Tag Archives: Retirement planning

On Raising the Fed Funds Rate

When you’re drinking beer, the goal can be to drink more.  That’s a problem for some people.  They do not recognize their disequilibrium.  Putting the glass down might not bring immediate gratification, but it is simply the right thing to do with any normal, long-term perspective.fredgraph Fed Funds Rate

The Fed needs to get off the sauce.  Current interest rates compromise reasonable capital allocation, and encourages uneconomic decisions.  The longer the distortion persists, the greater the risk.  Any investment decision that gets squeezed out because of a .25% interest rate increase, at current rates, was a bad idea anyway.  That represents net positive for the economy by discouraging inferior projects and speculation.

Interest rates are the cost of money.  It shouldn’t be virtually free.

Social Security: Take or Defer?

I crunched the numbers on the question of deferring Social Security for a year to increase the payment by 8%, for each year it is deferred to age 70.  Most advice seems to favor deferral, unless health is an issue.

My numbers do not necessarily support that conclusion.  While the 8% increase can be viewed as a compelling guaranteed return, it also comes with a long payback.  The breakeven of deferring, if the safe investment rate is 3%, is about 17 years.  This may be the best case for waiting.

On the other hand, recipients with other sources of income might be able to invest their social security payments at a rate competitive with the 8% Social Security escalator.  In this case, there is little benefit for deferring.

In summary, if the first year’s SS payment is invested and earns 8%, then it is equal to the first payment if deferral is elected.  This process repeats for all payments, so the payment streams are equal.  When we consider a safe money reinvestment rate, there is a small benefit to deferral, but the payback period is long.  The decision is not as clear as I’d assumed.

My spreadsheet (in PDF format, so no formulas) is here, https://www.daltonfin.com/wp-content/uploads/2015/06/Take-or-Defer-Spreadsheet-Analysis.pdf.

Observations on Variable Annuities

A 64-year-old woman asked her financial advisor, “Why is the annuity a good idea?”  He replied that it gives her what she wants, a guaranteed income.  That is the key.  His approach solves problems by giving people what they want.  Wants are emotionally based.  Needs are comparatively fact-based.

Rather than pander to emotional desires, I try to convince clients to do what I would do if I were in their situation.  A fiduciary does not begin with the emotional component as the objective.

As interest rates increase over the next few years, it will be easier to generate income from a diversified portfolio.  While interest income will be taxed as ordinary income, capital gains and qualified dividends are currently taxed at lower rates.  Lower expenses, the step-up in basis for non-qualified (not in a retirement plan) assets, and access to a much wider investment universe are benefits of regular investing versus an annuity.

She is concerned about negative media. She believes everyone is expecting a market correction.  I responded that if most people are bearish, then that would be baked into prices already, reducing the risk of a correction.  Negative sentiment is healthy.  Exuberance is dangerous.  Markets are counter-intuitive, which explains why emotional investing is a bad idea.A Balanced Fund vs S&P 500

As reference, the above chart illustrates a popular, low-cost balanced fund (the blue, top line).  The 2000 – 2002 correction barely registers as a dip with the balanced fund.  The blue line shows that a 3 to 5-year reserve fund would have been sufficient to avoid selling at a loss during the 2008-2009 crisis.  The fund’s performance suggests that concerns referencing the last 2 major bear markets are more about the unknown than they are grounded in fact.  This is not unlike children being afraid of the monster under the bed.

The orange line below the blue line represents the S&P 500.  Investing in only the S&P 500 is not a good idea, but that seems to be the straw man argument many insurance companies use to sell annuities.

Finally, consider the commission.  How much is it and where does it come from?  This is not alchemy.

Past performance is not a guarantee of future results. Investing involves the risk of principal.  The chart illustrates the performance of a popular balanced fund from January, 1999 to April 27, 2015.  The fund may hold up to a 75% equity allocation.  The chart is intended to illustrate the performance of a diversified portfolio relative to the S&P 500 during the 2000 – 2002 and 2008 – 2009 bear markets.  Diversification does not guarantee against loss.  The balanced fund is the Dodge and Cox Balanced Fund, and the data is from Morningstar.

How to Prepare for the Next Crash

First let’s define “Crash”.  To most, the term implies a decline of severe magnitude. A key question is the duration of the impairment, or how long might it take to recover?  Another consideration is stock market valuation.

By my observation, there hasn’t been a stock market crash in the US in the last hundred years that began with stocks at historically reasonable valuations that persisted more than 5 years.  The risk of a crash depends on valuation.  The average PE ratio in 1929 was about 60 times earnings. Fifteen or sixteen is widely considered average, and implies a 6.25% to 6.67% earnings yield.  That’s reasonable.  Today, the PE for the S&P 500 is was 18.94 on 9/26/2014 according to the Wall Street Journal, and that’s a little above normal.  It implies expectations that the economy and growth will continue to accelerate from the anemic post mortgage crisis recovery.

So how do you prepare, just in case?  The conventional approach to hedging the stock market is to incorporate bonds to a portfolio.  You own bonds for either of two reasons; either you need income, or you want to reduce the volatility of a portfolio.  Currently the ability of bonds to generate income is diminished by Fed policy.  While bonds may still provide some stability in the event of a crash, it is widely recognized that interest rates are likely to rise and that will reduce the value of outstanding bonds with fixed coupons.  Choose your poison.

An alternative strategy is to focus on the likely duration of a downturn in the stock market, and plan for expected liquidity needs for that amount of time.  A key benefit of financial planning is that it identifies liquidity needs.  During a period of low interest rates, one can substitute a reserve strategy, often called the Bucket Approach, to provide for anticipated liquidity needs for as long as a crash/correction might be likely to persist.  This frees the remainder of the portfolio for management with a longer time horizon, and with focus of fundamental metrics like valuation and macroeconomic factors.

A Better Financial Planning and Investment Process

When you meet with a financial planner, you might expect to answer a series of questions designed to measure your risk tolerance.  If you are a moderate risk investor, you’ll get a portfolio constructed to accept moderate volatility.  If you are conservative, you’ll get a safe portfolio with limited growth potential.  In other words, your emotional state dictates your investment strategy.

Emotional investing does not often lead to good outcomes.  As an investor, I believe emotions can be your worst enemy.  Evolution wired us as herd creatures based on the safety of numbers.  Straying from the herd is dangerous.  We seek affirmation, which leads to the tendency to buy high and sell low.  According to research from Morningstar Inc., investors routinely underperform the funds they invest in. It is hard to make money doing what everyone else is doing, but we like to buy things after they’ve already demonstrated good performance.

Investing based on an assessment of emotional condition puts disposition at the forefront of investing strategy.  This seems to be the way the financial planning profession approaches investment advice.

I believe that the most important aspect of financial planning is identification of goals and the liquidity required to fund those goals at the right time.  Rather than build the portfolio around an emotionally based risk number, I suggest starting with a rational assessment of liquidity needs.  The greatest risk is having to sell a security when the price is temporarily depressed, converting a temporary loss into a permanent loss.  Let’s address that risk by planning for liquidity events.  The remaining balance can be invested to maximize returns rather than pander to your emotional state.

Emphasize fundamentals like Warren Buffett.  Make tactical adjustments based on fundamentals, and try to keep emotions out of the equation.