Letter to Our Clients - September 2005
To My Friends and Clients:
Summer is winding down. So far 2005 has not been much to brag about for investment returns. The good news is that it has not been a big loss year either – so far! It has now been almost 3 years since we pulled out of the 2000 to 2002 bear market. Are we due for another downturn, or...?
Not even Alan Greenspan knows. In 1996 he complained of “irrational exuberance” and tried to rein in the stock market. He was not successful then. In recent speeches Greenspan has made it clear he intends to keep raising short-term rates, but admits he is befuddled as to why long-term rates have not also gone up. “Asset prices” have risen to unsustainable levels, he has said, and “history does not treat kindly” those who disregard the danger signs. At the end of this letter I have quoted from a Greenspan speech of August, 2003. It makes for difficult reading, but I found it fascinating. Naturally I added my comments, which can either serve as a summary or a “Cliff’s Notes” version.
Investment Planning – For Those Now Retired – or Almost There!
When I ask people to define risk, they generally say something like “losing my money.” However, investors react most strongly when they see that their account drop in value, usually using as their base the high point of their portfolio. This decline in market value is then translated into “losing money,” and this is what drives most investment decisions. But fluctuation is not the real threat for someone depending upon their investment accounts for retirement cash flow. Spending down principal is the greatest risk.
The long-standing philosophy about how to use investments for retirement is to pick a withdrawal percentage that seems “safe.” In the 1990’s, for example, it was common to suggest that an 8% withdrawal rate was safe, and that 10% to 12% was practical but would need watching. The 2000-2002 bear market has caused the “experts” to reduce the withdrawal percentage to 3.5% to 4.5%, depending upon how optimistic is the expert. However, they still preach the concept that it is safe on a consistent basis to sell stocks, bonds or funds, and use the proceeds for retirement distributions.
I do not believe this approach is prudent. In the 2000-2002 period, a portfolio with fluctuation range similar to the S&P 500 would have been down more than 40%. Withdrawals from principal at any level with this kind of market drop increase the likelihood that the account will be spent to zero.
The “safe” approach, in my opinion, is to withdraw from the account only what is generated by interest and dividends. This figure will change over time, as companies increase or decrease their dividends, as bonds mature and are replaced with higher or lower yielding bonds. Some of the underlying stocks likely will become worth less, some will grow in value. Overall, though, the cash flow should stay relatively stable, as will the principal.
For those who want to spend their children’s inheritance, I would urge caution. Spending down principal is always an investor’s choice, and will be especially tempting after a lifetime of careful saving. However, until you know the date of your death, you do not know how much you will need to spend. Withdrawing from principal to meet income needs increases the risk that the money will not be available for end-of-life care.
If most of the income is generated by dividends from stocks then it is also possible that – over time – both the income stream and the underlying portfolio value will increase. The problem with bonds, even high-quality bonds, is that they mature at a stated value and thus have no appreciation potential, and their cash-flow is locked in from the date of purchase and again has no appreciation potential. Their attraction is that cash flow and ending values are predictable their disadvantage is that inflation reduces the buying power of both the income and the maturity value.
How is it that investing in stocks can offer the possibility of increased income and appreciation? Assume a stock is selling for $20 per share, and is paying a dividend equal to $1 per year, or $0.25 per quarter. This represents a 5% dividend ($1 dividend divided by $20 share price). If the share price goes to $40 per share and the dividend remains $1 per share, the yield to the new buyer will be 2.5% ($1 dividend divided by $40 share price). The investor who purchased at $20 a share is still receiving $1 per share of income, or 5% on their initial investment.
If the share price drops to $10, a new investor will obtain a 10% yield ($1 divided by $10), while the original investor is still receiving the $1, or 5%, they obtained at the time of their purchase.
This is how cash-flow can stay relatively stable. While the stock price goes from $20 to $15 to $30, as long as the dividend stays at $1 per share, the income received from that stock remains the same.
Cash flow can go up when companies are sufficiently profitable that they can raise their dividend. Some companies can boast of raising dividends every year for decades. I have read that the Bank of New York has paid dividends every year since it became a publicly traded stock in 1792! Cash flow can go down when companies encounter difficulty and reduce their dividend. Kodak and Ford are two companies that come to mind that have reduced their dividend since 2000.
There will be fluctuation of principal, but a portfolio built for income in this way should be viewed as similar to an income real estate investment, that is, one does not fret constantly about whether the value of the property/account is up or down. During the 2000 to 2002 period, many stocks saw their share prices drop by 50% or so, yet their dividends either stayed the same or increased. Some of them have regained the stock prices of 1999, some have not, and some have gone up past their 1999 values. Over time a well-managed portfolio offers the opportunity to have income slowly rise and asset values slowly rise.
This is how one can invest for income and maintain a relatively predictable cash flow without worrying about the ups and downs of the overall portfolio value.
Please be certain to call if you have questions or concerns, of if you would like to schedule a meeting. I look forward to talking with you again.
Robert K. Haley, JD, CFP®, CLTC
REMARKS OF CHAIRMAN GREENSPAN
“Monetary Policy Under Uncertainty”
August 2003, Jackson Hole, Wyoming
as quoted by John Mauldin, on August 12, 2005
(The speech started as follows:)
“Uncertainty is not just an important feature of the monetary policy landscape it is the defining characteristic of that landscape….*
(The rest is excerpted from different sections of the speech:)
“Despite the extensive efforts to capture and quantify these key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and in all likelihood will always remain so. Every model, no matter how detailed or how well designed conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis. Consequently, even with large advances in computational capabilities and greater comprehension of economic linkages, our knowledge base is barely able to keep pace with the ever-increasing complexity of our global economy...*
“What then are the implications of this largely irreducible uncertainty for the conduct of monetary policy? … In implementing a risk-management approach to policy, we must confront the fact that only a limited number of risks can be quantified with any confidence. And even these risks are generally quantifiable only if we accept the assumption that the future will replicate the past. Other risks are essentially unquantifiable *… because we may not fully appreciate even the full range of possibilities, let alone each possibility’s likelihood.”
* Emphasis inserted by Haley
Many believe Alan Greenspan has been a genius at guiding the financial markets, while others feel he is overrated and responsible for the bear market of 2000 to 2002. I think he is a very intelligent individual with many competencies who has been less than perfect along the way. I do not mean to be flippant, but I really do feel this summarizes the intent of his speech:
1. “I don’t really know how things will turn out.”
2. “It is not possible for anyone to scientifically determine what is the best thing to do, or even to know what are the potential outcomes for any decision.”
3. “I am/we are doing the best we can.”
4. “Trust us – even though we don’t know what we’re doing.”
* For illustration purposes, assume a starting retirement portfolio value of $1,000,000. Withdraw 4% Year 1 ($40,000) leaves a balance of $960,000. Assume down 10% for Year 1 ($96,000) equals $864,000. Withdraw 4% Year 2 ($34,560) equals $829,440. Assume down 10% for Year 2 (82,944) equals $746,496. Withdraw 4% Year 3 ($29,859.) equals $716,636. If zero gain or loss in Year 3, a 4% withdrawal Year 4 ($28,665) reduces the account to $687,970.
Year 4 the account is down 31%. With no further withdrawals the account must go up about 45% to return to the original $1,000,000.
The annual income withdrawals of 4% have gone from $40,000 to less than $28,000, a drop of over 25%.