March 2010

Tactical Asset Allocation: Adjusting Based on Valuations

The most common method for determining your stock/bond allocation is to base the decision primarily upon your age, then make an adjustment based on your personal tolerance for volatility.

The idea is that, over extended periods of time, stocks are likely to outperform bonds. So the longer your investment time horizon, the more you should have invested in stocks.

But one could (quite reasonably) make the case that the likelihood of stocks outperforming bonds over a given period also depends upon:

  • Market valuation levels at the beginning of the period, and
  • Available interest rates at the beginning of the period.

So wouldn’t it make sense to take those factors into account when determining your asset allocation?

Estimating Future Returns

Tactical asset allocation strategies seek to estimate the future return of the stock market over your investment time horizon. Then, you compare that estimated return to the return offered by other investments–most notably TIPS due to their predictable returns–and determine your allocation accordingly.

For example, if the expected return that you calculate for the stock market is no higher than the current rate available on TIPS, it wouldn’t make sense to hold very much in stocks. (Why take on the additional risk if there’s no additional expected return?)

To date, the best method I’ve seen for estimating future market returns is the Gordon Equation, which states that inflation-adjusted market returns must equal:

  1. Dividend yield, plus
  2. Inflation-adjusted earnings growth, plus (or minus)
  3. The effect of changes in the market’s P/E ratio.

Because of the compounding nature of dividends and earnings growth, as we look at longer and longer periods, the first two factors become the primary determinants of return. Over shorter periods, however, changes in P/E play the biggest role in determining return.

Implementation of Tactical Asset Allocation

So how, exactly, should a tactical asset allocation strategy be implemented within the context of an investor’s lifetime? For example, how should you incorporate your age into the equation (if at all)?

My suggestion would be this: The longer your time horizon, the smaller the risk premium you demand. (That is, the younger you are, the smaller the necessary spread between the expected return of stocks and the available return on TIPS.)

Why? Because the longer the period in question, the more confident you can be in the Gordon Equation’s estimate of future market returns. (Reason being that the first two factors–dividend yield and earnings growth–are the more predictable ones. And the longer the period in question, the greater the portion of returns they comprise.)

Causes for Concern with Tactical Asset Allocation

As much sense as it might make to consider market price levels and market interest rates when determining your allocation, there are a few reasons I’ve been hesitant to implement such a strategy with my own portfolio.

First, regarding the Gordon-Equation-based strategy, there’s always that third factor–changes in the market’s P/E ratio–which simply can’t be predicted with certainty. Even if you can say with a fair degree of confidence that the market is undervalued (or overvalued) there’s really no telling when it will correct itself.

Second, no matter what strategy you come up with, it’s going to have a built-in historical bias. That is, it’s going to be optimized to work in conditions that resulted from the chain of events that occurred over the last 85 years or so (the period for which we have market data). How well it will work over the next 85 years is unknown.

Third, there are numerous funds that implement tactical asset allocation strategies. Yet they don’t appear to make up a noticeably disproportionate amount of top-performing funds. Why is that?

March 31, 2010 7 comments

Why I Don’t Pick Stocks

You’re a weekend poker player. You like to play, and you’re actually pretty good. While visiting a friend, he describes an online poker site he’s been using:

  • There’s a $5 fee to play,
  • You get to pick the game,
  • You get to choose the maximum and minimum bets, and
  • You don’t get to know the identity of your opponent.

Are you interested in playing? If so, how much would you be willing to stake on a game?

And, do your answers change if you know that, more likely than not, your opponent is a professional poker player?

March 29, 2010 9 comments

Tax Deferral and Value Averaging: Weekend Reading

Happy Friday, Dear Readers. A fairly short collection of links this week. I hope you enjoy them. :)

Investing Articles

Other Money-Related Articles

Blog Carnivals

As always, thanks for reading!

