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Many
years ago an older couple came into our office to discuss replacing
their portfolio-the sole source of support for their retirement
life- with our strategies. There were plenty of securities that
we thought had meager prospects, and several speculative issues
which really were inappropriate. However, much of the portfolio
consisted of blue chips purchased in the nineteen fifties and
sixties, names like Merck and General Electric, held through good
times and bad for the companies, held through the Vietnam War,
Arab oil embargoes, rampant inflation, stagflation, disinflation,
bubbles up and bubbles down. They never sold anything-it was like
a grandma's attic of corporate equities.
There
was a great treasure in that attic, great for them and enlightening
for us. As we perused their assets and the cost of those assets,
we began to connect the dots between what they had paid for the
stocks and the dividends those companies were now paying. The
so-called "current yield" on the portfolio was nothing
to write home about, but the yield on what they had paid originally
was astronomical. You might not notice that a certain stock was
paying $3 a share in dividends for a current yield of about 2%,
until you realized that their cost for those shares, adjusted
for splits, was, 30 years prior, also about $3 per share. Not
only had the stocks risen twenty- and thirty-fold over the decades,
but their return from income alone, based on original cost, was
in many cases over 100%. Each and every year they were making
roughly 100% on those original investments no matter what the
volatility of the stocks. Even adjusting for inflation, in current
dollars their income return on cost was well over 30%.
Of
course the stock prices grew because the underlying businesses
grew. But could we separate that from the fact that dividends
grew so much? Could Merck, Vioxx and all, possibly sell today
at a price that would provide a dividend yield of 100%? Of course
not. The stock price would rise if for no other reason than that
the dividends increased. That, we saw, was the quantitative or
numerical way of determining whether an investment was a good
one: amidst the chaos of information and interpretation and competition
and creative destruction and changes in the economy and the world,
one principle stood out as elemental and immutable. As the dividend
increases, eventually the price of the stock producing that dividend
will increase as well.
The
principle here is critical, both for investors seeking to accumulate
wealth, and even more importantly today, for investors hoping
that investment assets will support their later years. As the
Baby Boom generation eases into retirement, the notion of distribution,
of spending from assets, has become the subject of the day. Whereas
in the past investment was all about accumulation and building,
investors now realize that their investment capital must provide
"life support" from now and into old age. The definition
of "old age" itself has been greatly expanded by advances
in medical science-and therefore the need for savings to support
the distribution phase has stretched even further.
This
problem is not simply a matter of scratching out numbers on a
yellow pad. The problem is deep, and the proposed solutions that
have been put forth to date don't seem adequate to us. What's
deep is the "bag lady" fear that can afflict both men
and women. What happens to me if I'm not working and the market
crashes? What happens if I live to be 95 rather than the 85 I
expect and I can't pay anyone to help me? In the most subterranean
levels of the unconscious, no matter how affluent we are today,
we can imagine (and somewhere inside we have imagined) it all
going horribly horribly wrong- our expenses got too high, our
assets got too low, all the work and toil to build our wealth
for naught, because it wasn't enough…
How
can we make our savings last? A small industry of planners and
advisors has arisen recently to address this problem, proposing
plans that are, in our view, both overly complex and frighteningly
fragile as solutions. Most suggest a withdrawal rate of 4-5% per
year plus increases to reflect inflation, drawn from a portfolio
of diverse assets that isn't very different from earlier portfolios
recommended during the accumulation stage, just more conservative.
The
question that arises when looking at these plans: will the assets
be there to be withdrawn? Gains from stocks are always presumed,
but history tells us that those gains don't necessarily arrive
on a convenient schedule, and can be absent for years and years.
This is a much trickier area than accumulation investment planning,
because to some extent-through withdrawals and the steady increase
of those withdrawals-the investor is always undermining the notion
of long-term compounding. Without a presumption of rising equity
markets there are fewer and fewer assets but the assets remaining
are asked to produce higher and higher withdrawals. And rising
markets must be part of the equation. If one relied only on bonds
(which do not rise), for example, 5% withdrawals plus inflation
increases could completely wipe out the portfolio in as little
as 13 years during a period of normal inflation.
