Investing for a recession-proof, typical income retirement. Part 1: What the experts won’t tell you
You won’t believe how much it actually takes to be recession-proof
Introduction
Uncountable numbers of retirement planning articles promise to tell you how much investment assets you’ll need for your retirement. If there’s a single one that doesn’t fail to deliver on that promise, I haven’t found it. So I decided to write it myself. It turned out to be a longer article than I expected, so I split it into more readable chunks. This is part 1.
Part 1: the median income lifetime investment goal
Part 2: options if you can’t meet the goal
Part 3: some ways to beat the goal
Part 4: tools to do your own planning
Here’s the answer: $14.2 million. That’s substantially more than you may have been expecting to need — why so much? Because it expects you to continue your typical lifestyle after you’ve retired, not suddenly adopt a frugal, near-poverty-level lifestyle because that’s all that you can afford.
When combined with a median Social Security benefit of nearly $15,000, an investment portfolio of $14.2 million gives you enough investment income to achieve the median U.S. per person income of $31,500, provides enough growth to keep pace with inflation, and is as immune as possible to the fluctuations of gains and losses due to market fluctuations. It assumes, and these are big assumptions, that bond yields average 2.4%, inflation averages 2.0%, and investment management fees are 0.25%.
Recessions are inevitable, but nobody can predict when the next one will occur. When you’re working, your salary is relatively independent of market returns and doesn’t fluctuate much with bubbles or recessions. During a recession, your company may forego annual raises for everyone, and even lay off employees (hopefully not you), but across-the-board salary cuts are very rare. But when you’re retired, you’re dependent on the returns from your retirement nest egg, and your investment portfolio needs to be structured to withstand the inevitable recession.
Why the experts don’t talk about retirement income this way is something of a mystery. It’s possible that they just don’t understand how inflation works, and aren’t such great experts after all. A plausible explanation is that most of them are selling something, like their services, or selling investment securities, or even selling your attention to the advertisements placed near their analyses. In all of these cases, these “experts” are motivated to sacrifice total honesty and integrity and provide you with an optimistic perspective, and to deemphasize any bad news that might cause you to look away.
The box below summarizes a strategy for building and maintaining an investment portfolio that can provide you with the income you need to sustain a median lifestyle in your retirement years without fear of falling purchasing power.
In the rest of this essay we’ll talk about why accounting for inflation, fees and taxes is important and discuss this plan in more depth.
What makes an inflation resistant, recession proof investment portfolio?
First, we need to clarify a concept. Economists and financial analysts use a misleading definition of “recession”. Recessions are officially declared by the National Bureau of Economic Research (NBER), which they define as ending when things stop getting worse. You may have lost half of the value of your portfolio, but you should be happy, because the recession is over! We, on the other hand, will not even begin to be satisfied until we’re back where we started, and can continue growing from where we were before this mess began. That is, we’re concerned here with the time between the start of a recession and complete recovery back up to the level where the value of our investments was before the recession began. There doesn’t seem to be any accepted term for this interval; for reasons that seem to have more to do with marketing than with making good investment choices.
For our purposes, we’re going to consider a “business cycle” with three phases, a contraction phase that corresponds to a conventional recession, a de-contraction phase, where the economy recovers to its previous peak via pseudo-growth processes like re-hiring laid off workers and restarting idled production lines, and an expansion phase, where the economy actually grows beyond its starting point.
“Recession proof” then means that your investment income stays constant throughout all three phases of this business cycle, and your portfolio keeps growing to match or exceed the rate of inflation, so that your buying power is not inflated away.
Yield MIFT — the returns killer
Yield MIFT, which rhymes with “miffed,” means Yield Minus Inflation Fees and Taxes. It’s what you really end up with as a buyer, rather than the value that gets quoted by sellers and the people that they talk to who create articles and analyses. The diagram below shows how this works.
What makes this so important is that inflation and fees can add up to more than the uncorrected yield of the investment, meaning that you end up losing money even when the advertised yield is positive. Economic pundits get all upset and confused when the advertised yield goes below zero, and famous economists talk about the “zero lower bound” on Federal Reserve interest rates as if it’s some kind of important barrier that makes managing the economy much more difficult. Its importance isn’t because it’s some kind of intrinsic economic threshold, but because it’s psychologically and bureaucratically embedded in the financial system. Millions of computer software modules that run global finances are coded as if interest rates never go below zero, and nobody knows how many of them would break if rates fell below zero, with undetermined consequences that could be enormous. Or maybe not. Japanese, Swiss and Swedish central banks have their interest rates below zero these days, and the Eurozone’s rate is exactly zero. Rates in those areas have sometimes been negative for years without disastrous consequences. This bureaucratic convenience is why the US Federal Reserve System tries to keep inflation at two percent a year rather than zero, and they say so explicitly, although not quite this bluntly.
Investment management fees work the same way as inflation, subtracting from your investments before you get to take home any of their growth or income. We’ll use inflation as an example, because there are official government measures of it, and there are many sources that track inflation and turn it into helpful charts. Management fees take a far lower profile, and industry statistics are hard to come by. But don’t ignore them, because they can take a bigger bite out of your portfolio than inflation.
