Review of William Bernstein’s new e-book on Lifecycle Investing

William Bernstein is beginning an experiment of sorts. He is writing a series of low-cost e-books called Investing for Adults. The first of these is now available: The Ages of the Investor: A Critical Look at Life-cycle Investing (Investing for Adults).

As he notes, these books are not for beginners. They are for adults who have outgrown their beliefs in stock-picking fairies, market-timing fairies, and risk fairies. I think the first two are clear. The risk fairy tells you that the risks of holding stocks decline with time. Despite the name “expected returns,” you cannot simply expect greater returns for having loaded more funds into volatile assets.

The book is relatively short and is fully of interesting insights. I think it is definitely worthwhile. He divides investing life into three phases: the beginning, middle, and end.

The Beginning

For the beginning phase, the overwhelming consideration is that one’s human capital (the present value of future earnings) will likely dwarf in size one’s portfolio of stocks and bonds. This is a justification for allocating more assets to stocks when young. As well, he discusses in detail the interesting issue of lump-sum investing versus period contributions. Young people are generally forced to contribute new funds as they age (they can’t borrow their human capital at the start) and this reduces volatility and allows them to take advantage of market dips.

Bernstein discusses age-in-bonds, the Ayres/Nalesbuff strategy of leveraging to 2:1 in stocks when young in order to better balance stock holdings with human capital, call options on a stock index as another way to leverage assets, and also the Fama-French approach to focusing on risk factors related to small-capitalization and value stocks.

Despite the fact that young people can take much greater financial risk, Bernstein argues that young people are actually quite risk averse and should probably start with no more than 50% stocks. Then, they should gauge their reaction after experiencing their first big market drop to decide whether their appropriate stock allocation might be more or less than 50%.

The End

As for the retirement phase, Bernstein describes the goals-based approach to retirement income flooring. The objective becomes to secure lifestyle needs and take as little risk as possible. Retirees should build two separate portfolios in retirement: a “liability matching portfolio” (LMP) structured to support desired lifestyle spending with inflation-protected and secure assets, and a “risk portfolio” with any remaining assets which can be used for luxuries and bequests. As RIIA says: first build a floor, then expose to upside.

He describes various options for the LMP portfolio, including inflation-adjusted single premium immediate annuities, a ladder of TIPS, delaying Social Security to 70, and a mix of TIPS and deferred annuities. He also discusses part-time work and a portfolio of stocks and bonds. He notes that about half of the dividend yield on stock holdings could be treated as part of the LMP.

He indicates that it is tough to know which risk is greater: running out of funds because you live longer than the end date for your bond ladder, or running the risk of a systematic financial crisis that wipes out the ability of the insurance company and the state guarantor to provide you with your annuities payments. 

He does look at several examples of people with different spending needs. A rule of thumb he provides is that by age 70, people should have enough safe assets to fund at least 20 years of spending needs after accounting for Social Security and other pensions. Of course that is very tough to do, especially in today’s low interest rate environment.

The Middle

This period is saved for the end because it is about shifting from the aggressive early part of life to the defensive latter part of life. There’s lots of interesting tidbits here, including the idea of waterfalls which get at the heart of intergenerational risk. Those born just a few years apart may have very different lifetime investing experiences. To me, this suggests a need for intergenerational risk sharing as we enjoy with programs such as Social Security. Relying solely on defined-contribution pensions means relying much more on luck.

All in all, this is a very worthwhile e-book and I am looking forward to the next volumes in this series.

Retirement Income and the Tyranny of Compounding Fees

Clearly, the wonderful magic of compounding returns has been overwhelmed by the powerful tyranny of compounding costs.

-          John Bogle, Enough, p. 42

Another optimistic assumption of classic safe withdrawal rate studies is that investors are able to earn precisely the underlying index returns, even after accounting for any portfolio management fees, risks that active management does not precisely match the underlying benchmarks, or behavioral and timing mistakes of buying high and selling low. In reality, many investors will find that their investment returns will lag behind the annually rebalanced and indexed portfolios enjoyed by the hypothetical retiree in the safe withdrawal rate studies.

