Saving for retirement is an important goal that everyone needs to take seriously.
Much of the time, the advice being given to investors is to begin your investing young and choose 100% equity portfolios. I believe this is misguided.
In this piece I will discuss how to think about retirement and conservative investing.
Forget Everything You Think You Know About Retirement Investing
Saving for retirement is a hot topic these days. People are concerned about their lack of retirement savings, whether pension funds can get the returns necessary to meet their obligations, and so much more. Much of the discussion is about how to invest for retirement, which is largely dominated by discussions about equities, but I think many people are confusing investing with speculating in stocks. There is nothing better than picking a high flying stock, getting in at the bottom, and riding it higher. Far too often I encounter people who think their retirement account is a tool to allow them to speculate in stocks. No wonder there are those incorrectly saying that the 401(k) experiment has failed. Instead we need to rethink retirement investing, which needs to be very different than general investing.
The purpose of the retirement account is to save money for the future. There is a great difference between investing and saving. The idea behind saving is that you want the money back, with a reasonable rate of return such that you can replace your income in your retirement years. Unfortunately, Americans are not doing well at saving for retirement, with 56% of Americans having saved less than $10,000 for retirement. The first step to change this situation is to increase the savings rate of Americans, which can only be done once they are out of debt. This underscores the seriousness of the over-indebtedness of American households and its effect on the real economy, which will become more and more severe.
Let’s Think Differently About Retirement Saving and Investing
Traditional retirement investing advocates that investors take on maximum risk at the beginning of their working life, and gradually take less and less risk as they get closer to retirement. This is largely how a target date fund works, which is used by millions of Americans as their only vehicle for retirement savings. I believe this philosophy is greatly misguided. The idea behind the various retirement accounts is to replace your income when you enter retirement, it is not to gamble and “make a big score.” Instead of speculating in stocks, hoping that stocks are worth more in the future than they are now, and hoping that the market does not tank two days before you are about to retire, let’s look at a different approach to retirement planning and investing.
In this piece I want to ask you to rethink how you are investing for retirement. I am not suggesting that people should not own equities, but as a general rule, I have found you need a much smaller allocation to equities than you might think. The current model which proposes investors use upwards of 70% to 100% of their assets in equities exposes an investor’s wealth to excessive and unnecessary risks, for what may turn out to be less return.
The Mechanics of Zero Coupon U.S. Treasury Bonds
A zero coupon U.S. Treasury bond, also known as Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities), differs from other bonds in that a normal Treasury bond will pay you a rate of interest every year until maturity. A strip bond, on the other hand, is not an income generating security. The purpose of a strip bond is to achieve a desired payment at some point in the future. Treasury STRIPS sell at a deep discount to par, with the difference being the interest that will be earned on the bond. The bond is thus taking the yield you are set to receive at the time of purchase and reinvesting it for you over time. At maturity you will receive your principal plus all interest payments compounded. Therefore, these are the perfect securities for a retirement portfolio because you can buy them and allow them to compound until maturity, without the stress of wondering what the market did today. Because you are buying them every year, you are thus creating your own pension fund in effect, with each bond set to mature each year when you start retiring. With a Treasury strip you can count the cash, and calculate the value of your investment at your desired date of retirement.
Many are amazed that there is a way to project future cash flows, and know exactly how much you will have at retirement, on a worst case scenario. This relieves many of the great stress of whether they will have enough in retirement because they can see whether they need to save more or will have enough. As an aside, this is also a good vehicle for college savings. If you begin when your child is born, you know you have 18 years before you will begin to need the money. So you can set the bond ladder up to mature when your child is 18, and then another when they are 19, 20, and so on. But back to talking about retirement.
Let’s say you decide to begin your own pension fund. Let’s assume you start at 22, and every year you put money in a 30 year Zero coupon U.S. Treasury security. By doing this every year, you also guarantee they will mature beginning when you are 52, and continue on at 53, 54 etc. to which you can then fine-tune the duration to the exact date when you will need the money. Maybe you want to retire at age 62, so you can begin buying 10 year Treasury bonds at that point, taking advantage of the yields at that time. What you have is a guarantee, backed by the full faith and credit of the U.S. Government, that you will get your money back, and earn a reasonable return during the period. But nothing says you have to hold it for 30 years, or 10 years. Maybe the bonds go up and you take a profit, and wait to reinvest at higher yields. Maybe equities fall 30-40% and you decide to take profits on your bonds and buy equities at basement valuations. The point is, you are providing yourself with a far better opportunity set to invest for retirement. That includes the ability to simply hold, and roll long term zero coupon Treasuries without the stress of watching the market. This is particularly advantageous for those with high savings rates.
