or our withdrawal rate, knowing or having some sense of what the market might return is super important.
Just going back to this slide real quick. I would say that in terms of forecasting what the equity market will return our analysts use a formula that is pretty similar to what you see at other firms. Where they're looking at their expectation of earnings growth over the period, as well as starting dividend yields, as well as their expectation of P/E expansion or contraction. So it's mainly the P/E contraction that's driving the relatively low results for US stocks. Here most firms kind of approach these capital markets forecast for equities in this fashion. Mr. Bogle used to take that same approach when he would talk about what the market was likely to return.
So on the fixed income side the relationship between starting yields and subsequent bond returns is pretty tight. So if we're looking at bond yields, Bloomberg Barclays Aggregate Bond yield in the neighborhood of 1.6%, 1.7% today, maybe even ticking higher. We could expect that bond returns will be roughly in that same ballpark.
So this is just a slide that depicts the tight relationship between starting fixed income yields and subsequent fixed income returns. So what you can see going back to this slide from Morningstar Investment Management, our team has pretty low expectations for fixed income securities and cash. Certainly lowest of all for cash. And other firms corroborate that view. I would say that there is pretty much a consensus on this, that bond returns, high quality bond returns, will be fairly constrained over the next decade. Which is absolutely not a reason to avoid high quality bonds. But I think it is a reason to check expectations about them being any sort of return engine for a portfolio because starting yield is just so predictive.
Another thing that we've seen during this period is that low quality bond yields have declined a lot. So you can see that they spiked during that teddy bear market in March of 2020 at the outset of the pandemic. That was a great buying opportunity for investors who were inclined to dabble in junk bonds, lower quality bonds, but you can see that the yields have gone down, down, down since that time. So arguably the margin for error for investors in lower quality bonds today is just not that great because the yield differential between them and higher quality bonds, which is what we're looking at on this screen, is very low. So you just don't have too much of a margin of safety as a bond buyer. And lower quality bonds, which is not to say don't own them, but I think that it's important to think of them as equity alternatives.
I like the idea of people, to the extent that they have emerging markets bonds or some sort of a junk bond fund in their portfolio, to think of it as kind of an equity substitute. Take it out of your equity allocation as opposed to the bond allocation. And also calibrate your time horizon, your holding period, accordingly. So I like the idea of someone having a 10-year time horizon if they have lower quality bonds in their portfolio, and that'll give them the chance to ride out what will inevitably be some bumps in that asset class over the years.
This is just a quick slide that shows that, in general, firms are expecting higher returns from higher quality bonds and again this goes back to yields being better. So high yield and emerging markets bonds really across the board from these firms, other than Morningstar are estimated to be higher than will be the case for US high-quality bonds but with more volatility.
Inflation, I mentioned, is another thing that should be on your retirement/ pre-retirement dashboard, and this is just a very long view of inflation. You can see that in the US and in Canada inflation has run in the two, and a half two percent range over the past 20 years. In other parts of the world inflation has been more modest. So something to think about. More recently of course, we have seen the first real inflation in decades where for December, year over year, we saw a 7% increase in the CPI.
So many of us naturally have inflation on the front burner. If we've been to the grocery store, if we've put gas in our cars, we know that things are costing more than they were a year ago. And this is just a quick quick slide that illustrates how variable inflation is by category, where we've seen food prices increase quite a bit. In fact, food prices have been one of the leaders in this most recent inflationary period. Gas prices have been going up, home heating prices have been going up. I just paid our power bill here or our gas bill. Here in the Chicago area we've had kind of a cold January so far, and I noticed our bill was like $430, which is quite a bit more than usual, even for winter, and that's in part because some of the home heating costs have gone up.
We've also seen residential prices going up. So for people who are home buyers in this environment, they have had to contend with higher prices as well. So I do think it's important to look at inflation category by category and then also compare that to your budget. And compare that to how you are spending, and use that as a way to decide how big a deal inflation is for you.
Jason Zweig wrote a great piece that I often sort of mentally reference, as well as reference in context like these. He called it “me flation.” And his basic point was that inflation is very personal for all of us. So rather than just taking CPI and running with it, it's valuable to think about what your customized inflation is like based on your personal consumption basket.
