The 5% rule to retirement planning

THE question we have heard the most from our investors in the first quarter of 2018 might have been “Where is the market heading to?”.

Over the past few months, global equity markets went through a correction amidst rising concerns of trade war between the two largest economies in the world, United States and China.

The MSCI APAC ex-Japan Index posted a return of -0.44% for 1Q 2018 while the MSCI HK and MSCI Japan indices saw a further downturn, resulting in -1.01% and -4.81% returns respectively, over the same period.

To truthfully answer our investors, we believe no one can make a better prediction than tossing a coin.

However, that does not mean that investors cannot capitalise on the opportunities in the current market situation. Patient value investors will see a payoff by holding a diversified portfolio and buying into undervalued stocks, which will surface as hidden gems in bad times.

At the end of the day, it really depends on whether you are playing the long game or short game in investing.

According to a recent global UBS study, even millionaires have cost worries if they live to a 100, a valid concern given overall longer life expectancies and the higher quality healthcare available.

The 2018 UBS Investor Watch Research study found that 45% of the high net worth respondents in Asia worry that their finances will not sustain them to age 100, with the rising costs of healthcare and cost of living in keep with their current lifestyle.

When surveyed on their preferred investment asset classes, equities and real estate were unsurprisingly found to be favoured across the board.

However, close to half (40%) of the high net worth individuals in Singapore and over half of the same group in Asia (52%) preferred to hold cash, which generates little returns.

Many high net worth individuals, who are accredited investors, invest like retail investors and are not epitomizing their money management to sustain themselves in retirement.

The 5% ‘safe withdrawal rate’

You need retirement income. The question is how much money should you take out each year?

You want to make sure you don’t spend down your money too fast. The answer is determined by calculating a “safe withdrawal rate”.

A safe withdrawal rate is the amount of money that you can withdraw from your investments each year, with the ability for future years’ withdrawals to increase with inflation, and with a high likelihood that this money will last for the remainder of your life expectancy.

Back in 1994, Bill Bengen, then a financial planner in Southern California, pioneered the “4% rule”.

His method then proved that retirees could create a paycheck that lasted over a 30-year period by sticking to an inflation-adjusted 4% of their initial retirement portfolio balance.

Bengen also advocated that a retirement portfolio allocation of 50% equities and 50% bonds would last at least 30 years with a 4% withdrawal rate.

We believe we can do better. We believe a 5% withdrawal rate is possible. One percent more might not seem a big deal – but on a US$2mil portfolio, with a 4% withdrawal rate, it amounts to US$80,000 a year, and with a 5% withdrawal rate, it is US$100,000 a year. That is a difference of US$20,000 a year.

And not only that – instead of your money lasting just 30 years, it can last in perpetuity. This means that the retiree won’t run out of money even if he lives to 100. To make this possible, you will need to invest the retirement sum fully in a basket of value stocks, instead of the conventional 50:50 stock-bond mix.

Value investing

What are value stocks? Value stocks are stocks which have the characteristics of low price-to-earnings ratio, low price-to-book ratio, low price-to-cash flow ratio and high dividend yield ratio.

There are many definitions of value investing and implementation methods – but the general idea is to buy an asset for a cheap price and get a bargain. The value investor never overpays for an asset. The value investor always gets more than his money’s worth where buying an asset is concerned.

Following the conventional way of investing for retirement has not brought about the desired results. If you speak to most financial planners, they will suggest a portfolio mix of bonds and stocks.

The stock components are usually unit trust funds. This approach generally will not generate adequate returns to allow the 5% withdrawal rate because these funds run high fees and expenses due to distribution costs and they also suffer from poor investment performance.

The recent popularity of investing in ETFs (usually the market index) instead of active stock picking has helped to alleviate costs issues and at the same time deliver investment results in line with the market.

ETFs are a cheap and effective way of getting exposure to the stock market – but the market index over the long term still cannot beat the performance of a basket of value stocks.

For example, if you have just retired and put US$1mil into a stock investment portfolio just before recession in 1984, your portfolio would have declined by half to US$358,278 – but it is still safe for you to withdraw US$4,166 a month (to be adjusted for inflation by 2% per annum) from the portfolio for your retirement expenses. You will not run the risk of running out of money with this safe withdrawal rate.

Fast forward 34 years to Dec 2017, your retirement portfolio of a basket of value stocks would have grown to US$2,954,479 – And after adjusting for inflation, your monthly withdrawal is now US$8,142 per month.

The total amount of withdrawals that you would have enjoyed since Feb 1982 till Dec 2017 is US$2,415,470.

Avoiding the ‘cash drag’

Conventional retirement planning also allocates a fair bit to bonds and cash equivalents. A mix of bonds and cash delivers an average return of 2% to 3%. This cannot support a 5% withdrawal rate.

Having too much of this will drag the portfolio returns down. This is termed “cash drag” and investors do not realise the long-term devastating effects of this on the portfolio.

A quick computation: If an investor holds on average of 25% cash equivalents in his portfolio of US$1mil over a period of 30 years, the result at the end of the period is a “penalty” of US$1.9mil. (Assume the cash equivalents to yield 1%, and the general stock market to return 8%, the difference is 7% – and apply this to US$250,000 cash drag). That US$1.9mil opportunity lost is significant, it is almost twice his entire portfolio at inception.

In short, to successfully apply a 5% safe withdrawal rate to sustain your retirement funds and end up with substantially more money than when you started, we see the only way is to fully invest in a basket of value stocks.

Eric Kong is a co-founder of Aggregate Asset Management, which manages a zero-management fee fund, Aggregate Value Fund. (www.aggregate.com.sg)