In What’s Your Investment Approach Part 1 we explored one dimension of the high level process of investing. Specifically we looked at two opposite complementary approaches to portfolio construction. We referred to selecting specific desired assets as the “additive” approach to synthesizing a portfolio, and starting with the universe of available assets and eliminating specific undesired as the “subtractive” approach to synthesizing a portfolio.
Here we examine another dimension of the overall portfolio construction process. In particular we look at how you expect to realize returns.
It’s usually assumed the investor will accumulate assets over the course of his investing career and then sell them to meet the costs of living in retirement. In fact vehicles for doing this are built into the tax code. These include the Individual Retirement Account (IRA) and the 401(k) in the US. You contribute before tax income during your working years, and are then expected to draw down or distribute the accumulated nest egg during retirement, paying income tax on it at that time. The term “Required Minimum Withdrawal” (RMD) highlights this; there are tax penalties for failing to do so.
It’s not without reason; it effectively aims to model an annuity, a stream of income that lasts as long as you live and leaves nothing left. That’s an efficient approach to getting the most out of your assets if you have no heirs. The popularity of such models is largely an attempt to replace increasing scarce pensions.
Often, however, investors treat assets held outside these vehicles the same way, selling them to meet expenses during retirement. Financial advisors promote accumulation and distribution plans based on this assumption.
One example is based on the popular “4% Rule”. At retirement you withdraw 4% of your portfolio and each year index that amount to the CPI. Based on historical market performance, statistical life expectancy, etcetera, most people shouldn’t run out of money before they die.
Yet it’s not without controversy. Some authorities argue the risk of running out of money is greater than in the past due to increasing life expectancies or lower return prospects due to rich market valuations or both. To be on the safe side, some suggest a “3% Rule”. Some even recommend that instead of just figuring your annual withdrawals at one point in time and never adjusting them for anything but the CPI, incorporating some kind of feedback mechanism, such as just withdrawing 3% of the balance each year.
This structurally builds in safety since withdrawing a specified fraction always leaves a remainder.
But it still assumes you must sell. And if you buy the indexes, especially cap weighted US stock indexes, that assumption is correct. The yield on the S&P 500 for example is currently only 1.5%, reflecting those concerns about overvaluation. That particular group of stocks would need to sell for half the price for you to be able to sustainably withdraw 3% without selling.
At this point a voice in the back of your mind should be whispering doubts about the assumption that this is the only way to invest.
Of course it’s not. By emphasizing dividends, quality and value and expanding your investment universe beyond pricey US shores, it’s possible to assemble a solid portfolio that yields 3%. Or looked at the other way around (subtractive versus additive), reducing or avoiding exposure to supersized companies that pay no dividends, and overpriced and low quality stocks.
And because you’re reducing your reliance on having to sell to realize a return, you’re reducing your exposure to the risk that stock prices will be unfavorable in the future when you want to sell. Because of this, you can allocate more to stocks and less to bonds, reducing your exposure to the risk that inflation will eat you alive. This is the concept behind the Income Portfolios on the Financology Model Portfolios page.
No. Accumulating low or no yielding assets and selling them off is not the only way to invest for retirement. It may be appropriate for part of your nest egg, for example due to the tax considerations mentioned above, or more, especially if you don’t have heirs to whom you wish to leave a substantial legacy. But if you do want to leave a legacy, or even because your life expectancy might be longer than average and you don’t want to gamble on the risk of running out, or even if depleting your assets just makes you uncomfortable, it doesn’t have to be all of it. It also may overlook that you already have substantial annuity assets, such as Social Security or a pension. Whether and how much you devote to each method is a personal decision, but it should be one made consciously and purposefully, not merely by default.