So I think it's worthwhile to kind of run through that exercise. The tricky part is that your inflation might depend a little bit on your life stage. So this is a slide that shows two calculations of CPI. So there is the CPI for All Urban Consumers, the CPI-U, that's the middle column. And then the Bureau of Labor Statistics has also been working on what's been called the CPI-E, which is a CPI for older adults, people 65 and above. And it's interesting to see that the consumption baskets for these two groups tend to differ a little bit. So one of the big areas I would call out is health care, medical care. You can see that older adults quite intuitively are spending more on medical care than is the case for the general population that's reflected in CPI-U. They're spending a little less on gas and on transport than than the general population. Older adults are spending a little less on clothes. So it's just important to kind of think about how your spending might change as your life progresses. And one thing we know is that health care costs often accelerate especially later in life where a person might have higher health care costs than was the case earlier on.
So I keep an eye on this CPI-E statistic. More recently I would say the good news is health care costs have been kind of lower during this period, really since the passage of the Affordable Care Act, but especially during this pandemic period where we've seen some downward pressure on health care costs. And that'll tend to be, to the extent that it persists, will tend to be a positive for older adults. But it has been a bit of a headwind for them in the period prior to this recent sort of leveling off of health care inflation.
So this is just a slide that shows how health care inflation has historically risen a bit higher than the general inflation rate, and that's been a headwind for older adults. So I just want to spend a little bit of time on the implications of inflation in retirement and why inflation can be a big deal in retirement. I would say that one is that the categories that retirees, older adults, spend on may be inflating at a higher rate than the general inflation rate.That's one concern. And then another thing to keep in mind is just that retirees don't typically have a fully inflation-adjusted income stream. Some do so. A great example would be the federal worker who has a nice inflation-adjusted pension that gives a nice nudge up to help keep them whole with inflation. That I would say is sort of a best-case scenario.
But typically if we're withdrawing from our portfolios in retirement, the portion of our portfolio that we're withdrawing to spend on is not inherently inflation adjusted, and if we have that portion of our portfolio positioned too conservatively, if it's just in fixed rate investments, the threat is that that will negatively impact our portfolio, negatively impact our spending.
So that's a risk factor that I think as we think about our retirement portfolios that we want to try to mitigate because the inflation on a fixed rate investment will just eat away at the purchasing power of that investment. Another reason why inflation is a big concern for retirement is that more conservative portfolios--which in retirement, portfolios naturally are more conservative than would be the case for someone who's accumulating assets for retirement--more conservative portfolios simply have lower return potential.
So if you have cash and bonds in that portfolio, and you should, you need those assets in your retirement portfolio, they'll just have lower returns. So that makes inflation a bigger threat for retirees than would be the case for that young accumulator with a 90% equity portfolio. So what are the implications of all of this?
We've talked about how you'd want to have equity valuations and yields and inflation on your dashboard. Let's talk about the implications for various aspects of a retirement plan. And I'll just take these one by one. Withdrawal rates have been a big research area for me and my colleagues. Over the past year we put out a research paper which I have a link to at the end of this presentation. But we wanted to examine the state of retirement income and the state of withdrawal rates on a forward-looking basis. This slide depicts on a backward-looking basis what various asset class mixes would have supported over a 30-year time horizon. So you can see the person with a 100% stock portfolio, in a good 30-year time horizon was able to take the richest withdrawal. So that a 100% portfolio would have supported a 6.5% withdrawal in kind of the best case scenario. In the worst case scenario the sustainable withdrawal rate would have had to be half that amount. And down the line you can see that the mattress portfolio, the portfolio that isn't invested at all, quite intuitively, supports the lowest withdrawal rate. So withdrawal rates are down in the 1.4% to 2.5% range. And then in between you can see that the withdrawal rates were a little bit more balanced and tended to to run less to extremes than was the case for the 100% equity or the mattress portfolio.
So this is looking back in time at what various portfolio mixes would have delivered in terms of sustainable withdrawal rates over various time periods. The tricky part of setting withdrawal rates is that the right withdrawal rate is completely variable and it will only be evident in hindsight when we're no longer around, right. Only then will we know how much we could have safely withdrawn from our portfolio.