Here, I will look at the impact of fees and/or account underperformance. When discussing a 1% fee, what I mean is that at the end of each year the remaining account balance is reduced by 1%. This could result from actual fees or from other types of investor underperformance compared to the indices. I simplify by just referring to it as a fee.

I am using the same assumptions as described in my entry on William Bengen’s SAFEMAX. These assumptions include withdrawals at the start of the year, annual rebalancing from a 50/50 portfolio of stocks and bonds, a 30-year retirement, and inflation-adjusted withdrawal amounts. The two cases are for no portfolio fees, and for a 1% annual fee. Data is from the SBBI Yearbook.

First, Table 4.1 shows the maximum sustainable withdrawal rates for the baseline case with and without fees. In both cases, 1966 retirees are the source of our SAFEMAX. Without fees, a 1966 retiree could sustain withdrawals over 30 years using a 4.04% withdrawal rate. With a 1% fee, the SAFEMAX fell by 0.48 percentage points to 3.56%. From the perspective of the SAFEMAX, a 1% fee would have resulted in reduction of potential spending power by 11.9%. Across the historical period, fees caused the maximum sustainable withdrawal rates to fall on average by 0.63 percentage points or 11% of spending power.

Despite common misconceptions, there is not a one-to-one tradeoff between fees and withdrawal rates. As the portfolio decreases in size, fee amounts decline while real withdrawal amounts do not change.

Table 4.1 Maximum Sustainable Withdrawal Rates (MWRs) Cases: (1) No Fees,  (2) 1% Annual Fee For 50/50 Asset Allocation, 30-Year Retirement Duration, Inflation Adjustments Using SBBI Data, 1926-2011, S&P 500 and Intermediate-Term Government Bonds
Year	MWR (No Fees)	MWR (1% Fee)	Difference	Year	MWR (No Fees)	MWR (1% Fee)	Difference
1926	7.28	6.47	0.81	1955	5.59	4.9	0.69
1927	7.03	6.24	0.79	1956	5.03	4.4	0.63
1928	6.03	5.35	0.68	1957	5.18	4.53	0.65
1929	5.12	4.54	0.58	1958	5.62	4.91	0.71
1930	5.39	4.79	0.6	1959	4.91	4.29	0.62
1931	5.81	5.16	0.65	1960	4.87	4.25	0.62
1932	7.13	6.34	0.79	1961	4.82	4.21	0.61
1933	6.78	6.02	0.76	1962	4.38	3.83	0.55
1934	5.63	5	0.63	1963	4.64	4.07	0.57
1935	5.79	5.14	0.65	1964	4.35	3.82	0.53
1936	4.91	4.36	0.55	1965	4.11	3.62	0.49
1937	4.35	3.87	0.48	1966	4.04	3.56	0.48
1938	5.55	4.95	0.6	1967	4.41	3.91	0.5
1939	4.75	4.24	0.51	1968	4.18	3.71	0.47
1940	4.8	4.3	0.5	1969	4.2	3.73	0.47
1941	5.19	4.65	0.54	1970	4.83	4.31	0.52
1942	6.26	5.62	0.64	1971	4.81	4.3	0.51
1943	6.47	5.81	0.66	1972	4.64	4.16	0.48
1944	6.15	5.52	0.63	1973	4.44	4	0.44
1945	5.93	5.32	0.61	1974	5.27	4.76	0.51
1946	5.28	4.73	0.55	1975	6.89	6.24	0.65
1947	6.69	6	0.69	1976	6.4	5.8	0.6
1948	7.42	6.64	0.78	1977	5.99	5.44	0.55
1949	7.76	6.93	0.83	1978	6.93	6.3	0.63
1950	7.29	6.49	0.8	1979	7.64	6.95	0.69
1951	6.97	6.18	0.79	1980	8.31	7.56	0.75
1952	6.89	6.09	0.8	1981	8.51	7.73	0.78
1953	6.59	5.8	0.79	1982	9.77	8.87	0.9
1954	6.85	6.01	0.84	1983 +	30 Years of Data Not Yet Available
Note: SAFEMAXs are boxed. All MWRs below 4% are bold-faced.

