(Part two of this review, Steve Thorpe’s compilation of the best advice and insights from Unveiling the Retirement Myth by Jim Otar, will run tomorrow.)
For individual investors planning for retirement, basing those plans on averages just doesn’t cut it. For example, one might estimate an investor’s expected life span, future investment returns for a given asset mix, inflation rates, etc. But the investor may live longer than average, the sequence of future investment returns could easily go against him or her, likewise inflation effects can be enormous over time. Bad luck in any of these areas can easily deplete a retiree’s investment portfolio to zero during his lifetime. Unfortunately we are unable to change the luck factors that can so profoundly affect a retiree’s future income stream – or lack thereof.
Jim C. Otar, a financial advisor, Certified Financial Planner, and engineer, clearly explains these topics and more in his book Unveiling the Retirement Myth: Advanced Retirement Planning based on Market History. This review contains only a sampling from this fine body of work; accordingly I’d recommend that you pick up a copy if you want to understand all the details.
Most Research and Many Strategies Are “Just Plain Garbage.”
He covers a lot of ground in the book including: diversification, rebalancing, optimum asset allocation, warning signals of potential diminishing luck, flaws of investment simulations, budgeting for retirement, determinants of a portfolio’s success, and many others. This review will focus mainly on two core insights. First, that luck plays a remarkably large part in how well any retirement plan holds up. Second, that lower withdrawal rates, not savvy asset allocation, is the best defense against bad luck.
Otar’s 45-chapter tome studies multiple retirement portfolio techniques and strategies, with a relentless focus on how each strategy would have performed based on data going back to 1900. Instead of forecasts, he presents “aftcasts” of potential outcomes based on actual market history.
Otar categorizes prior outcomes into lucky (10% would have performed better), median (half better, half worse), and unlucky (10% would have performed worse). He recommends choosing strategies that build in the distinct possibility of being unlucky. In other words: plan for the worst. He writes that a properly-designed retirement plan, based on actual market history, should last through the investor’s age of death at least 90% of the time, with no more than 10% loss in inflation adjusted withdrawal values, and for most individuals using 95 years old as the projected age of death. While 95 years is longer than most might live, this is certainly a possibility and should be accounted for by the plan.
Otar’s analytical background shines throughout the book. Early in the book he writes “I am a typical engineer. I am skeptical of everything that I hear or read about, especially in the investment world. If I come across a strategy that looks interesting, then I like to work through the numbers until I can clearly see if and how it works. That is how I discovered… that most research and innovative strategies you hear or read about, are just plain garbage.” (emphasis mine).
Traditional Retirement Planning Can Lead to Disaster
Indeed he does work the numbers, elegantly demonstrating critically important concepts, exposing myths promulgated by the financial industry, and backing it all up with historical evidence and mathematics.
Otar begins the book showing how simplified traditional formulas can lead to disastrous outcomes. In a series of “aftcasts” Otar looks at a 65 year old retiring with a $1M equity portfolio with a $60,000 per year initial annual withdrawal rate and assumes that withdrawal will increase 3% per year to keep up with inflation. He studies 3 different actual retirement dates: retired in 1929 (at the start of arguably the worst stock market crash ever) vs. retired in 1966 (at the start of a prolonged sideways trend) vs. retired in 2000 (at the end of long-term bullish trend). He compares what actually happened in the market in the years following those three retirement dates against deterministic projections that predicted total average net annual return of 8.8%. The 8.8% was estimated by assuming an average annual index growth rate of 7.3% plus a 2.0% annual dividend minus 0.5% management fee.
How did these retirees fare? Not well! Rather than earn the 8.8% annual return predicted, the 1929 retiree, assuming they had left all their money in the stock market, was broke ten years and three months later. The 1966 retiree’s portfolio lasted only 13 years and 7 months. The 2000 retiree likely ran out of money less than 11 years into retirement.
Throughout the book, Otar uses graphs to great effect. The following example displays all historical outcomes for a given strategy, again using actual market history. As you can see, there is a startling range of outcomes—many of them leading to portfolio depletion that is not predicted by simplistic models. In the graph below, the dark line is what an 8.8% return through retirement would have lead to. Not once in the last 109 years, did reality match that. Some periods beat it, but many fell far short.
He wisely notes that “When we are designing a plan, we must focus on the lower part of the aftcast chart. This is where all bad things happen. This is where a good design can protect you. It is not about wishful thinking, it is not about making assumptions, and it is not about selling dreams. It is about confronting reality.” (emphasis mine).
The book shows one of the main ways to confront that reality is to adjust the initial withdrawal rate (IWR) downward — from 6% in this case and the most frequently cited 4% — to surprisingly low annual percentages (usually no more than 3%). Here is one of Otar’s graphs, illustrating the effect of different initial withdrawal rates had on the probabilities of decreased portfolio size over time.
For retirees with high annual withdrawal needs or an insufficient portfolio size, Otar later demonstrates the best option is often to annuitize part or all of an investment portfolio.
Otar contends that asset allocation is much less important than the financial industry would have you believe. It does help during the accumulation stage when a retirement portfolio is being built, as it helps to reduce the volatility of returns. However for retirees, asset allocation isn’t enough to overcome a bad sequence of returns. A run of poor market returns (bad luck) during the early years of a retirement can be absolutely devastating to a portfolio.
Wish for Luck, Withdraw Very Little
“Luck is by far one of the most important factors in retirement planning,” Otar writes. “It is second only to the withdrawal rate for influencing the portfolio life. Many advisors feel uncomfortable conceding that the success of a retirement plan has more to do with luck than their talent and good counsel. If you ignore the luck factor, the chances are you will suffer financially during your retirement and this pain will continue for the rest of your life. On the other hand, if you accept it as large component of the outcome, then you will set yourself free to look for solutions.”
In another chapter he notes that those solutions can include annuities as a protection against bad market luck: “At all withdrawal rates, the luck factor is the most important contributor to the success of a portfolio. If luck is not on your side, your investment portfolio can do little for you. The remedy is not in what you can do with your portfolio, but what you can do with your assets. Insurance products, specifically annuities, become a natural choice.”
Two important components of “luck” as Otar sees it are:
- the sequence of returns, or how the asset classes your money is invested in perform after you retire, (he says this is the most important part of luck)
Otar doesn’t just offer reasons to worry. He comes up with some concrete advice as well. These simplified rules-of-thumb for the investment allocation for someone in retirement are one example:
- “If you do not need money from your portfolio allocate 50% in equities and 50% in fixed income.
- If you need a small periodic income, 4% or less, then allocate 40% in equities and 60% in fixed income.
- If you need a larger periodic income, over 4%, then allocate 35% in equities and 65% in fixed income.
- If your withdrawal rate is over 5%, then asset allocation counts for less than 15% of the whole picture. So, even if you are a little wrong, it just does not matter.”
The following table comes from the chapter on sustainable withdrawal rates. I really love this table, as it clearly shows the historical probabilities of portfolio depletion over a range of time frames and asset allocations. It vividly demonstrates the market realities actually experienced by investors during the past 109 years. While the numbers may be depressing to some, I believe this knowledge is a powerful reality check to help inform retirement planning.
Note: “alpha” in the context of Table 17.6 includes effects of dividends, expenses, and management skill. For example, if the S&P 500 index returns 1.2% in dividends, but your fund shaves off 0.2% in management fees but incurs no other expenses or fees, and gains no extra value from management skill, you’d have 1% alpha according to Otar.
The next table summarizes his findings on the relative importance of the different determinants of a portfolio’s success. As you can see, the luck factor is huge—especially for those withdrawing more than 4% of their assets each year. Higher withdrawal rates combined with the inevitable market downturns increase the chances of running out of money. At lower withdrawal rates, manageable factors like asset allocation and fees can have a more meaningful role.
Otar includes a helpful way of thinking of a retirement portfolio in terms of what “zone” it belongs to. The green zone is where a retiree has abundant savings—it is the best situation and there are many possible options. A retiree in the gray zone has sufficient savings, though a suitable retirement plan would require annuitizing at least some assets. (Otar provides guidelines to help determine how much to annuitize.) Retirees with insufficient savings are dubbed to be in the red zone, and they need to export all of their risk to an insurance company using annuities and also cut back on expenses. A more effective way of handling this situation is to delay retirement.
Where We Disagree
My views are not 100% in lock-step with Otar’s, for example: He is a Canadian, and many of the analyses are presented with two different tables or graphs – one for US investors and one for Canadians. For certain investors, he advocates rebalancing your portfolio to match its target asset allocation only at the end of US Presidential election years. Otar also has a chapter with a tactical asset allocation strategy that historically improved returns over a more traditional strategic asset allocation. I’m skeptical that US vs. Canadian investors should have differing strategies, that presidential election year rebalancing is better than rebalancing when asset allocation has drifted beyond a certain percentage from target (such as 5%), or that tactical asset allocation is suitable for but a minuscule percentage of investors (if any) – especially when tax and human behavioral issues are taken into account. Otar also includes dividends as part of alpha, the so-called “excess return” relative to the market. In my opinion dividends are not alpha, they are part of the market return itself.
That said, these and a few other differences-of-opinion I had are very minor and to some extent only semantic. I could not agree more with the main ideas presented by Jim Otar, extensively analyzed and illustrated based on more than 100 years of actual market history.
Otar himself writes, “Don’t believe everything you read in any research, article, book or media”, and I believe that includes even his own book. Nonetheless, Otar’s “Unveiling the Retirement Myth” is a great reality check, providing knowledge of how various retirement planning strategies would have historically turned out if implemented during 109 years of actual market history. That knowledge can be a powerful tool in helping prospective and current retirees make better informed plans for their future.
The book is available in PDF or hard copy formats from the site http://retirementoptimizer.com/. I personally sprung for the $49.99 hard copy, and feel it was money well spent. The PDF version would only set you back $5.99, plus you’d be “green” to boot! (Disclaimer: I am not compensated for writing this review, or if any copies are sold. I’m simply a satisfied reader who volunteered to write this blog entry for Portfolioist)
Steve Thorpe is the founder of Pragmatic Portfolios, LLC, a fee-only Registered Investment Adviser based in Durham, North Carolina specializing in developing sensible investment plans integrated across all of a client’s investment accounts. He also chairs the Research Triangle Park, NC area chapter of the “Bogleheads” investment interest group. Observing conflict-of-interest laden behavior of various charlatans from Wall Street has always inspired Steve to help others navigate the sometimes-treacherous investment landscape.
All graphs are included by permission of Jim C. Otar.