So this slide I love because it depicts how the right starting withdrawal rate completely does vary by time period. You can see by time period and asset allocation. So you can see on this slide that at various points in time a 75 % stock/ 25% bond portfolio would have supplied a 10% starting withdrawal rate, and then at other points in time, like that period that I've circled on the slide, sort of the mid ‘60s period, it didn't matter what asset allocation mix you had, you needed to take about 4% over your 30-year time horizon to avoid running out of money. And this is kind of the Bill Bengen conclusion. Many of you are familiar with Bill Bengen's seminal research on withdrawal rates, and he found that was the period where if we wanted to try to plan for the worst case scenario that's what we'd want to be thinking about. And so that's where the 4% withdrawal rate was born, where Bengen looked back on various periods in market history and found that that was the sort of it in the worst case environment that if you took a 4% withdrawal right over a 30-year time horizon you would be okay.
So before I go any further I just wanted to discuss the underpinnings of the Bengen strategy. So it's important to understand when we say 4% we're not talking about 4% year in and year out in perpetuity because from a quality of life standpoint that would just introduce way too much volatility into one's spending. And I know that some retirees do in fact like to take a fixed percentage withdrawal. But I think for many other retirees it just is going to require too much course correction in terms of their spending. too much volatility in terms of spending. So the underpinning of the Bengen guideline is kind of a fixed real withdrawal system. So when we say 4% that means that you would take 4% of the portfolio balance in year one of retirement and then you'd inflation adjust that dollar amount thereafter, and in so doing you'd have kind of a paycheck equivalent where you are keeping pace with inflation, but basically pulling a steady amount from the portfolio annually.
In reality we know that retirees don't really spend that way. That spending does tend to be a bit variable and retirees, many retirees, don't mind making course corrections,especially if their portfolios have declined in value. But that was sort of the underpinning of the Bengen research.
He wanted to incorporate a fixed real withdrawal system. So using that same sort of fixed real withdrawal system but incorporating more forward-looking return estimates in our work at Morningstar what we came up with was incorporating lower returns for stocks, lower returns for bonds over the next 30 years, we concluded that a starting withdrawal in sort of the low to mid 3 percent range was a good place for people to kind of think about their retirement spending.
So this slide illustrates various time horizons as well as various asset allocation mixes. Time horizon is super important in this context so we've been talking about a 30-year time horizon. If you're someone who's been retired for 10 years and now you're 78, well you can use a shorter time horizon. Your life expectancy has declined and so you can safely take more of your portfolio. So you can see that those allocations for 20-year time horizons, for example, are in the neighborhood of 5%, so significantly larger than would be the case for the person with the 30-year time horizon.
On the other hand on the right-hand side of the screen you've got people with longer time horizons and you can see that, quite intuitively, we're calling for lower withdrawals for them, that they should be very conservative in terms of their retirement withdrawal rates. So again, this is using a fixed real withdrawal system--that's what we incorporated into our research--we also incorporated a 90% probability of success, meaning not running out. If you take that down to say 80% you can also enlarge the starting withdrawals.
So there are lots of different ways to tinker with this in an effort to enlarge withdrawals. So if you're someone who is thinking about, well should I retire now or should I retire in five years, an easy way to enlarge withdrawals would be to retire in five years and draw down over a shorter time period.
One thing I would say that jumps out at me and jumped out at us as we worked on this research is that pushing up the equity exposure doesn't substantially enlarge the withdrawals, and I think that is largely because of the sequencing risk. So the idea is that if a retiree comes into retirement and has a 90% equity weighting or 100% equity weighting that the risk of that is simply going to introduce a lower probability of success over that 25 to 30-year time horizon. So this to me argues that swinging for the fences really isn't the answer, that balance makes the most sense for retirees today.
So how do we think about withdrawal rates as we are contemplating potentially a not great market environment for the next 10 years. One thing I would think about is if you're using a fixed real withdrawal system, going back to that slide that showed a sort of low 3% withdrawal rate made sense. If you're using that sort of fixed withdrawal system starting lower and I think potentially giving yourself the opportunity to take more later on is a good starting point.