March 26, 2010 1 comment

Backtesting Investment Strategies

I just finished reading Jim Otar’s Unveiling the Retirement Myth (mini review: packed with important insights and bizarre hypothetical examples).

Otar explains his approach to investment planning this way:

“Instead of presenting a ‘forecast’ of a client’s future financial picture based on assumptions, [I present] an ‘aftcast’ of client’s potential outcomes based on actual market history.”

In other words, Otar argues that, rather than making potentially faulty assumptions about the future, we should stick to the only real data we have: market history. Otar’s methodology is similar to that of the famous Trinity Study: to determine the viability of an investment strategy, check to see how frequently it would have worked in the past.

I’m in agreement that the fewer assumptions you make, the more well-founded your conclusions will be. But there’s one assumption I’m comfortable making: The future won’t look exactly like the past. And as I wrote last week, there’s a big difference between:

  • “Historically, Strategy X has worked 90% of the time,” and
  • “Strategy X works 90% of the time.”

Conclusions from Hindsight

The fact that an investment strategy (a market timing method, for instance) has not worked historically may be a sufficient reason not to count on it to work in the future. But the fact that a strategy has worked in the past isn’t sufficient evidence that it will work in the future.

When you have the benefit of hindsight (and the computing power and data to back-test any strategy you can come up with), there are an infinite number of investment strategies that will have succeeded based on nothing other than randomness. (Investing based on last year’s butter production in Bangladesh comes to mind.)

Rather than investing based upon back-tested observations like these two provided by Otar:

  • Rebalancing on presidential election years has historically provided the best returns, or
  • If the last year’s market performance was worse than the average of the last six years, next year is likely to be better than average

…I prefer to base my investment strategies on simple concepts. Concepts like the following:

  • Diversifying across many asset classes and many companies helps to reduce risk,
  • Reducing investment costs helps to increase investment return, and
  • Given enough time, most economies will create wealth.

March 24, 2010 9 comments

Single Premium Immediate Annuity: Why They’re Useful and When to Buy Them

The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.

Many annuities (maybe even most) are a raw deal for investors. They carry needlessly high expenses and surrender charges, and their contracts are so complex that very few investors can properly assess whether the annuity is a good investment.

That said, one specific type of annuity can be an extremely useful tool for retirement planning: the single premium immediate annuity (SPIA).

What’s a SPIA?

A single premium immediate lifetime annuity is a contract with an insurance company whereby:

  1. You pay them a sum of money up front (known as a premium), and
  2. They promise to pay you a certain amount of money periodically (monthly, for instance) for the rest of your life.

The payout may be a fixed amount each period (making for a single premium immediate fixed annuity), or it may be linked to the performance of a mutual fund (making for a single premium immediate variable annuity).

Sometimes, the payout on a fixed SPIA will be set to adjust upward each year in keeping with inflation. However, an inflation-adjusted fixed annuity requires a higher initial premium than a fixed annuity without an inflation adjustment.

SPIAs (fixed ones, in particular) are helpful tools for two reasons:

  1. They make retirement planning easier, and
  2. They allow for a higher withdrawal rate than you can safely take from a portfolio of stocks, bonds, and mutual funds.

Retirement Planning with SPIAs

Fixed SPIAs make retirement planning easier in exactly the same way that traditional pensions do: They’re predictable. If you know that you need $X of income each year in retirement, you can go to an online annuity quote provider, put in $X as the payout, check “yes” for inflation adjustments, and you’ll get an answer: “For $Y, you can purchase an annuity that will pay you $X per year, adjusted for inflation, for the rest of your life — no matter how long you might live.”

Pretty easy, right? You now have a specific figure for the minimum amount of savings necessary to retire safely.

With a traditional stock and bond portfolio, retirement planning is more of a guessing game. There are whole books written on the subject of how to determine how large your stock/bond portfolio must be in order to retire safely.