The tyranny of compounding fees is shown even more starkly in Table 4.2. This table shows the remaining real value of wealth after 30 years for someone who retired with wealth of 100 and used a 4% withdrawal rate. Over the 30-year period, annual real withdrawal amounts are 4. With the other standard assumptions, this table shows the remaining wealth for the cases of no fees and a 1% fee. About these calculations, when wealth falls below zero, fees are no longer deducted. Real wealth is shown as negative to reflect the total desired real withdrawal amounts which could not be taken from the portfolio.

The difference in wealth amounts between the two columns shows the combined impact on wealth of a 1% annual fee. The combined impact of the fees include both the actual fee paid and the loss of subsequent capital gains and interest that would have been earned if the fee amounts had stayed in the investment portfolio.

With a 4% withdrawal rate and a 30-year retirement period, the total withdrawals enjoyed by the retiree add to 120. Clearly, when the portfolio grows, the fees paid are larger. In some cases, which are both lucky and shocking, the retiree ends up paying more through the 1% fee than they do for their retirement spending on everything else. That can be seen clearly for the 1982 retiree who had real wealth of 465 after 30 years in the no fee case.  Note that compared to a withdrawal of 4, 1% of that wealth amount is 4.65. In total, fees for the 1982 retiree led to a total reduction in potential wealth of 145.2.

Though the 4% withdrawal rate was sustainable in every rolling period from this historical data, a 1% fee would have fully depleted the wealth for 8 of the 57 retirees. Though the total lifetime fees paid by these unlucky retirees tend to be less, this is only because they experienced rapid wealth depletion which limited fee collections. For a further example, a 1970 retiree would have maintained the real value of their principal when not paying fees, but the real value of their principal would only be about 30% of its initial value when fees are included. Since timing the market and actively selecting investments is quite difficult, this table strongly suggests that retirees should consider whether low-cost index funds may better suit their needs.

I do not mean to suggest that the services of a financial planner may not be helpful. If a planner helps a retiree to choose a reasonable asset allocation and to stay the course and avoid behavioral mistakes, then the overall gains from these actions could more than make up for the impacts of fees. My attack on fees is more directed at overpriced mutual funds than anything else. 

Table 4.2 Remaining Wealth After 30 Years (Measured in Real  Terms) Using a 4% Withdrawal Rate and Retirement Date Wealth=100 50/50 Asset Allocation, Inflation Adjustments for Withdrawals Case: (1) No Fees, (2) 1% Annual Fee Using SBBI Data, 1926-2011, S&P 500 and Intermediate-Term Government Bonds
Year	Real Wealth (No Fee)	Real Wealth (1% Fee)	Total Cost of Lifetime Fees (Fees and Missing Capital Gains)	Year	Real Wealth (No Fee)	Real Wealth (1% Fee)	Total Cost of Lifetime Fees (Fees and Missing Capital Gains)
1926	255	160	95	1955	74	35	39
1927	227	140	87	1956	56	18	38
1928	138	76	62	1957	71	27	44
1929	85	34	51	1958	96	46	50
1930	106	50	56	1959	55	15	40
1931	138	74	64	1960	60	15	45
1932	257	160	97	1961	54	12	42
1933	210	127	83	1962	28	-8	36
1934	129	66	63	1963	48	5	43
1935	147	78	69	1964	27	-10	37
1936	75	25	50	1965	8	-20	29
1937	27	-8	35	1966	3	-24	26
1938	125	64	61	1967	38	-6	44
1939	61	16	44	1968	19	-18	37
1940	57	17	39	1969	23	-17	41
1941	85	38	46	1970	103	32	71
1942	164	97	67	1971	95	30	65
1943	184	111	73	1972	68	15	54
1944	140	81	58	1973	43	0	43
1945	99	56	43	1974	134	66	68
1946	69	33	36	1975	306	194	112
1947	155	95	60	1976	238	146	92
1948	174	111	63	1977	198	116	81
1949	178	115	63	1978	291	186	105
1950	150	94	56	1979	288	190	98
1951	135	83	52	1980	358	240	117
1952	114	69	45	1981	376	253	122
1953	112	66	47	1982	465	320	145
1954	131	78	53	1983 +	30 Years of Data Not Yet Available
Note: All wealth values below 100 are bold-faced. When wealth reaches zero, real withdrawal amounts are deducted to show the degree of underfunding from the spending goal. No further fees are collected.