U.S. Treasury Zeroes Performance
Most investors hear U.S. Treasury bond and instantly say “no way…I don’t want that low return!” This really demonstrates that they do not understand the mechanics of zeroes and the incredible opportunity to achieve above average returns, with the added benefit of downside protection when held to maturity. When we look at a 30 year U.S. Treasury Zero Coupon Bond, we see that over the past 20 years, the bond has a cumulative return of 428.22%, which outpaces both the large cap market segment represented by the Vanguard S&P 500 Index Fund (VFINX), and the mid/small cap market segment represented by the Vanguard Extended Market index fund (VEXMX).
|1997-2017||U.S. Treasury Zeros Advantage|
|Vanguard S&P 500 Index Fund||277.10%||151.12%|
|Vanguard Extended Market Index Fund||367.54%||60.68%|
|30 Year Zero Coupon U.S. Treasury Bond||428.22%||–|
The largest objection I receive when I go over this data is that, “well that’s the past and the odds of Treasuries outpacing equities again are 0%,” but are they really 0%? Currently, we have equities at the second highest valuation ever. We have geopolitical risk everywhere, and more importantly, we have a world saturated in debt at both the government and household levels.
There is a very serious demand problem across the globe, which I believe, coupled with demographic challenges in developed markets, will lead to less consumption in the future, and thus lower earnings and lower stock prices. In a deflationary world, the zero coupon U.S. Treasury bond is the instrument of choice for investors seeking to preserve their wealth.
I project that yields will continue falling down to below 2% on the 30 year and below 1% on the 10 year. If I am correct, then yields on the 10-year will fall from 2.10% where they are now, to 1%, which is a 52.38% reduction in yields, providing investors with a fantastic return. If I am wrong, then the bond can be held to maturity and you will earn 2.10% compounding until maturity.
Equities do not have this built-in fail-safe yield. Many investors are taking on ever more risk in the stretch for yield. They are buying high yield bonds, and dividend paying stocks. However in the process, they are trading in assets which are totally risk free when held to maturity (backed by the full faith and credit of the U.S. Government) and trading it in for an asset which has a significant downside potential at sky high valuations. Investors who believe they are shielding themselves from downside risk by owning dividend paying stocks are deluding themselves. In the 2008 financial crisis, the Vanguard High Dividend Yield Index Fund (VYM) fell dramatically, so why does it matter that you are getting an extra 100bps in yield when you are putting your capital at risk of losing 30% or more? Zeroes continue to outpace equities, and will likely continue to do so as the world attempts to deal with the drastic debt situation globally.
Vanguard High Dividend Yield (VYM)
Performance During the Financial Crisis
Savings vs. Investing
Whenever I am asked to run a simulation on whether an individual should take a lump sum on their pension my answer is generally yes, for a number of reasons. First and foremost, you take possession of the asset which is generally a good thing in this world where virtually nothing is guaranteed. Secondly, it is relatively easy to outpace the returns of most pension funds. Finally, it is possible to create your own pension fund from the capital using a portfolio of mostly U.S. Treasury securities. Now obviously these decisions should be made with each individual’s circumstances in mind, and there is no universal right answer, but more times than not, it is relatively easy to build a pension fund that you control and taking a lump sum payout makes sense. Buying zeroes by creating a bond ladder that has one bond maturing every year, provides one with a stable income, without depending on the ups and downs of dividend paying stocks.
For a younger investor this is even more appealing because they can take advantage of the power of compounding. This also allows for the investor to tailor any portion put into equities to tilt the portfolio towards higher beta stocks. This is because an individual’s risk exposure should be determined by their need and desire to take risk. A young person generally has the desire but not the need to take on excessive risk, so a greater level of risk taken with a smaller pool of capital creates an optimal risk and return proposition. For young people, their greatest power to attain wealth is their income and ability to save rather than taking on asymmetric risks in an attempt to achieve high levels of returns. As I tell people who ask me about investing, you want to hit singles when building a portfolio; you want to be the tortoise, not the hare. Slow and steady wins the race. Level of savings is what matters, do not try to hit home runs by taking inordinate amounts of risk to try to attain high levels of return.
To illustrate this point let’s take a look at a young person who can max out both a 401(k) and Roth IRA. They would be saving a maximum of $23,500 every year based on current limits. If they marry and their spouse can do this as well, they save $47,000 a year. If they were single and saved $23,500 every year and earned a modest return, which averages out to just 3% on their investment, they would have $2,069,137.61 when they retire at 65. If they were married at 22 and did this as a couple, saving $47,000 a year, they would have $4,138,275.23 when they turned 65.