On the other hand another thing that we explored in our research was some of these variable strategies for taking withdrawals, and I know there are some really good threads on the Bogleheads wiki site about some of these variable strategies. A couple of that I would call to your attention would be what's called “the guard rails strategy.” This was developed by financial planner Jonathan Guyton and computer scientist William Klinger. And the basic idea is that it is an efficient withdrawal system. So it encourages a retiree to take less when the market is down a lot, but then he or she can also take more when the market is up appreciably. And the net effect of those periodic course corrections is that the retiree consumes more of his or her portfolio.
So this strategy would tend to be important, or would tend to be valuable, for people who really do want to try to maximize their own consumption over their lifetime. It'll tend to be a little less appropriate for people who are super bequest minded because the name of the game, especially in this, in the course corrections where you,have your portfolio perform well and you give yourself a raise, the net effect of that is that you're consuming more of the portfolio as the years go by.
But that strategy showed really well from the standpoint of enlarging starting withdrawals quite a bit, and then importantly enlarging lifetime withdrawals quite a bit. If you want more of a fixed real withdrawal system, one simple tweak that you could make to help enlarge starting withdrawals as well as lifetime withdrawals would be simply to forego the inflation adjustment in the year after your portfolio has had a loss.
So you're only having to do this very periodically and that those might be environments where it might not be too difficult because in weak market environments that's also often a weak economic environment where inflation might be fairly mild anyway. So we found in testing that approach that that tended to elevate starting withdrawals and elevated lifetime withdrawals a little bit, not to the extent that the guardrails approach did. But nonetheless it was helpful versus sort of that fixed real withdrawal system.
How about asset allocation in retirement, asset allocation today. What you've probably concluded as you've been listening here, is that retirees are balancing competing issues. Where on the one hand I'm saying you need bonds, you need that ballast, you need something that you could spend through if a weak equity market materializes early on in your retirement. On the other hand retirees also need growth that comes along with having stocks because we showed how bonds are likely to return under 2% over the next decade. With inflation, that is barely staying in the black, if it is staying in the black.
So retirees are balancing those two competing issues and so to me that argues for balance from the standpoint of asset allocation. One thing that comes to mind is this rising equity glide path research that Michael Kitces and Wade Pfau came out with a couple of years ago. The basic idea was that if retirees want to protect themselves against sequencing risk that perhaps coming into retirement with a safe portfolio blend and then ramping up to a more aggressive equity-heavy allocation might make sense. Arguably it's a pretty attractive strategy in an environment like right now where we fear that equity valuations are pretty extended. That would argue for coming in somewhat defensively positioned and ramping up to a higher equity exposure. I guess the key consideration is whether behaviorally that works. Whether a retiree would be comfortable enlarging the equity weighting in the portfolio after the portfolio had endured some kind of a brutal bear market. I think that's kind of an open question.
The interesting thing to my mind is that this bucket strategy that I often talk about and write about on morningstar.com, it kind of gets you to the same place as that rising equity glide path, at least in a bad market environment. So I'll just discuss what we're looking at here.
This is a three bucket system that I often write about and I would like to always credit Harold Evensky, who's a financial planner, for coming up with this bucket approach. As I think about it, his basic comment to me was--it was probably more than 10 years ago--he and I were talking and he said, “Yeah, use this cash bucket with my clients. I manage a long-term balanced portfolio with the rest of their assets. But we typically hold aside a couple of years worth of portfolio withdrawals in cash investments, and that serves as kind of a buffer for them. That the equity market can do what it'll do, and you know bonds might bobble around a little bit, but we know that we have our living expenses set aside in cash.” And he told me that it really worked with his clients. That his clients found a lot of peace of mind in knowing that they had their cash flows set aside.
So that's the underpinning of this bucket strategy that I talk about,where you've got anywhere from a year to two years, maybe even as low as six months worth of living expenses in cash and then you're just stepping out on the risk spectrum with the rest of the portfolio. So you might have another five to eight years in high quality fixed income assets and then the remainder of the portfolio can be in equities where you have like a10-year time horizon for the equities.
So if we encounter another lost decade for stocks like we had from 2000 through 2010, the idea is that a retiree with this sort of framework could spend through buckets one and two before ever having to touch stocks. In reality that's not necessarily how you would maintain a bucket approach. So my view is that retirees who have used buckets over the past decade, for example, my hope is that they've been periodically peeling back on stocks and selling into a higher market and using those to replenish that cash bucket as it's become diminished.
