Managing Money During Retirement
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Defined Withdrawals
 A strategy for steady, dependable, and long-term investment income.
 
   
 

Navigating an Investment Storm

By Roger & Kevin Katzenmaier

November 7, 1998

Note: When this article was written the Income Strategy Generator was called the Investment Scenario Generator

It is one thing for your investments to have a bad year, but what about a bad decade? What if the day you retire turns out to be like the beginning of 1966, the start of one of the worst time periods in our financial history. No, it is not our intent to rain on everyone’s parade. Rather, we will show that with good planning and navigation skills, you can survive even the worst financial storms. This is not to say that it will always be easy or without sacrifice. But, if you can make it through the storms, brighter days will follow.

In this article we will describe the unique methodology used by the Investment Scenario Generator or ISG software. Then, we will put this methodology to the ultimate test to see what might have happened if it were used to develop a plan for a person retiring in 1966.

Before we get started, it is important to realize that the amount of skill required is dependent upon one’s income needs in relationship to one’s wealth. A portfolio equally balanced between stocks and quality bonds will yield about 3% annually today. For those who can meet income needs strictly from yield and after investment management costs, navigation is relatively easy. However, this strategy requires a tremendous amount of capital and will not be feasible for most retirees.

The ISG strategy was designed for people who need to get the most out of their resources but also want to be able to sleep at night! Following are some of the key philosophies of the ISG:

  • Plan to hold stocks for the long term while income is maintained from interest-bearing obligations (fixed-rate investments).

  • Use both the principal and interest from a ladder of interest-bearing obligations to fund guaranteed income for a predetermined number of years.

  • Own diversified categories of stocks including both blue-chip and growth stocks.

  • Plan for inflation adjusted income.

  • Use calculated benchmarks to guide future decisions.

Suppose the ISG had been used to develop a retirement plan at the beginning of 1966. The years that followed were devastating for many retirees. Even though pensions were common, most were not adjusted for inflation and savings were often insufficient to make up the difference.

On January 1, 1966, looking back at the investment performance of both blue-chip and growth stocks, one could easily have been filled with sheer optimism. Post World War II, the lowest average annual compounded rate of return for any 5 year period when investing half in blue-chip stocks and half in growth stocks was 8.8% from 1946 through 1950. In fact, there were only three 5 year periods that did not return at least 10% for this combination of investments (1946-1950, 1956-1960, 1959-1963). Further, all 10 year periods, post World War II, enjoyed a performance significantly greater than 10% for a combination of half blue-chip stocks and half growth stocks. Inflation averaged only 2.8% per year from 1946 through 1965 and was only 1.9% during 1965. But, a storm was brewing.

After 1965 everything changed. From 1966 though 1975 the annual compounded rate of return for blue-chip stocks averaged only 3.3% and for growth stocks only 4.0%. Inflation was a ruthless force, averaging 5.7% per year. Of course in 1965 there was no way to know this and no reason to expect it. In all probability the retiree would have developed a plan based on investment performance assumptions that were not achieved.

We will demonstrate what would have been required to navigate this investment storm using only the information that would have been available to a retiree at the time. However, we will assume the use of today’s tax-deferred investment options and use dollar values that might be more appropriate for someone retiring today.

Let’s assume our retiree has $300,000 of investment capital that can be reallocated without current taxation. Further, assume the retiree will have a modest fixed pension of $5,000 per year and an initial annual social security benefit of $6,000. Only the social security benefit will increase with inflation. During the first year, the retiree desires a total annual income of $25,000. Therefore, income from investments will be $14,000 during the first year which represents 4.7% of invested capital. Our retiree will also plan to have total income increase at an assumed inflation rate of 2.8% per year.

We will assume an average yield to maturity for interest-bearing obligations (IBOs) of 4.9% which was the yield rate for U.S. intermediate-term government obligations at the beginning of 1966. We will use the historic average rates of return for blue-chip and growth stocks which were 10.4% and 11.3% respectively at the beginning of 1966. However, these rates will be reduced by % for blue-chip stocks and 1% for growth stocks for investment management costs. Blue-chip stock dividends will be reinvested. Using the ISG Holding Period concept, we will assume that blue-chip stocks may have to be held for up to 9 years to realize the assumed rate of return and that growth stocks may have to be held for up to 11 years. Income will then be maintained by a ladder of IBOs during these holding periods. The above investment assumptions would have appeared reasonable and relatively conservative at the beginning of 1966.

