The Controversial Strategy for Higher Retirement Income

last week a client called me after finding an article online about a particular investment strategy that suggested it could provide him with a much higher income in retirement and the evidence looked pretty clear he could be hundreds of thousands of pounds better off by following this strategy so his question was james why aren't we doing this which was a fair challenge because this is a legitimate strategy that can generally give you a much higher more sustainable income in retirement but why then had i not recommend we do this well in this video i'm going to explain exactly what that strategy is how it works but also why it can be extremely dangerous in the wrong hands [Music] hello and welcome back to the channel if you're new here hi my name is james i'm a financial planner and this is a place where you can learn to make smarter financial decisions 40 years ago retirement planning was a breeze because typically the company you worked for would continue to pay out a percentage of your final salary when you retired and if you've been working there for a long time this could be as high as 60 or 70 percent of your last salary paid for life and this income would increase in line with inflation each year can you imagine that these were known as defined benefit pensions but unfortunately these are now all but extinct and we now have to fend for ourselves it's now our responsibility to build up a portfolio of assets over our working lives that can then provide for us in retirement you can do this through investing in property or more commonly this is done through investing in a pension or an investment account like an isa or a 401k if you're in the us and these types of investment portfolios are typically built from two key components stocks and bonds aside from property these are the two main tools we have for building wealth so it's really important that you understand the role that they play within an investment portfolio and this knowledge is also key to understanding how this strategy works first we have stocks when you invest in a stock you are becoming a part owner of a business investing in one business would be extremely risky so instead we should be diversifying to invest in thousands of businesses from all across the world which is actually very easy to do through things like index funds over the long term a globally diversified portfolio of stocks has produced an average return of roughly nine percent per year but remember that is just an average as you can see here there have been periods where returns have been far higher than that but there's also been periods when returns have been far lower but the longer we wait the higher chances we have of stocks producing a positive return so yes stocks can offer high returns which is why they are the main drivers of growth within a portfolio but their outcome can be very uncertain especially over shorter periods of time whereas with bonds your outcome is much more certain when you buy a bond you are essentially lending money to somebody else in return for a predetermined set of future cash flows it's just like a mortgage but in reverse as an example if you bought ten thousand pounds worth of a five-year government bond at a three percent yield you can be very confident that it will pay out 300 pounds each year for the next five years and then at the end you will get your money back with a bond your outcome is much more certain than with stocks but as a consequence they typically offer lower returns this is the trade that you need to make if you want higher levels of certainty or a lower level of risk you have to accept a lower return so stocks are the long-term drivers of growth within a portfolio whilst bonds can be used to give us more certainty in the short term and we combine them together in different allocations to give us different portfolio characteristics the higher our allocation to stocks the less certain our outcome is going to be especially over the short term and we should expect to see our portfolio drop in value dramatically at times it's going to create a lot of short-term pain but because of that we should also expect to see a higher long-term return but as we add more bonds to the mix that journey starts to get a lot smoother it's a lot less painful but because of that we should expect to see a lower return it's likely that you are already invested in a portfolio like this probably through a workplace pension and if you've never gone into your pension and changed the funds that you're invested in it's likely that you are invested in a default fund that will automatically reduce your exposure to stocks and increase your exposure to bonds as you get closer to retirement this is based on the theory that as you get closer to retirement you need to reduce risk to give you higher levels of certainty but on the face of it this theory is flawed as my client discovered when he stumbled across this analysis that i'm about to show you this was a study investigating how different combinations of stocks and bonds can affect the chances of a retirement plan being successful they started off with an objective of drawing 50k per year from a half a million pound portfolio over a 20 year period increasing this income in line with inflation each year and they wanted to test how the chances of this plan succeeding varied across different combinations of stocks and bonds with success meaning that they did not run out of money during the period to do this they used a monte carlo simulation to test the plan against historical returns to show us how often it would have succeeded in the past and this is what they found for a portfolio of 50 stocks and 50 bonds the probability of success was zero percent for 70 stocks and 30 bonds the probability was 3 percent and for 100 stocks it was 21 so all in all not a great chance of success but then again a 10 withdrawal rate is very high so they then tested a seven percent withdrawal rate or a 35k per year and the results got slightly better for the 50 50 portfolio 23 for 70 30 46 and 400 stocks 63 clearly the portfolios with higher allocation to bonds are not producing enough growth to maintain seven percent a year and even the 100 stocks portfolio is failing a lot of the time as a side note this is actually highlighting a common mistake that people make with retirement planning where people often assume that if the stock market produces an average return of nine percent a year they think that they can sustain an income of nine percent per year but firstly nine percent is only an average so 50 of the time returns have been worse than that and even if you do end up with high average returns over a 20-year period if you happen to get a very poor sequence of returns right at the start of retirement and you keep making the same amount of withdrawals it can devastate your portfolio before it has a chance to grow this is known as sequencing risk and is the reason why most retirement plans should target withdrawal rates that are well below average returns for at least the first five to ten years of retirement so back to the data with a five percent withdrawal rate again we see higher success rates across the board and then when we go down to a three percent withdrawal rate finally we get 99 success across the board and 99.9 is as high as this goes just as a reminder that we are using historical data here and even though it was successful in all of those periods anything can happen in the future and the returns in the future could be very different so what are you thinking when you look at this data well you're probably thinking the exact same thing as my client if 100 stocks gives us the highest chances of success in retirement then why do we bother with bonds at all why is it the default to decrease our exposure to stocks as we get closer to retirement if this is actually