So the way that you would manage these buckets really depends on the market environment that you happen to retire into. If stocks are poor at the outset of your retirement, the bucket one and bucket two builds you a runway that you could spend through if you needed to, before having to touch stocks.
This is just one of my model portfolios that incorporates the basic bucket framework. so we're assuming a $60,000 portfolio withdrawal and then we're just structuring each of the buckets accordingly. So we've got sixty thousand times two in cash, and by the way, we're not really monkeying around with risk in that cash bucket. The idea is that our money is there if we need it and so we don't want to take risks in that portion of the portfolio.
Bucket two does include a little bit of risk so it has high quality short-term bonds, high quality intermediate term bonds, and a little bit of TIPs exposure in that portion of the portfolio. And then bucket three is a globally diversified equity portfolio. Here's where I would include, to the extent that I had them in my portfolio, I’d include a little bit of lower quality fixed income exposure. I wouldn't put that stuff in bucket two because in terms of its performance I think it's more equity like.
So this is just a real basic portfolio. I know bogleheads would naturally have Vanguard funds as their first choice, so I actually have some model portfolios that are composed exclusively of Vanguard funds. This one's kind of a mix of different funds from different firms. You could also do a very minimalist version of this where you might have cash, you might have just a total bond market and then total US, total non-US for the bucket three so you can skinny down the number of holdings as well.
The reason I have accentuated Vanguard Dividend Appreciation in this equity bucket, it's just that I like that it's kind of a higher quality cut of the total market. I've augmented it with a little bit of total market exposure. But it tends to be a little bit lower volatility than the broad US market so that's why I've included a dash of that fund. But you could certainly just use the total markets, as well for Taylor's Three Fund Portfolio, for example.
I mentioned that bucket buckets one and two, or maybe I didn't mention, they have opportunity cost, So that's the reason why you wouldn't want to err too much on the side of having too much in those buckets. You could arguably even shrink them down a little bit if you wanted. I think the key is that I would try to think about having, I would say, eight to ten years worth of portfolio withdrawals in those two buckets. The risk of having a shorter number of years in those two buckets is just that stock market volatility can sometimes be lasting, and even if it's not losses for several years running it might still be difficult to claw back into positive territory. So referencing again that lost decade. Which is why I would like to think of retirees who are using a system like that to be thinking of eight to ten years overall in buckets one and two.
Wade Pfau has also helpfully argued that people might use other non-cash assets to keep cash from dragging on their portfolios. So a couple of assets that he would recommend would be kind of a standby reversed reverse mortgage. People who have life insurance may be able to draw upon the cash value without holding that dedicated cash bucket. Annuities may also be a fit in this context.
Inflation protection. We talked about how inflation protection might be a bigger threat for retirees than it might be for people who are still working and getting those cost of living adjustments in their paycheck. So when you are thinking about your retirement portfolio, I think you want to think about incorporating inflation protection into it. And one of the best ways we do that really throughout the life cycle, so in our accumulation years as well as in our decumulation years, one of the best ways we do that is to simply own stocks in our portfolio. Because even though stocks aren't any sort of direct hedge against inflation, so if inflation goes up seven percent this year stocks won't necessarily go up seven percent this year. But over time we know that stocks tend to out earn inflation. So you want to include stocks in your retirement portfolio. To the extent that you have fixed income assets I think treasury inflation protected securities and I-bonds can be a fit. Both of them give you some insulation and help make you whole in periods when inflation is running higher than expected.
And then you might look at some sort of niche asset classes to complement-- I would say those would be the two core pieces that I would use to protect against inflation, so inflation protected bonds as well as stocks-- but then you might also consider Reits as a component of the mix. Commodities tend to show very well as inflation hedges. The unfortunate part is that commodities products, commodities tracking products, I think, are imperfect to say the least. So I think that that's a potential headwind for commodities owners, but we do see that they tend to be pretty good inflation hedges. Bank loans and high yield bonds, really that category of higher risk bonds tend to be pretty strong performers in inflationary environments. So you might consider adding these securities around the margins of a portfolio. But I would look to stocks and inflation-protected bonds as kind of the main ingredients that I would use to protect myself against inflation.