Next, assume our retiree used the ISG to create a 30-year plan and after exploring many investment scenarios, selected an initial allocation of capital as follows:

IBOs

40%

Blue-Chip Stocks

30%

Growth Stocks

30%

Total

100%

With this scenario and the above investments assumptions, the ISG predicts that capital will grow to $1,190,512 after thirty years, which is equivalent to $519,924 adjusted for 2.8% inflation. The plan also accounts for the desired income and gives annual benchmarks which will prove valuable for navigating the difficult years ahead.

The 13 years from 1966 through 1978 provided the greatest challenge. Let’s step through these difficult years and see how a retiree might have navigated this storm. At the beginning of 1966, capital is allocated as follows:

IBOs

$120,000

Blue-Chip Stocks

90,000

Growth Stocks

90,000

Total

300,000

The IBOs are purchased with staggered maturities such that as they mature, the principal and interest exactly meets the desired investment income for the first 9 years. This does not necessarily mean that stocks will be held for 9 years. It simply means that they can be held this long if necessary.

After 3 years, or by the end of 1968, the retiree’s actual results would have compared to the ISG benchmarks as follows:

          

Actual Results

 

ISG™ Benchmarks

IBOs

$ 91,691

(face value)

$ 91,691

Blue-Chip Stocks

109,945

 

119,464

Growth Stocks

204,187

 

120,773

Total

405,823

 

331,928

* Interest rates were on the rise, so the true value of the IBOs would have been less than their face value. However, since all IBOs will be held to maturity, this is inconsequential, and for simplicity we will track the face value of IBOs.

Blue-chip stocks were not quite meeting expectations, but growth stocks had far exceeded expectations. Let’s assume the retiree took this opportunity to sell some growth stocks to replenish IBOs. We will assume that the retiree sold $83,414 worth of growth stocks which is the amount over and above the benchmark.

At this point, income was guaranteed for another 6 years by the existing ladder of IBOs. If additional IBOs were purchased to extend the current ladder, these IBOs would generate interest that would not have been needed for income during the next 6 years. This interest could be re-invested. But, let’s assume that our retiree used the $83,414 to purchase zero-coupon bonds with 6-year maturities. These bonds would then mature at the end of 1974 precisely when the retiree needed to create a second ladder of IBOs for income. We will assume that the yield for these zero-coupon bonds would have been at least 6.0%, which was the yield for U.S. intermediate-term government obligations at the time.

At the beginning of 1969, capital was then allocated as follows:

 

Actual Results

IBOs (initial ladder)

$ 91,691

IBOs (zero-coupon bonds)

83,414

Blue-Chip Stocks

109,945

Growth Stocks

120,773

Total

405,823

During the first three years, interest rates and inflation were already on the rise. However, the retiree probably would not yet have suspected the extent of this trend. The favorable results from growth stocks may have given the retiree a false sense of security. However, by the end of 1974, a summary of the damages would have been as follows:

  Actual Results   ISG Benchmarks
IBOs (initial ladder) $ 3,239 $ 3,239
IBOs (zero coupon bonds) 118,324  
Blue-Chip Stocks 86,600 210,485
Growth Stocks 46,850 217,481

Total

255,013 431,205

To make matters worse, inflation averaged 5.6% during the first 9 years, while income (except from the social security benefit) only increased 2.8% per year. The retiree was probably feeling a squeeze on income but with total capital well behind expectations and now a very uncertain future, the retiree could hardly afford to raise income. In fact, depending on the retiree’s age and personal tendencies, the retiree may have chosen to reduce income to get back on track. In some cases this is the only way to survive a financial storm, especially if the original plan is aggressive. However, our retiree started with a relatively conservative plan and we will assume that the retiree decided to maintain the current level of income and continue to increase income each year by 2.8%.