Here’s a chart of a common measure of inflation. There are several variants but they all look pretty much the same. Naively, this looks like the Fed has been doing a pretty good job of managing inflation for the past 20 years or so. Inflation didn’t exceed 3.5% per year, and dipped to near zero in the aftermath of the great recession in 2010.
But that’s the year-to-year changes. Here’s what’s been happening as those little losses add up.
Over the 50 years shown in the chart, prices have gone up by a factor of 6, and an investment in dollars stashed under your bed, or held in a checking account at 0.01% interest, has lost more than 80% of its value. If you’re managing your investment portfolio for the long term of your retirement, it’s critical that you stay ahead of inflation and fees.
Managing market risk
Market Risk is the risk that the market for the investments in your portfolio will decline while you’re holding those investments, so that when the time comes that you need to sell some of them, you’ll have to sell for less than you paid.
If you hold a well-diversified portfolio of stocks, like an index fund that matches the entire stock market such as the Vanguard Total Stock Market ETF (VTI), then as long as you hold it long enough, you’ll come out well ahead. But you need enough patience and discipline to hold that investment, and not sell during downturns that last longer than even many professional investment advisers can comprehend. They forget previous market peaks as they slide off the left side of the charts that they look at every day and become invisible, and celebrate “record-setting periods of uninterrupted growth” while from a long term perspective their accounts are still underwater.
Here’s how another broad-based index, the Standard and Poor’s 500, did over the past 50 years. (The S&P 500 has a number of ETFs that track it, such as State Street SPDR’s SPY and Vanguard’s VOO) Notice that it was below its previous peak for more than 12 years from 1999 to 2011. And notice that it’s been basically flat for the most recent two years.
If during those periods you were relying on financial pundits’ advice that the stocks grow at an average rate of 9% per year, you should have been seriously disillusioned. You might take sad comfort in the words of revered economist John Maynard Keynes: “The market can stay irrational longer than you can remain solvent.”
Different life stages need different investment strategies
Nevertheless, over a 30 or 50 year timespan, the S&P 500 gained nearly 600%. When you’re young and far from retirement, you can afford to work with a plan that works on that timescale. If you’re making regular contributions to your retirement fund, dips are actually good news, because your contributions will buy more when prices are depressed, and you’ll gain proportionately more when prices recover.
But as you near retirement age and begin anticipating the transition of your income from your job to your investments, you can’t tolerate having to convert those investments from growth-oriented to income-oriented while their value is depressed by a recession. You’re unlikely to have the supernatural ability to know when the market will achieve its peak before your retirement date and execute that conversion just at the right time, so you’ll need to make a gradual shift in the balance of your investments over some period of time. This will buffer the effects of any dip or downturn, allowing you to catch the benefits of any recovery when you have time, while insulating your investments from severe losses as your retirement becomes imminent.
And then when you finally retire, the stability of your income is entirely dependent on clockwork payments from your investment portfolio. Any deviation of those payments from a regular schedule has a direct impact on your lifestyle. And, the size of those payments, and the size of the principal behind them, need to outpace inflation or you’ll actually be on a slow road to poverty.
How do you time the midlife shift? You want to be able to outlast any reasonable downturn. Figuring this out from first principles gets complicated, and nobody convincingly understands what those principles even are, but you can look to history as a guide. Carmen Reinhart and Kenneth Rogoff studied the big picture over a timespan of eight hundred years. The short answer: you need to be able to withstand a downturn lasting as long as about 10 years. It was 10 years from the stock market crash of 1929 to the beginning of World War II in 1939. It was 11 years from the financial collapse of 2008 that led to the “great recession” until recovery was complete in 2019.
So your investment strategy for this transitional period in your life should be approximately this: Invest in 100% stocks up to ten years before your retirement date, then over the next ten years, gradually adjust your investment profile to protect more and more of your portfolio from any shortfall from a downturn. As you’re rebalancing your portfolio regularly, at least annually, or better yet quarterly, as well as continuing your practice of monthly contributions, you’ll generate a lot of transactions that are tedious to keep track of.
An investment management firm will do this bookkeeping for you individually if you instruct them what to do, but they’ll charge a significant fee, and you’ll have to watch them carefully to make sure that they remember to keep to the plan you’ve specified for them. But since the 1990s, there’s been an easier way: invest in a target date fund. Because the fund is following the same strategy for all of its investors, its administrative costs are lower, and you’ll save on fees as well as on work. But be alert as you’re shopping for a particular fund to use, because they may have a double-layer fee structure that will end up costing you more than the rate that is mentioned most prominently in their prospectus descriptions. Even the otherwise quite good discussion of target date fund advantages and disadvantages by Caroline Banton for Investopedia is less transparent about fees than it is about other aspects of the funds that it discusses.
Congratulations!
If you put this plan together, with somewhat optimistic assumptions about how interest rates and inflation will develop, and assume that you are able to use low-cost exchange-traded index funds or robo-advisors to keep fees low, you’ll be able to achieve the U.S. median income of just over $31,000 per year, and you’ll be able to relax with confidence that it won’t be eaten away by invisible factors, provided that you can put together the $14.2 million needed before you retire.
How much are you going to need to allocate for those monthly contributions in order to have $14.2 million on that happy retirement day? And what can you do if you don’t make your target, and have to work with a smaller portfolio? That’s the subject of Part 2.
