In parallel, doctrines on effective investment practices emerged to guide investors in managing their retirement portfolios. The theory was that, by contributing regularly throughout their careers to a tax-privileged portfolio and following a simple asset allocation strategy, everyday American workers could hope not to “get rich quick” but, rather, to accumulate net worth slowly, end their careers with enough of a nest egg to ensure a comfortable retirement funded by their personal savings and investments rather than corporate pension plans and, eventually, “die rich,” with a decent financial legacy to pass on to their heirs.
Underlying these ideas were some basic assumptions and principles that, starting in the 1980s and continuing into the tech stock boom of the 1990s, were disseminated widely by increasingly popular personal finance gurus in books, television programs, and radio broadcasts:
- Based on its historical performance, it was reasonable to expect that the stock market, over a long period of years, such as a 30-year working life of a middle-class investor saving for retirement, would deliver a rate of return exceeding inflation and outperforming most other investment options available to the average person.
- A repeat of a financial catastrophe of the magnitude of The Great Depression was nearly impossible due to the regulatory measures that had been put in place and the methods, such as monetary policy, that the government had available to respond to an emerging financial crisis.
- Sound investment practices such as dollar-cost averaging and a strategy for allocating investments between equities vs. current income instruments like bonds would give investors good odds of achieving slow-and-steady growth while minimizing risk and smoothing out the volatility of the equity market. According to the theory, an asset allocation strategy would create a disciplined, built-in approach to the old “buy low, sell high” model. When stocks do well, some are sold into cash-like holdings to permanently preserve a portion of the gains. And when stocks drop more shares are purchased at a “value price,” increasing the benefit from an eventual recovery.
- A good way to invest in equities is through a highly diversified instrument such as an S&P 500 index fund, which follows the overall trends of the stock market, smoothing out the volatility and risk of investing in individual stocks or more aggressive mutual funds and, over the long run, outperforming actively managed mutual funds.
- Equities are an appropriate part of an investment mix for a goal, such as retirement or children’s college, that is more than five years out.
These principles seemed to work well for a while, but there were warnings of trouble ahead. The market crash of 1987 brought to an end “the fat years” of the Reagan 80s, shutting down the “yuppie party” fueled largely by defense-oriented technology companies that benefited from the administration’s deficit spending on military projects.
As the economy recovered in the early-to- mid 1990s there were more warnings, such as the drop in the stock market that followed Alan Greenspan’s infamous “irrational exuberance” speech. And at least a couple of television documentaries presented evidence that the stock market could be overvalued, and spotlighted examples from the past of long periods of economic malaise that, if repeated, could easily eat up a substantial portion of the working years of one person saving for retirement. These historical precedents included “The Long Depression” of the 19th century and the imposing stretch of years it took for the stock market to return to its previous highs after The Great Depression of the 20th.
But once the tech bubble started to form, around 1997, most of us seemed to forget these warnings. We were caught up in irrational exuberance yet again, buying into the story that we had entered “a new paradigm” in which rising stock prices didn’t need to be linked to tangible earnings. Then the tech bubble burst, and the market tanked again after 9/11. Since then, throughout the 2000s, the market has been sluggish and tentative. The Dow struggled for several years to get back to the important 10,000 benchmark, and it wasn’t until June 2007 that the S&P 500 finally exceeded its March 2000 high. Yet by December 2008, in the midst of the financial sector’s meltdown, the market had abruptly fallen back to levels close those of the fall of 2002, effectively erasing all the gains of the decade.
In view of this abysmal performance, we must ask whether investment principles like those listed above still hold true -- if, indeed, they were ever true. To gain insight into this question, I created a model retirement portfolio for a fictitious investor who starts out in 1999 at age 50 with a $100,000 investment and manages the portfolio according to the following guidelines:
- Maintain an allocation of the investment in equities based on the formula “100 percent minus your age.”
- Invest the equities portion in an S&P 500 index fund and the remainder in a Ginnie Mae Fund. Ginnie Maes are bonds consisting of pooled, government-guaranteed mortgages. They are recommended by finance gurus such as Bob Brinker as a low-risk instrument with a favorable rate of return compared to inflation and other types of bonds.
- Rebalance annually to adjust the allocations for market fluctuations and for the yearly change in the “100 percent minus age” formula.
So what happens during the 10 years? As the chart above shows, by the end of 2008, the portfolio has indeed grown, from $100,000 to nearly $124,000. But that total is down from a high of nearly $140,000 as of the end of 2007, leaving the total growth for the 10 years at 23 percent, which translates to an anemic annual growth rate of 2.3 percent. The asset allocation formula worked to the extent that it helped preserve growth in spite of the sharp equity drops at the end of 2008. But our fictitious investor, now 60 years old, is faced with a portfolio that has not accomplished much for the past 10 years -- which, after all, could be one-third or more of an investor’s earning life -- toward achieving retirement goals.
