“Global Stocks Dive as Trades Unravel,” screamed the front page of The Wall Street Journal the morning after the S&P 500 fell nearly three percent this summer on August 5, a move accompanied by an even more alarming VIX spike over 60, both apparently precipitated by the unwinding of – wait for it – the yen-dollar carry trade.
Should you care? Of course not, and if your phone was exploding with rattled clients, you might revisit how you screen prospects.
To understand why, it helps to consider a person’s global asset structure – not just stocks, bonds, and bank accounts, but also their human capital: the sum of all appropriately discounted future paychecks.
Next, apply that investment capital/human capital paradigm by age. The below schematic diagram plots a person’s investment capital, human capital, and the sum of the two, in units of yearly income over the lifecycle:
Consider, for example, a twenty-something with millions in future human capital. This dwarfs his five-figure retirement savings; even if he leverages his portfolio – probably not a good idea – it would still constitute a small fraction of his total capital. On top of that, he won’t need his retirement savings for a generation or more.
Best of all, a sequence of low, volatile equity returns, rather than a misfortune, is a pennies-from-heaven opportunity to load up on equities at bargain prices. Far from fearing financial blood in the street, he should get down on his knees and pray for it; in short, there’s no reason for him to get worked up on a day like August 5.
It’s not just youngsters who should treat a Wall Street fit with the equanimity it deserves. Imagine a retiree – call him “Fortunate Fred” – whose Social Security and pension income completely cover his retirement bills. His stocks and bonds don’t belong to him at all, but rather to his heirs and charities.
Fortunate Fred, with his zero portfolio burn rate, sits at one extreme of the retirement continuum. At the other extreme are retirees with little or no financial assets, and right next to them are those whose living expenses mandate a more than four percent per year stock/bond portfolio burn.
These folks should indeed worry about the plunging value of their portfolios. Consider, for example, someone who retired in 1966 with a six percent burn rate (in the below graph, $60,000 in inflation-adjusted living expenses from a $1 million nest egg) who ran out of money in about 17 years, no matter what his stock/bond mix. This is a classic example of sequence-of-returns risk, when poor returns early in retirement on top of ongoing expenditures render moot any later stock prices recovery.
And that’s the good news. The bad news is that this analysis (similar to the one performed by the famous Trinity Study) relies on historically high U.S. stock and bond returns that are not likely to persist. Research by Wade Pfau that examined historical security returns outside the U.S. paints a more sobering picture: Maximum sustainable withdrawal rates averaged about three percent, with some national markets failing to support not much more than a one percent withdrawal rate.
The inescapable conclusion: The retiree with even a moderate burn rate and a conventional balanced stock/bond portfolio plays capital markets Russian roulette: Yes, five out of six times they’ll be OK, but the capital market’s revolver chamber doesn’t always come up empty.
Beyond the risky math of equity investing in retirement, there’s also a deadly psychological dimension. Imagine two retirees, the first with a $1 million stock/bond portfolio, the second with its actuarial equivalent, a $40,000 annual COLA-ed pension. Who will sleep better at night? Who will spend more wisely?
How retirees can stop worrying about plunging stocks
The safest way to ensure retirement security is to match, on a year-by-year basis, future spending needs with a reliable stream of inflation-adjusted income and maturing fixed-income assets. As we’ve already seen, a conventional stock/bond portfolio may not cut that mustard.
The prudent retiree wants, above all, the equivalent of an old-fashioned COLA-ed pension: in other words, an inflation-adjusted annuity contract.
Unless both the retiree and their spouse have diminished life expectancy, the average retiree gets part way there by spending down retirement assets in order to defer Social Security to age 70. This is the best inflation-adjusted annuity that money can buy, albeit in most cases it doesn’t supply enough income to meet the typical retiree’s needs.
Supplementing that with an inflation-adjusted annuity would be ideal, but, alas, the last of those disappeared in 2019. (This was likely because their initial payout rates, being lower than those of nominal annuities, proved unappealing to prospective annuitants blinded by the money illusion.)
