Retirement Income Drawdown Part 2: Inflation and Market Returns

Retirement Income Drawdown

Part 2: Inflation and Market Returns

Hello $wanigans! Welcome back to The Green Swan! We continue today with my thoughts on Retirement Income Scenario Matrices (RISMAT) as authored by Nobel Laureate William Sharpe. A good chunk of Dr. Sharpe’s analysis in his 729 page book is related to code for MATLAB which helps model and simulate retirement through matrices and other inputs for financial advisors.

However, there are also a load of takeaways through his thoughtful analysis and the way he goes about thinking and solving investment “decumulation” challenges.

In a prior post, I introduced RISMAT and provided my initial thoughts on longevity which is a key variable in any retirement investment drawdown strategy.

Today I will be taking a look at Dr. Sharpe’s thoughts on inflation and market returns.

Inflation

Let’s start with the obvious. In retirement, the objective is to generate income for the purpose of buying goods and services to support an enjoyable lifestyle. While the endpoint of a happy lifestyle in retirement is what we’re trying to gauge and maintain, everyone spends money in that pursuit differently. Therefore, there is not a specific index to measure the cost of maintaining a specified level of happiness for you or any other particular consumer of household.

Instead, we are left with using a generic economy-wide gauge such as the Consumer Price Index (CPI). While that may not be a great gauge to maintain your individual happiness levels throughout retirement, it is still better than ignoring price changes completely.

So what should we expect to see on the inflation front?

I’ve always found that having a solid historical perspective helps frame future expectations.

The chart below shows US CPI from 1871 to 2014 per the website of Robert Shiller from Yale University.

Retirement Income Drawdown

Looking back on CPI beginning in 1871 can be quite a scary picture. As shown in the chart, prior to WW2 inflation was all over the board…jumping up 20% in a year and dropping 10% or more in other years. Additionally, the 1920s and 1930s saw more deflation than inflation. Gees, what wild times!

However, in more recent eras, inflation has been more stable which is reassuring. The US Federal Reserve Bank does have modest inflation as a stated goal which it targets at 2%. From 2000 to 2014, they’ve done fairly well with that target with the average change in cost of living being 2.25% with a standard deviation of 1.09%.

Prior to having read RISMAT, I long held the belief that while inflation can erode the value of stock market appreciation, that it wasn’t a huge deal because the two were correlated. I thought if we were to experience significant inflation, I should expect stronger market performance to offset the impacts.

Well that isn’t the case so much. As shown in the chart below from data on Robert Shiller’s website, there is only a very small positive correlation year in and year out.

Retirement Income Drawdown

Concluding Thoughts on Inflation

While I can’t hang my hat on strong market performance to offset times of peak inflation, I am more comfortable in the US Federal Reserve Banks ability to moderate inflation.

Dr. Sharpe also did go into Purchasing Power Parity briefly. That is to say, things I buy locally may be cheaper (or more expensive) in other locations. He talks about the Big Mac Index which has been calculated by The Economist since 1986 which demonstrates this exact principle. While across a large “basket of goods” the cross-border variances in prices will converge over time, this may be an interesting tool for two reasons.

First, the Big Mac Index could be a particularly useful guide when determining where to travel in retirement and get the most bang for your buck.

And secondly, say you need to stretch your retirement investments for a year or two because of bad returns or increased inflation…perhaps extended stays in lower cost countries is a solution. Maybe the details would be hard to work out, but something to think about and consider.

Market Returns

Dr. Sharpe focuses his analysis on market returns on two investment asset classes: riskless and risky. While this may seem oversimplified, he explains that it isn’t as limiting as you may think when modeling prospective returns since they can be combined in a myriad of ways.

In terms of my personal view, I’m a big believer in the long-term returns of the stock market and I am 100% invested in it (primarily through broadly diversified domestic and international index funds). That would fall into his category of a risky asset. And I’m fine with that since I’m a long term investor.

Since I’m not overly concerned with the riskless asset (defined as inflation protected securities – TIPS), I didn’t focus much on Dr. Sharpe’s discussion here. But I did find it fascinating that inflation protected bonds as we know them today are a relatively new phenomenon. In 1981, the UK issued its first “linkers” based on the General Index of Retail Prices (RPI) and, for the US, it’s first Treasure Inflation Protected Securities (TIPS) were issued in 1997. That really isn’t that long ago!

Given the major secular changes in TIPS rates since their relatively recent introduction, it is hard to gauge how well they track traditional non-indexed government bonds. Especially considering how interest rates are in uncharted territory in recent years.

In either case, they aren’t for me. If you’re curious to know more, check out Chapter 6 of RISMAT…it’s only 14 pages long. I’m more focused on what Dr. Sharpe has to say about the risky returns.

“Risky Assets”

I think it is safe to say that Dr. Sharpe is in favor of a simple world with a simple “market portfolio” constructed of EVERY publicly traded security held in proportion to the total amount outstanding. While you can not buy such single index fund today, you instead have to resort to a combination of four index funds (US stocks and bonds & international stocks and bonds). The values of said four components and respective weights as of June 30, 2015 are outlined below:

Retirement Income Drawdown

Note that if you are like me and consider yourself as a stock-only investor, then to have equal weights of US and Int’l it would be 54.5% and 45.5%, respectively. I myself weight about 35% of my portfolio toward international which would be slightly more conservative given the general higher risk profile of international stocks.