And then at the plan level, as you're thinking about protecting yourself against inflation, I should say Social Security is a nice inflation protected income stream. So even though the income and adjustment at points in time might be not as large as we might hope, it does include some insulation against inflation. So delaying Social Security. There are multiple benefits to doing so, but one of them is that the enhanced return that you pick up for delaying is also inflation adjusted.
And then also factoring inflation into your portfolio spending plan. So if you're worried that inflation might run higher in your retirement years, that argues for actually taking your withdrawal rate down a little bit to accommodate the prospect of potentially having to take more later on to account for inflation and to help make you whole with inflation.
Non-portfolio income sources. I won't spend a lot of time on this but I've mentioned a few times the value of delaying Social Security. And lower starting yields make delayed Social Security filing even smarter, I would say, because the benefit that you pick up has not been adjusted to reflect the fact that we're in this very low interest rate era. So you can pick up quite a substantial benefit, as many of you know, from delaying Social Security from 62 to age 70. But what I always say is that you don't have to wait all the way until age 70 to enjoy some kind of a benefit. If you delay by a couple of years past your full retirement age that will tend to deliver a meaningful pickup in benefit. And it's also important for the person who's been the main earner in a household to be super thoughtful about Social Security claiming. So oftentimes it makes sense for that person to delay even if he or she is older than the spouse who has had less of an earnings history. It often makes sense for that older higher earning partner to delay in an effort to enlarge the surviving spouse's eventual benefit. Here I would make a call out for Mike Piper's great tool for Social Security filing strategies.
Mike Piper is a generous contributor to this community, does a lot of speaking ,and Mike has created a great free tool for experimenting with Social Security. So I would urge you to check it out. It's really terrific.A free resource that you can use to help make your Social Security filing decisions.
Annuities, I'll just touch on briefly. It's a huge basket, in fact the term is so broad that I would argue it's kind of unhelpful. But I would also say it's unhelpful that some people assume that I'll retire, that all annuities are terrible or a dirty word, because certainly there are some terrible high-cost annuities that are really opaque and it's difficult for consumers to have a good experience with them. On the other hand, I think that some annuities are very low cost, very transparent, and can in fact be helpful to retirees' portfolio plans.
And specifically I would call out deferred income annuities as well as immediate income annuities, the very basic vanilla product types. The single premium immediate annuities, for example. And I think they're particularly beneficial for retirees who do not have pensions.
So the idea would be that you are with your Social Security and with a potential annuity purchase you're basically trying to find a way to cover your fixed expenses. And that buys you a lot more flexibility with your portfolio withdrawal rate if you know that your fixed expenses are covered through those non-portfolio income sources. If it turns out that the market isn't great and you want to take less from your portfolio, well having laid the groundwork with your Social Security filing as well as potential annuity purchase would kind of protect you in that scenario.
So one thing Alan Roth always points out in this context is that inflation protection is an issue here. That as an annuity buyer you're relatively unprotected from inflation. But the key thing that you benefit as an annuity buyer is that you benefit from what's called longevity risk pooling. So even though there's some downward pressure on annuity payouts because interest rates are so low today, as an annuity owner you're in the pool with other people who have different mortality expectations. So some people will die early and they won't get their fair share of income payments from the annuity. Some people will die later and get more than their fair share. And so your goal is to be someone who dies later, that would be sort of the ideal scenario, where you're someone who lives a very long life and you're able to take that stream of payments for longer.
So it's not a simple decision about whether to purchase an annuity by any stretch. But nonetheless I think that it's something to not reflexively avoid as part of your tool kit.
So I think that's all I've got. On this screen I've got some ways to reach me, or to read my stuff, or listen to my podcast that I do with my co-host Jeff Ptak. I've had a lot of the Bogle luminaries on there whether Rick Ferri, Alan Roth, Bill Bernstein have all been guests on the podcast. MIke Piper who I mentioned. So check out our podcast. I also mentioned that I would include our
withdrawal rate research so a link to that paper is included.
Slides and chat
The slides used in this presentation and the chat session of this presentation are available at the following links: