Stress test shows that retirees need not park more of their funds in bonds and cash
By Teh Hooi Ling
Most statements in life, when repeated often enough, will be taken as the indisputable truth, especially so if our general, everyday observations sort of suggest that the statements are right.
Few will stop to question their validity; what are the assumptions embedded in those statements, who made those statements and to what purpose, and have robust tests been done to verify claims made in those statements?
In the field of finance, one tenet which is often purveyed is that of life-cycle investing.
The theory goes that young people should be more aggressive in their investments, namely that they should allocate a higher proportion of their portfolios to equities for the long-term compounding effect to take place.
But when they approach retirement age, they should cut their exposure to equities and hold more of their portfolios in bonds and cash.
This makes intuitive sense: Equity prices are more volatile than fixed-income instruments and, unlike the latter, there is no assurance of regular payouts from equities.
Therefore, it would be "safer" for retirees, who are dependent on their life savings for their daily expenses, to park their money in a less volatile portfolio.
What if a retiree had her entire life savings in equities, and saw her portfolio diminish to less than half during the global financial crisis in 2008? That would be a nightmare scenario, wouldn't it?
But here's the thing: The image of this scenario is likely to be most vivid when the stock market crash is at its worst.
At that point, we see in our minds retirees with their wealth halved compared with the pre-crisis level. "Poor things!" we'd think. "That's why retirees shouldn't put all their nest eggs in the stock market."
But you know what? Markets recover, even from the worst of crises.
As long as retirees don't panic and cash out their entire portfolios at the bottom of the market, there is a good chance that they will see their portfolios recover.
We did a stress test on an all-equities portfolio at each of the previous market peaks in the Singapore market going as far back as 1973.
Let's assume that there were seven retirees.
Each retired with $1 million and decided to put the entire sum into the stock market.
The bull markets at the time of their retirement gave them confidence that the stock market was a good place to keep their savings.
So each of them plonked their $1 million into the market at the beginning of 1973, 1982, 1984, 1990, 1997, 2000 and 2008.
And each wanted to withdraw 5per cent from that $1 million, or $50,000 a year, to pay for their living expenses.
As it turned out, the years that the seven retirees put their money into the market were the years of market peaks. Soon after, major crashes or market corrections took place.
Could the $1 million equities portfolio have lasted them until today?
Well, six out of the seven portfolios did.
The initial $1 million portfolios were worth between $824,000 and $3.4 million as of the end of last year, with one exception.
For the person who retired in 1982 with $1 million invested entirely in the Singapore stock market, her portfolio as of the end of last year was worth $3.4 million.
This was after she withdrew $50,000 a year from the portfolio for the last 31 years. The withdrawal amounted to $1.55 million in all.
For the person who retired on the eve of the Asian financial crisis, her portfolio as of the end of last year was worth $1.6 million. And in the intervening years, she had taken out $800,000 from her portfolio as spending money.
From the table above, you can see that the two who retired on the eve of the two most recent market crashes - the dotcom bubble burst in 2000 and the global financial crisis in 2008 - still had $824,000 and $842,000 in their portfolios respectively.
At a 5 per cent withdrawal rate, the lowest the six retirees' portfolios ever fell to was $429,000. That was for the person who retired at the peak of the dotcom bubble.
But as long as there is still money in the market, there is a chance of recovery.
The only retiree whose portfolio didn't survive was the one who put her money into the market during the massive 1973 bubble in the local market.
At that time, according to Thomson Datastream, the Singapore index was trading at a price-earnings ratio of 35 times. It was the time when OCBC was trading at $50 a share and Metro was at $26.
In other words, there was a massive bubble in the Singapore market.
At a 5 per cent withdrawal rate, her money was depleted by 1984. But if she had reduced her withdrawal rate to 3 per cent - taken out $30,000 instead of $50,000 a year to spend - she would have survived the numerous crashes that followed and would still have an equities portfolio of $1.6 million as of the end of last year.
For the above calculations, we used the Thomson Datastream calculated Straits Times Index as a proxy for how an all-equities portfolio would have performed.
Dividends were added to the portfolio. No transaction costs were taken into account. The portfolios were valued once a year on Dec 31 and withdrawals were done on that day as well.
So what are the main takeaways from the study?
It's that the chances of an all-equities portfolio being completely wiped out at a withdrawal rate of 5per cent a year are minimal under normal market conditions.
The exception is when someone buys into the market at the peak of a massive bubble, as was the case in 1973.
Readers who would like to stress-test their retirement funds over various cycles in the US going as far back as 1871 can check out the website www.firecalc.com
Another noteworthy point is that as long as the portfolio is not too decimated and as long as the money stays invested in the market, there is a good chance of recovery, given time.
Admittedly, the ride can be quite rough at times. The portfolio can plunge by half in a year. The key is to hang on tight.
So the upshot is that someone who has $1 million can relatively safely withdraw $50,000 a year to fund his retirement for as long as he lives, and yet still leave an estate for his children if he puts the entire sum in the equities market.
Time to say goodbye to perpetuals, annuities and bonds, which usually form the core of a retirement portfolio.
But there is one very important caveat here. The equities portfolio must be made up of a diversified basket of stocks of real businesses and purchased at a price which is unlikely to result in a significant permanent loss of capital to the investor.
Buying into stocks such as Blumont, Asiasons or LionGold, whose business prospects are uncertain, and at overvalued prices, is a sure-fire way for you to outlive that $1 million in the shortest possible time.
The writer, a CFA charterholder, is head of research at Aggregate Asset Management, manager of a no-management-fee value fund.