If you are an index investor (which I predominantly am), you can feel good knowing that your investment class selection has the support of a very smart man in Dr. Sharpe. But what do you expect, he’s an academic after all.

He goes so far as to say about “smart” investments strategies:

“In this sense a strategy that can successfully “beat the market” will carry the seeds of its own destruction.”

Later on he says:

“Financial history is replete with examples of cases in which an investment approach with superior past performance fails to “beat the market” in the future.”

And lastly:

“In any event, it pays to be very skeptical indeed of schemes that purport to be able to ‘beat the market’.”

He goes on and on with numerous examples and calculations to support his rationale of the market portfolio.

Are you surprised in his point of view on “smart” strategies…after all that is the general foundation of the Capital Asset Pricing Model (CAPM) and Sharpe Ratio for which Dr. Sharpe is known for being behind. Additionally, he was one of the primary advocates of index funds having helped built the first one institutionally for Wells Fargo…a fact that I’m pulling off memory after having listened to him on the Masters in Business podcast with Barry Ritholz.

Returns of the Risky Asset

So how much should we expect the market portfolio to return in the future? Isn’t that the ten million dollar question? Of course nobody can answer that, even Dr. Sharpe, but it does help to look at historical returns.

Dr. Sharpe looked at a 60 / 40 split between the S&P 500 index and 10-Yr US Treasury Bonds and adjusted the historical returns for inflation. From 1928 through 2014, the arithmetic average real return was 5.88% with a standard deviation of 12.57%. Nearly 6% isn’t all that bad! This would of course vary (and be higher…) with an all stock portfolio which I’ve outlined in my invest to win post.

Additionally, a broader view to include international investments was provided in Triumph of the Optimists: 101 Years of Global Investment Returns which estimates the average real returns of 5.0% with an estimated standard deviation of 12.83% per year.

As for future returns, Dr. Sharpe is cautious:

“Political affairs, technology, communications, financial markets and financial economics have all changed radically over the last several decades. And they will undoubtedly change substantially in the future. When estimating future return distributions, humility is very much in order.”

For early retirees, I think that calls for conservative estimates and plenty of cushion!

Concluding Thoughts

My picture of retirement consists of aggressive asset allocation (an all stock portfolio) and yet ultra conservative estimates in terms of my retirement lifestyle and the size of my investment portfolio having plenty of cushion to support said lifestyle. That may be confusing to you, but it makes sense to me:

Step 1: I plan (hope!) on having a long retirement horizon. I need my investments to last. The best investment class for long term performance is stocks (after-all, I want my retirement to be long…). If I hold a broad swath of these stocks with US and Int’l index funds, I should be good.

Step 2: Given the long time frame and multiple life-stages my retirement will cover along with plenty of known unknowns and unknown unknowns, it is better to be safe than sorry in estimating our annual costs to live.

Step 3: The 4% Rule is a solid estimate for a safe withdrawal rate, but there do seem to be some flaws. Therefore, a slightly more conservative 3.5% withdrawal rate feels better to me.

What does Dr. Sharpe think about the 4% Rule?! We’ll find in Part 3 of my RISMAT overview series as Dr. Sharpe begins to dive into specific withdrawal strategies. I’m here to provide the overview so stay tuned!

Thanks for taking a look!

The Green Swan

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6 Comments

  1. I’m glad you’re giving this so much thought! I imagine once I have a portfolio that is too big to lose I’ll care quite a bit more about asset allocations and expected returns. I’m curious about your decision to hold a relatively high percentage of international stocks in your portfolio and how you defend the incessant rumbling that international funds are too risky. I believe it was Jim Collins who argues that holding a broad US-based index fund would supply enough coverage in international markets simply because companies in the US already have “global” business ventures. Just curious as I am 100% vtsax at the moment but always looking for advice from more experienced investors 🙂

    1. To me the global exposure is simply to diversify my equity exposure. There’s a lot of great companies abroad and having a world wide portfolio helps make it more broad based. Similar to small caps, foreign exposure does come with a higher risk reward trade-off which over a long term should pay off (2017 has been great for international!). And broadly speaking, each category helps balance out the other… Not everything does great every year! That’s my view and stance anyway but I’m not an expert by any means. We all have to weigh the pros and cons. Good to know that Dr Sharpe has a similar view as me though.

  2. JW, thank you for reading his 729 pages, and boiling it down the the key elements for us in your articles. Interesting read. Curious, with your large exposure to stock, how many years of cash are you carrying to ride out any bear markets? I’m only ~50% stock, but am planning to have ~3 years in “Bucket 1” (cash) when I implement my bucket strategy for next summer’s retirement.

    1. Well I still have some time before I pull the retirement trigger so I hold the right to change my mind, but I don’t plan on holding more than a half year or one year maybe in cash. Not much.

      To me, equities are the best place for return and I don’t expect that to change. So the key is being able to ride out the waves which I plan on doing simply through having more than I need in retirement investments and cutting back discretionary spending slightly if need be. A large portfolio offers great flexibility in taking this risk which again in the long run should make longevity risk moot.

      I certainly understand the draw of having a large cash surplus though. The peace of mind would be great.

  3. I am more than 10 years away from reaching FIRE. At that point, I am planning on having a 50/50 balanced portfolio. I am planning on adding a portion of TIPS to my fixed allocation at that point.

    1. Thanks for sharing your strategy, Dave! Sounds like a safe and conservative approach which should provide for a stable and long retirement. Thanks for sharing!

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