Maybe that is too ambitious. How many 22 year olds can save $23,500 a year? Let’s give this young person five years of not saving and start them at 27, maxing out tax advantaged retirement plans and saving $23,500 per year. That still gets you to $1,748,429.60 for an individual and $3,496,859.21 for a couple by age 65. Remember they are only earning 3% on their investment. The power is in their income and ability to save, the return is less important. I am not saying return is not important; you certainly want to maximize return, but not without taking prudent levels of risk. Current investing dogma throws caution to the wind for a 22 year old, and would tell them to be 100% in stocks, because they can withstand the volatility. This is also built on the notion that the equity risk premium will provide the investor with a higher return than a risk free U.S. Treasury, which we can see was clearly not the case for the past 20 years. In fact a larger study proves that Treasury bonds have done quite well for a much longer period of time.
Stock market investors took the risk—riding out every bubble, every crash, every spectacular bankruptcy and bear market, over a 30-year stretch. How much were they compensated for the blood, sweat, and tears spilled with all this volatility? A measly 53 basis points per annum! Indeed, those that have incurred the ups and downs over the past decade have lost money compared to what they could have earned from long-term government bonds. They’ve paid for the privilege of incurring stomach-churning risk. Not only did Treasury bond investors sleep better, they ate better too!” – Rob Arnott, Research Affiliates
Quantitative Exploration of Portfolio Risk
For a young person just starting out, a zero coupon U.S. Treasury allows you to buy a 30 year bond and hold it to maturity as a worst case scenario. If you buy them every year with money you save for retirement, you again create your own pension fund with part of your portfolio, and allow the other section of it to take advantage of any growth opportunities that present themselves, thus taking advantage of market volatility over time. Because the portfolio is constructed with a limited equity allocation, and because of the negative correlation of equities and U.S. Treasuries, it is very difficult to lose money with this portfolio when the bonds are held to maturity. As we know from research it is very difficult to recover from significant market losses. Therefore part of the equation for outperforming over the long run is being able to avoid significant market losses, which is why a retirement portfolio, in my view, should be dominated by rolling long term zero coupon U.S. Treasury bonds.
Investors drastically underestimate risk when investing their hard-earned money. They also fail to understand the mathematics of investment loss. Seeing as investors can always choose the risk-free rate, in order for an investor to step out on the risk curve, they require a premium in returns. This what we call the equity risk premium – put simply, the additional return required from taking additional risks in equity securities. I have demonstrated that this theoretical construct failed investors over the past twenty years. While equities have surely risen over the recent past as a result of QE and the increased equity premium offered by seemingly risk-free, Fed-controlled markets, investors are assuming the future will look like the recent past. It will not, and in the process, investors are exposing their money to more and more risk of loss.
It is no use having this discussion in the abstract, so let’s look at several drawdown periods to explore the dramatic impact of investment losses on long-term wealth creation ability and why a risk-managed approach to investing is superior using zero coupon U.S. Treasury bonds.
The Effect of Drawdowns
|Draw Down Period||% Loss||$ Loss||Ending Value||%Gain needed to get back to even|
Retirement investing advice is dominated by model portfolios that emphasize stocks. This is largely due to the notion of an equity risk premium that indicates investors should own stocks for the long run. However, data provides some doubt as to whether equities truly offer an increased return for their increased risk exposure. This is especially true at today’s valuations, where the P/E 10 is 30.4, with an implied future return of less than 1%. Below is a chart showing the U.S. stock average real compound returns versus 10-year CAPE ratios 1881-2011.
Therefore, it is time to rethink how we approach savings and investing for retirement. We can no longer assume an equity risk premium when we plan investment portfolios, instead we should be considering a more reasoned and rational approach that allows investors to count the cash, and project what they will have in retirement, rather than guessing and hoping they have enough.
Savings is an investor’s greatest tool for wealth accumulation; U.S. Treasury STRIPS provide retirement savers with a dependable rate of return, when held to maturity. Even better, over the past twenty years, rolling a portfolio of zero coupon U.S. Treasury bonds would have produced investment returns that have outpaced equities. Treasuries allow an investor to customize their portfolio to when they will retire, and in effect, create their own pension fund. The purpose of an investment is not to make a bet, it is to get your money back along with a reasonable rate of return on capital. Investors should reconsider how they think about investing, and saving for the future.