SPIAs and Withdrawal Rates

Fixed SPIAs are also helpful because they allow you to retire on less money than you would need with a typical stock/bond portfolio. For example, as of this writing (Sept. 2010), according to Vanguard’s online SPIA quote provider , a 65-year-old male could purchase an inflation-indexed annuity paying 5.56% annually.

If that investor were to take a withdrawal rate of 5.56% from a typical stock/bond portfolio, then adjust the withdrawal upward each year for inflation, there’s a meaningful chance that he’d run out of money during his lifetime. That risk disappears with an annuity.

How is that possible? In short, it’s possible because the annuitant gives up the right to keep the money once he dies. If you buy a SPIA and die the next day, the money is gone. Your heirs don’t get to keep it — the insurance company does. And the insurance company uses (most of) that money to fund the payouts on SPIAs purchased by people who are still living.

In essence, SPIA purchasers who die before their life expectancy end up funding the retirement of SPIA purchasers who live past their life expectancy.

But I Want to Leave Something to My Heirs!

For many people, knowing that the money used to purchase an annuity will not go to their heirs is a deal breaker. And that’s OK. It’s perfectly natural to want to leave something to your kids or other loved ones.

The important takeaway here is that if your retirement may last thirty years or more, and if your savings are of a size such that you’d need to use a withdrawal rate much higher than 4%, you may not have much of a choice. If you choose not to annuitize — in the hope of leaving more to your kids — the decision could backfire. You could run out of money while you’re still alive, thereby becoming a financial burden on your kids.

What Portion of Your Portfolio to Annuitize

How much of your portfolio should you devote to an annuity? Let’s look at an example.

EXAMPLE: Greg is a 65-year-old male investor with a $600,000 portfolio. To fund his lifestyle, Greg plans to withdraw $30,000 in his first year of retirement and adjust that amount upward each year for inflation.

In other words, Greg wants to use a 5% withdrawal rate ($30,000 ÷ $600,000 = 5%). That’s more than most financial planners would recommend for a non-annuitized portfolio.

If we assume that Greg is comfortable with a 4% withdrawal rate for the non-annuitized portion of his portfolio, and we use the annuity quote from Vanguard mentioned above (5.56% payout for a 65-year-old male), we can calculate the amount Greg should annuitize (A) as follows:

  • 0.0556 x A + 0.04 x (600,000 — A) = 30,000

The answer: If Greg wants to purchase the annuity at age 65, he should put $384,615 into it to achieve a 5% withdrawal rate for his overall portfolio.
But should Greg purchase the annuity at age 65, or should he wait?

When to Purchase an Annuity

Again, using Vanguard’s quote page, we can see that for a 65-year-old male with, for example, $100,000 to annuitize:

  • If you annuitize now, you’ll get a monthly in-come of $463 (which adjusts upward for inflation) for the remainder of your life.
  • If you wait to age 66, an annuity paying $463/month would only cost $95,673.

Therefore, you’re better off waiting if you believe that, between ages 65 and 66, you can invest that $100,000 on your own and, while spending $463 per month, have $95,673 or more left (after adjusting for inflation) when you turn 66. Doing so would require an after-inflation annual return of approximately 1.25%.

The Role of Interest Rates

The above analysis assumes that the payout for an immediate fixed annuity for a 66-year-old one year from now will be the same as the quote for somebody who is 66 today. Unfortunately, that’s not entirely true.

Annuity payouts and premiums change as a function of market interest rates. When market interest rates are higher, annuity payouts are higher as well, because the insurance company knows that it can invest your money at a higher rate of return and can, therefore, offer to pay you a higher rate.

So the decision to delay is a function not only of what inflation-adjusted rate of return you think you could earn over the period in question, but also of where you think interest rates are headed next. If you expect interest rates to rise, delaying annuitization is more attractive than if you expect interest rates to decline.

Annuity Income: Is It Safe?

Because the income from an annuity is backed by an insurance company, financial advisors and financial literature usually refer to it as “guaranteed.”