By the end of 1974, the initial ladder of IBOs was almost depleted and it was time to create a second ladder. The capital from the zero-coupon bonds would have been enough to supply income for 7 more years assuming IBOs were purchased with an average yield to maturity of 7.1% which was the yield for U.S. intermediate-term government obligations at the end of 1974.

With steep interest rates and deeply disappointing stock performance, it may have been tempting to sell the growth stocks and purchase more IBOs. However, we will see that times like this are when it is most important to stay the course and resist selling stocks at a loss.

With a watchful eye on the next couple years, our retiree would have started 1975 as follows:

  Actual Results ISG Benchmarks
IBOs (second ladder) $121,563 $ 98,331
Blue-Chip Stocks 86,600 115,393
Growth Stocks 46,850 217,481

Total

255,013 431,205

By the end of 1975 the results would have been:

  Actual Results ISG Benchmarks
IBOs (second ladder) $110,191 $ 83,277
Blue-Chip Stocks 118,382 126,817
Growth Stocks 71,118 239,882

Total

299,691 449,976

And, by the end of 1976:

  Actual Results ISG Benchmarks
IBOs (second ladder) $ 97,277 $162,594
Blue-Chip Stocks 145,965 139,372
Growth Stocks 111,229 168,764

Total

354,471 470,730

By this time, the situation was starting to look a little brighter. Income was well behind inflation, but at least the gap was closing between actual capital and the benchmark. By the end of 1977, the results would have been as follows:

  Actual Results ISG Benchmarks
IBOs (second ladder) $ 82,689 $149,322
Blue-Chip Stocks 134,726 153,170
Growth Stocks 138,369 186,147

Total

355,784 488,639

And, by the end of 1978:

  Actual Results ISG Benchmarks
IBOs (second ladder) $ 66,284 $134,644
Blue-Chip Stocks 142,944 168,334
Growth Stocks 169,502 205,320

Total

378,730 508,298

Let’s jump ahead to the end of 1981:

  Actual Results ISG Benchmarks
IBOs (second ladder) $ 4,569 $ 81,241
Blue-Chip Stocks 210,665 223,442
Growth Stocks 378,444 275,523

Total

593,678 580,206

Total capital was finally in line with expectations and growth stocks were again significantly ahead. It was time to create a third ladder of IBOs. After selling the amount of growth stocks over and above the benchmark, the actual allocation of capital at the end of 1981 would have been:

  Actual Results ISG Benchmarks
IBOs (third ladder) $ 107,490 $ 81,241
Blue-Chip Stocks 210,665 223,442
Growth Stocks 275,523 275,523

Total

593,678 580,206

It may appear that blue-chip stocks were nearly on track with expectations. But, this was not really true. The ISG plan assumed that some blue-chip stocks would be sold periodically to purchase IBOs and instead only growth stocks were sold. This points out the need for diversification. It also demonstrates how the ISG methodology self-corrects. Notice that by the end of 1981, the actual allocation is very similar to the planned allocation even though investment performance was much different than expected.

The storm was over. Survival was not without sacrifice since real income did not keep pace with inflation for many years. But, one of the most difficult investment storms was successfully navigated and the future was bright. The remaining years would not have been a challenge and our retiree could afford a long overdue raise in income.

It was not until the end of the 30-year plan that blue-chip stocks finally met the original expectations. However, the spectacular performance of growth stocks more than made up for it. Imagine how different the outlook would have been if in 1975, the retiree decided to sell the under-performing growth stocks!

The secrets to successful navigation include: planning for maximum stock holding periods, diversifying stock investments, laddering IBOs to provide known guaranteed income and using the ISG benchmarks to guide future decisions. Hopefully, we will never have a storm like this again. But, financial cycles tend to repeat and there will likely be times that require skillful navigation. We hope this example provides some guidance for your journey!

Historic investment statistics were obtained from Ibbotson Associates; Stocks, Bonds, Bills and Inflation, Yearbook. Ibbotson’s Large Company Stock data was substituted for blue-chip stocks and Ibbotson’s Small Company Stock data was substituted for growth stocks. All blue-chip stock rates of return were reduced by % for investment management costs. All growth stock rates of return were reduce by 1% for investment management costs.

 

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