increasing our risk that we're going to run out of money well great question well done for asking and the answer is yes statistically investing in a portfolio of 100 stocks has in the past provided the highest chances of success in retirement but only if you can stay the course you see this data is not really giving us the full picture by only focusing on the success rate this analysis does not show us the journey we would have had to have endured as a 100 stocks investor so let's single out one 20 year period to get a taste of what that journey actually looks like 1996 to 2016 was a pretty average period to be an investor stocks produced an average return of 8.4 per year and we had two stock market crashes in that 20-year period which is actually slightly less than average and here we're looking at what would have happened if we retired in 1996 with a portfolio of 500k drawing 25k per year in blue we have 100 stocks in red 70 stocks 30 bonds and in yellow 50 50. during this period all three of these portfolios achieved their goal i.e they did not run out of money and the 100 stocks portfolio ended up with the most money at the end but let's take a closer look at this blue line you retire in 1996 with a portfolio of 500k this is your entire life savings and it has to provide you and your family with an income for the rest of your life and you decide to invest it in 100 stocks and start drawing an income of 25k per year now by 2000 you would have been feeling pretty happy with yourself despite your withdrawals your portfolio would have doubled in value but then the dot-com bubble burst and over the course of a year you would have seen your portfolio fall from a million down to just 600 k but it didn't stop there the market kept on bleeding out for three straight years until you were down to 470 000 that's 50 below its previous peak yes markets did recover up until 2007 but only for us to see another enormous crash where over just 18 months your portfolio would have fallen in value by 60 percent just put yourself in that position you're retired and this is your life savings that you've built up to provide you and your family with an income and over 18 months that portfolio is totally devastated with hindsight we know how this played out but back then at that point in time in the deepest darkest depths of the great financial crisis you would have had no idea what was going to happen and it genuinely did seem like the world was about to end and every part of you would be screaming for this pain to stop and it's very likely that you would have ended up selling some or even all of your holdings which would equate to failure because it's then likely that you would need to reduce your future income dramatically or face running out of money before crashes like this happen and when the markets are going up everyone says that they won't sell but you have never been there before even if you have experienced crashes like this in the past you have never experienced them as you are now at your current age or in retirement which is why these stats are misleading yes statistically over long time frames higher allocations to stocks give you more survivability but these portfolios are not run by robots they are driven by humans who can only tolerate so much pain so in reality most retirees cannot stomach the pain and uncertainty that comes with being invested in 100 stocks and if everybody tried to invest like this the success rate would actually be dramatically lower this is why you need to make sure you are investing in a portfolio that is not going to give you more volatility or pain than you can endure and this is why your tolerance for risk your tolerance for pain needs to be the high water mark for your asset allocation and you need to understand that this tolerance is also likely to change as you get into retirement the second question that you need to ask is do you actually need to take that level of risk to achieve your goals most of my clients only want to take as much risk as is necessary to achieve their goals they don't see the point in risking what they've got and enduring the stress of 100 stocks just for the chance of ending up with more money than they would ever need this is also how institutional money managers work instead of investing in whatever will give them the best possible return they invest in whatever will get the job done with the highest level of certainty and they do this through a process called asset liability matching as an example imagine i'm managing a large defined benefit pension fund and i know that over the next five years i'll need to pay out this set of cash flows to our members and i need to make sure that i have this cash available at these times so that i can make these payments over such a short time frame stock market returns are just too unreliable bonds however would give me much more certainty so much so that i can invest in a series of bonds that would be set up so that they could mature exactly when i need this cash and then for further out cash flows we can start to use stocks as over these longer time frames stocks have a much higher chance of producing positive returns for short-term cash flows where we need to be certain that that money is going to be there when we need it we use bonds and for cash flows that are further out where we can tolerate uncertainty in the short term we use stocks and other risky assets all these institutional managers care about is being able to pay out these future cash flows with the highest degree of confidence or the lowest level of risk which is exactly what most retirees want to which is why we can learn a lot from this approach we can create buckets for cash flows or goals that have different time frames attached to them and then find the perfect asset mix for each of those buckets as a retail investor buying individual bonds is not very practical but you can do a similar thing with bond funds i'll need to do a whole video on exactly how that works but once your cash flows for the next five years are protected you can feel much more confident about investing the rest of your money in more risky assets because you know that you are insulated from any crashes going back to this if i knew i had five years of cash flow already accounted for it would make investing the rest of my portfolio in blue much easier to bear but when we zoom out because we also have an allocation to bonds the overall result might give us something that's more like 70 stocks and 30 bonds so there's two ways we can look at it what is the best asset allocation for each individual bucket or goal and then once we've decided that and we zoom out we can see what is the overall allocation of the entire portfolio so what are the key takeaways from all this well firstly yes it's true statistically the higher allocation that you have to stocks the higher your chances of success in retirement but most people cannot bear the volatility and pain that comes with investing in 100 stocks bonds produce lower returns but with a much higher degree of certainty so should be used to protect short-term cash flow needs so we can feel comfortable taking higher levels of risk and targeting higher returns in other parts of our portfolio light touch asset liability matching or bucketing can help you to think more clearly about your future cash flows and how you should be investing to give each of them the highest chance of success you'll notice then just how important it is to have a good grasp of what your future expenses and cash flows are likely to be which is why you should now watch this video here where i explain how you can start to predict them much more reliably i'll see you there

Channel: James Shack

Views: 82,873

Keywords: investing, Retirement planning, retirement income, pensions, 401k, ISA, stock market, Bonds

Id: Eac2jZcelQw

Length: 16min 39sec (999 seconds)

Published: Mon Sep 05 2022