But that doesn’t mean it’s a 100% sure-thing. Just like any company, insurance companies can go belly-up. It’s not common, but it’s certainly not impossible, especially given that:

  1. The longer the period in question, the greater the likelihood of any given company going out of business, and
  2. The entire point of an annuity is to protect you against longevity risk (that is, the risk that you last longer than your money). So presumably, we’re talking about a fairly long period of time.

However, if you’re careful, the possibility of your annuity provider going out of business doesn’t have to keep you up at night.

Check Your Insurance Company’s Financial Strength

Before placing a meaningful portion of your retirement savings in the hands of an insurance company, it’s important to check that company’s financial strength. I’d suggest checking with multiple ratings agencies, for example:

  • Standard and Poor’s,
  • Moody’s, and
  • A.M. Best

State Guarantee Associations

Even if the issuer of your annuity does go bankrupt, you aren’t necessarily in trouble. Each state has a guarantee association (funded by the insurance companies themselves) that will step in if your insurance company goes insolvent.

It’s important to note, however, that the state guarantee associations only provide coverage up to a certain limit. And that limit varies from state to state. Equally important: The rules regarding the coverage vary from state to state.

For example, Arkansas provides coverage of up to $300,000 per annuitant, per insurance company insolvency. But they only provide coverage to investors who are residents of Arkansas at the time the insurance company becomes insolvent. So if you have an annuity currently worth $300,000, and you move to Illinois (where the coverage is capped at $100,000), you’re putting your money at risk.

In contrast, New York offers $500,000 of coverage, and they cover you if you are a NY state resident either when the insurance company goes insolvent or when the annuity was issued. So moving to another state with a lower coverage limit isn’t a problem if you bought your annuity in New York.

Minimizing Your Risk

In short, annuities can be a very useful tool for minimizing the risk that you’ll run out of money in retirement. But to maximize the likelihood that you’ll receive the promised payout, it’s important to take the following steps:

  1. Check the financial strength of the insurance company before purchasing an annuity.
  2. Know the limit for guarantee association coverage in your state as well as the rules accompanying such coverage.
  3. Consider diversifying between insurance companies. For instance, if your state’s guarantee association only provides coverage up to $100,000 and you want to annuitize $300,000 of your portfolio, consider buying a $100,00 annuity from each of three different insurance companies.
  4. Before moving from one state to another, be sure to check the guarantee association coverage in your new state to make sure you’re not putting your standard of living at risk.

One last point about annuitizing: Even if your only goal is to maximize your spending power, you may not want to annuitize everything. The reason is that annuities cannot easily be sold. And, since it’s always possible that you’ll be faced with a sudden, large expense, it’s usually best to keep a portion of your portfolio in liquid assets: stocks, bonds, cash, and so on.

Simple Summary

  • Single premium immediate fixed annuities can be helpful because they allow for a higher withdrawal rate than would be sustainable from a typical portfolio of other investments.
  • In exchange for this increased safe withdrawal rate, you give up control of the money as well as the possibility of leaving the money to your heirs.
  • The decision of when to purchase an annuity is a function of the rate of return you would earn on a non-annuitized portfolio, the rate at which annuity payouts increase with age, and the direction in which you believe interest rates are headed.
  • Before buying an annuity, check the financial strength of the insurance company and make sure you’re familiar with the rules and coverage limits for your state’s guarantee association.

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March 22, 2010 0 comments

Do You Pay Taxes? Weekend Reading

The Tax Foundation recently released a report showing that in 2008, approximately 1/3 of tax filers paid no income tax whatsoever. Kelly Phillips Erb and Kay Bell each do a great job of explaining why this is such a cause for concern:

Meanwhile, The Tax Foundation had two other particularly good reads this week:

Personal Finance Articles

Oblivious Investor on Tour

Blog Carnivals

Thanks for reading!

March 19, 2010 0 comments

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