A
50-50 bond and equity portfolio using historical equity returns
fares better, extending the assumed "life" of the portfolio
to 20 years (though that's not exactly a "safe" duration
for most people). The source of this duration extension is the
assumed greater return from stocks. There is a further assumption
that a portion of the gains from stocks can be captured and spent,
an assumption that, essentially, stocks will grow enough after
taxes to compensate for the relentless withdrawals that attack
the portfolio like carpenter ants.
Clearly,
the more equity the longer the withdrawals may be sustained-in
theory. But theory doesn't account for the realities a retiree
will experience during a severe bear market. What if the market
doesn't come back, or doesn't come back in time? A reasonable
fear, for we've seen periods even in recent history where stocks
have not performed according to theory. If you retired in 1968,
for example,"If you retired in 1968, for example, you would
have, unbeknownst to you, embarked on a 14-year period in which
stocks did not gain the proverbial 10% per year, but in which,
point to point, they in fact gained nothing.
Putting
aside for the moment the fact that there was some yield from equities
during the period (though you might have invested in nondividend-
paying equities, anyway), at a withdrawal rate of 5% plus inflation
you would not have lasted the entire "flat" period before
ruin. You would at best have had almost no capital left to capture
any gains from the bull market that began in 1982. You can see
what we mean by suggesting most plans are frighteningly fragile.
Over the past 100 years it has not been that uncommon for stocks
to go 5 or even 10 years without gains. And all the while you're
withdrawing. Gulp. If the "total returns" from which
you are withdrawing do not arrive as predicted, and pretty much
on a regular schedule, your plan risks failure. The results could
be devastating.
In
fact, it may be time to question the concept of total return itself,
when it comes to a distribution portfolio. As any accountant will
tell you, total return is the sum of income and capital appreciation,
and, your accountant will further tell you, except for tax issues
there's no difference between appreciation and income. Money is
money. End of discussion.
But
when it comes to investors with a spending need, there is something
more that definitely needs to be said, and understood. There is,
for a withdrawing investor, a qualitative difference between 1)
total return and 2) a return made up of income plus appreciation.
The difference is that the income portion of the return is always
positive, whereas the "appreciation" portion can fluctuate,
and can be negative. Accumulators can and should tolerate some
fluctuation in the interest of greater performance, but withdrawers
have to spend the money. Now. And the income portion needs to
grow even if the principal side doesn't, because the spending
need rises with inflation.
When
our investments are in higher yielding stocks, the income portion
of the total return is well defined (as opposed to low yielding
stocks where it plays a minor role). If your withdrawal need is
the widely-accepted 4-5%, you can obtain that from the right portfolio
of stocks. If your income need rises as a result of inflation
(and we can expect that inflation may be higher than it is now,
perhaps the same as the 1945-90 average of 4.7%), yield stocks
that have increasing dividends can meet that increased spending
need as well. A retiree can fund his or her living expenses without
having to invade principal.
If
you're spending income, rather than "total return,"
market fluctuations become irrelevant; if the portfolio is successfully
managed for rising income the value of the stocks producing that
income will ultimately rise as well, though the schedule for that
recedes in importance. It won't matter whether growth is in vogue,
or value, or mid-cap, or large-all that really matters to the
value of the principal is that the income increases to pay expenses
and meet inflation. The value of the principal will eventually
reflect the rising positive income yield it delivers, and there
is no need to invade it.
Clearly,
an income-equity approach based on high current income is "built"
for a retiree portfolio. Some diversification seems prudent, though
we don't know of any other plan with
as high a probability of meeting spending needs and preserving
capital indefinitely.
Not
only is there no "exhaustion" date for the assets, they
will be there in full, long after the retiree needs them, to help
loved ones and charities.
And
what about that older couple? The "good parts" of their
portfolio, with triple-digit dividend yields on original investment,
inspired us to design our Income-Equity Strategy. We've hitched
our wagon to that horse, and clip-clop, clip-clop, it continues
to forge ahead without getting tired.
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