The retiree is thus left with a choice – not mutually exclusive – of a TIPS ladder and a commercial single-premium immediate annuity (SPIA). The former, described in detail on this site by advisor Allan Roth, has the advantage of inflation-matched payouts, but taps out after 30 years. If you’re 75 years old, this isn’t a problem, but for the 55-year old, it well could be.
Moreover, at present no TIPS mature between 2035 and 2039. Finally, a TIPS ladder requires both a quantitative bent and the ability to navigate both Treasury auctions and secondary market purchases. These logistical hurdles can be lessened by purchasing TIPS mutual funds/ETFs with an average weighted maturity of half the investor’s expected longevity. However, this lessens the certainty of real spending power that TIPS offer at maturity.
A TIPS ladder constitutes what financial economists call a “Liability Matching Portfolio” (LMP) that pays out a real stream of maturities and income that covers, in real time, one’s living expenses. At the present average TIPS yield of 1.8 percent, a 30-year TIPS ladder will pay out a real annual 4.34 percent over its lifetime—better than the four percent “Bengen Rule.” Even at a zero average TIPS yield, the ladder supports a 3.3 percent payout.
A SPIA, on the other hand, behaves as a true life annuity, but only in nominal dollars; it succeeds only if two conditions are met: First, that the retiree banks a good portion of the high initial nominal payout against the steady erosion of its future real purchasing power; and second only if inflation remains at its low historical rate of about three percent per year. Given the nation’s spiraling debt accumulation, this is no sure thing. If inflation gets out of control, then the SPIA’s supposed longevity insurance disappears in a hail of funny money in extreme old age. (SPIAs can be bought with a fixed annual percent riser, but these have lower initial payouts and are actuarially equivalent to SPIAs without a riser; they thus will not provide adequate protection against inflation if it comes in higher than the riser.)
SPIAs also carry credit risk, and those reassured by the state “guarantees” in back of them would do well to review the history of Executive Life Insurance, whose private-equity related failure blew through that supposed backstop. While such an insurance company failure has admittedly proven a rare event, the increasing private equity ownership of the insurance industry, the proximate cause of the Executive Life flameout, is a red flag. Moreover, in a systemic financial system failure, all bets are off; in this case, any security containing the word “Treasury,” properly capitalized, becomes the asset of choice.
Don’t get me wrong; as long as the retiree puts aside a healthy reserve from the initial payouts against the future erosion of later spending power, SPIAs can be part of any reasonable retirement plan. A hybrid approach, such as buying SPIAs with maturing TIPS, may be worthwhile. But if you take inflation risk seriously, don’t bet the farm on SPIAs alone.
Many pre-retirees should definitely worry about plunging stocks
The hardest step of the lifecycle human/investment capital dance comes at the transition between the two phases, which typically occurs around age 55.
The prime directive of this transition is that when you’ve acquired enough assets to fund an LMP consisting of TIPS and SPIAs, you’ve won the game – and you should stop playing it. This doesn’t mean suddenly selling all your stocks to load up on TIPS and SPIAs. Rather, slowly accumulate – during periods of prolonged stock outperformance – enough of either or both to provide enough inflation-adjusted income to meet basic living expenses.
In other words, you want to become Fortunate Fred. Once you’ve set up your LMP, you can then again begin to accumulate stocks and allow them to grow, a “risk portfolio” that, as with Fortunate Fred, really doesn’t belong to you.
Once you gotten there, with or without a significant risk portfolio, feel free to break out the popcorn the next time stocks plunge.
William J. Bernstein is a neurologist, the co-founder of Efficient Frontier Advisors, an investment management firm, and a writer with several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from the CFA Institute.
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“Global Stocks Dive as Trades Unravel,” screamed the front page of The Wall Street Journal the morning after the S&P 500 fell nearly three percent this summer on August 5, a move accompanied by an even more alarming VIX spike over 60, both apparently precipitated by the unwinding of – wait for it – the yen-dollar carry trade.