Granted, this simple model leaves out much of what the full picture would likely be for a real-world investor who, between the ages of 50 and 60, would hopefully be at the peak of earning power, regularly making dollar-cost-averaged contributions to the fund at an aggressive rate of, say, $10,000 or more per year, and rebalancing more frequently. This would significantly increase the capital base, and the dollar-cost averaging would help smooth out equity fluctuations and allow the investor take better advantage of gains when stocks were up. One could also envision different asset allocation schemes that could have produced greater growth.
In this real-world scenario we would, in spite of the poor performance of stocks, be looking at a portfolio that is much closer to a level at which, if reinvested at retirement in an income-oriented, capital-preserving instrument, it could provide a reasonable supplement to social security and other assets and income sources during retirement.
Nevertheless, the model does demonstrate that, during the current recessionary period and the 10 years that preceded it, equities have not been an exceptional driver of the kind of value growth investors need to build a retirement portfolio that would provide a level of security comparable to that of the pension plans of the past that 401(k) plans are ostensibly intended to replace.
The recommended practices listed above were not sufficient to ensure a growth rate significantly above inflation and other investment options, and the “more than five years out” rule of thumb for investing significantly in equities did not hold true. The results suggest the possibility that we are in a long-term secular bear market of the sort that some of the contrarian voices in the 1990s told us could occur, even though there have been some short-term bubbles and rallies within the period.
It was nice, while it lasted, to think that we everyday Americans could succeed as miniature Warren Buffetts, building our own little investment empires within the tax-privileged confines of our retirement accounts. But, based on what we have learned from the market’s performance over the past 10 years, perhaps it is time for us to push our collective Rethink button with regard to what constitutes an appropriate retirement system. Having existed for under 30 years -- less than the typical span of working years for one individual -- 401(k) plans are too new to be thought of as having any kind of track record, and the confidence we placed in them was based solely on our understanding at the time of what we could expect from equities markets -- an understanding that, based on the past decade, could be highly flawed.
If 401(k) plans are not the answer, then what is the solution? The old system of pensions administered by individual companies faded away for a reason. It is unlikely to return due to its inherent pitfalls, such as the question of what happens to the pensions of retirees when a company goes bankrupt or is acquired, and the inefficiencies of innumerable individual companies managing investment pools to fund their pension plans. But a huge and Byzantine system administered solely by the government is not likely to be a good solution either. With Social Security already in a precarious position, we don’t need an even larger and more lumbering species of the same animal.
The eventual solution will likely lie in a public-private partnership that, benefiting from economies of scale and time, can viably pool and invest pension contributions from numerous employees and the companies they work for. In this scenario, a highly diversified and balanced mix of investments could be made in a variety of instruments, including those that are oriented toward current income as well as equities. The timeline for deriving returns on investments could be much longer in such a model, far exceeding the period of earning years of a particular worker or even the successful lifespan of a typical business.
Taking the longest, big picture view, such as the seven decades since The Great Depression, it would be fatuous to try to argue that the equities market hasn’t performed extremely well. Its flaw simply lies in the fact that the three-to-four-decade earning life of an individual worker may not be enough time to allow long-term gains to compensate for significant short-term losses. But in a large, long-term system designed to serve the needs of multiple generations of retirees, equities would almost certainly have an important role to play as one of a number of instruments in the investment equation.
Such a system would also create the added benefit of portability. Workers moving among jobs with different companies would not need to be concerned about moving their retirement accounts, about waiting periods to become vested in a new employer’s plan, or about the fate of their funds should a former employer become insolvent or cease to exist.
A new system will also almost certainly need to include a re-thinking of what is an appropriate retirement age for the average worker. Since the Social Security system was first conceived, life expectancies and the level of health of older people have increased enough, in the aggregate, that the current 62 to 67 timeframe needs to be reevaluated. For many people today, an expectation of working to age 70 may be not at all unreasonable.
But any reevaluation of retirement age will need to be in a context that provides stronger protections for older workers against discrimination in hiring practices and workplace environments, and to make allowances for the fact that, in the current state of healthcare and medical technology, the health and fitness levels of individuals in their 60s and 70s remains highly variable.
And, of course, all this is easier said then done. The devil will be in the details. A new retirement system will not be quick in coming and, understandably, does not appear to be among the immediate high priorities of the Obama administration as it faces crisis situations on several fronts.
Unfortunately, there may be no easy answer in sight to address, in the near term, the pain that many individuals are feeling now as they face heavy losses in retirement accounts that included significant investments in equities. But it is good to at least see signs of an emerging consensus that a re-evaluation is needed, and the beginning of a serious dialogue on the subject through forums such as the recently launched Retirement USA initiative.
Finally, for average individual investors, hopefully a more sober and realistic understanding of the role of the stock market will emerge. There is nothing inherently wrong with widespread participation of ordinary Americans in the stock market. Having a healthy level of exposure to the stock market is a good thing, as long as we return to a mindset that the stock market is a place to go with “risk capital” that one can afford to lose, and if we learn the fundamentals of how the stock market works and how to evaluate individual equities, or if we use the services of competent professionals who are pursuing realistic growth objectives rather than lucrative sales commissions or impressive but unsustainable short-term returns.
But recent experience suggests that the stock market may not be such a good place to wager one’s entire retirement future.
No comments:
Post a Comment