We are working with a lovely couple who really, really want to get out of the rental business. They are SO over dealing with the “Four Ts” of property ownership: tenants, trash, termites, and taxes. The property has been their main source of income, though, and they have understandable concerns about divesting from real estate that has been good to them. What is an alternative way to invest and create a replacement income stream if they don’t use real estate?
What about equities and fixed income? Well, the last few years have been an absolute rollercoaster of highs and lows. No “Four Ts” there, but instead, lots of wiggle … or, as is the technical term of art, “volatility.”
Is there anything to be done that could help them keep their principal (and their income) stable over time?
Good news! There are actually some clever mathematical levers you can pull to reliably build your retirement, as well as create a high “confidence factor” that your money will last longer than you do … Imagine That!™
Table of Contents
The Three Big Mistakes We See Investors Make
I should preface this by saying that there is no perfect investment platform. The trick is to get the math right most of the time.
In our search for consistent long-term performance, we have discovered two different but equally successful platforms. This month, we will focus on one of them, which uses math and history to build algorithms and prevent disastrous losses. There are a number of things to like about them. One of the things I greatly appreciate is their deep dive into the math of long-term successful investment performance.
Mistake 1: Investing using short-term results, not long-term performance.
Too often, investors chase the hottest-performing sector of the investment market from the prior year. The reality is that invariably, the sectors that are the highest performers in one year will be the worst performers in the following year or two. Instead of chasing returns and only looking at the last year or two, the math and history advise that we look at 20 years of returns or longer before making our investment choices.
In talking with new and/or existing clients, I find that periodically, there is a need to either educate or remind them that long-term performance beats high performance over one to two years. The best-performing fund or strategy is not the one without any losses; it’s the one that has balanced gains in the majority of years with infrequent losses … and those losses being modest rather than catastrophic.
It only takes one year of loss at -36.59%, as in 2008, to utterly devastate your retirement portfolio … and push off retirement by a decade or longer!
What’s a solution? Keep reading!
Mistake 2: Exaggerating the importance of investment gains and underestimating the importance of limiting losses.
Let’s look at the math to consider this point.
If your portfolio drops 10%, what percentage return would you need to fully recover from your loss? Most people would say 10%.
Great guess … but not quite accurate. Keep reading …
If you have $100 and lose 10%, you now have $90. If you gain 10% of $90, you now have $99. See what I’m getting at? You’ll need just slightly over 11% to get back to where you started… with $100 in your account.
That number only gets bigger the greater the loss that the investment portfolio incurs.
Losing 10% of your portfolio feels awful, but mathematically, it’s not the end of the world. But how about losing over 25%? You will need significant gains (and probably years!) to get back to where you started.
So, if you ignore the year you lost 36.59% but are really excited about those 15+% returns, it will still take a loooooong time to recover.
There are ways to prevent catastrophic losses. If you are curious about how … keep reading!
Mistake 2: The danger of relying on only one source of retirement income.
Once you begin receiving income (because you are now happily retired!), you face another danger that is seldom recognized. That danger comes from relying solely on your retirement account for income (in addition to any Social Security you receive.)
“What’s the danger?” you ask.
It ties in with something at Wealth Legacy Group we call “wiggle,” but the technical term for it is “volatility.” Once retired, the greater the differences are between the highs and lows in your investment returns (among other factors), the more likely your portfolio is to self-destruct.
The greater the volatility, the more uncertainty is created about whether your retirement nest egg will be able to confidently provide you with enough money to live comfortably for the rest of your life … or not!
If your portfolio is down -36.59% (2008), -21.97% (2002), or -18.01% like it was a year ago, you’re accelerating the deterioration of your portfolio by taking money out instead of letting it have a year (or two) to recover. And, without a backup plan, there could be some very serious and awkward conversations with your spouse/partner!
How about an example?
Let’s say when you retire, you have accumulated $1.5 million in an individual retirement account. You begin taking out $90,000/year in our example. (Normally, I would not recommend taking out that high a percentage – 6% – but it just makes the math easier for our discussion.)
Let’s also assume that you began taking out your withdrawals in 2001 for 20 years. By the end of 2020, your bucket would be running dangerously close to empty … having $224,111 still available for distribution. Gulp …
What do you do?
How about creating another “bucket” or two? A bucket of income, that is, to use when our primary source falls down the stairs?
Fortunately, there are several options I really like for creating additional buckets from which to draw income.
One of our favorite tools is an “investment-grade” life insurance contract structured to emphasize the non-taxable asset value growth, as opposed to having it for survivor benefit purposes. As we illustrate below in our chart, the insurance contract can provide a non-taxable income stream in those years when the primary retirement account is down. (This assumes that the insurance contract has been properly designed to keep the income non-taxable!)
But using a life insurance contract is not everyone’s cup of tea, or their health may prevent them from using this approach. Although, the beauty of this strategy is that we are using it for the income … and not the survivor benefit it could produce.
Side note: Someone who is not in the best of health could still find this a very attractive concept. The insurance company simply reduces the survivor benefit, but the income stream it could generate will remain largely the same as if he/she were in the best underwriting classification, which then requires a higher survivor benefit to comply with IRS rules. Boom!
OK, in addition to the insurance approach, what else do you have for me?
Let’s return to our couple who are weary of the “4 Ts” of real estate. And, by the way, we recommend always having real estate in your portfolio in some form for the rest of your life. But it doesn’t have to be the “active management” type of real estate! There are other ways to get there.
For accredited investors, there are tax-advantaged alternative investment options that keep real estate in their portfolio without the 3 a.m. calls that a water heater is leaking and pouring through the ceiling of an upper-floor unit.
They could instead invest in self-storage funds. In most years, it is the number one real estate investment in recessionary times. And usually one of the top two performers in real estate when the marketplace is doing well.
Or, they could invest in housing for “successful seniors.” After all, over 12,000 Americans will turn age 65 in 2024 and 2025 PER DAY! Investors receive an income that is non-taxable for at least the first 3-5 years, plus a share (up to 100%) of the net proceeds when the real estate project is sold. It qualifies for a 1031 exchange and can just keep rolling the funds into new projects, and in most cases, will have an increasing income stream as your principal invested amount grows.
OK, what does that look like in terms of our example?
Let’s assume you take out your $90,000 of income on January 1st each year. And, in any year where returns in your IRA are negative, the following year, simply take your $90,000 from the backup bucket. In the twenty-year period of 1/1/2001 through 12/31/2020, there were four years when returns were negative. By not being forced to take income out of your IRA in the years following negative returns and instead giving it a year to recover, it makes a huge difference! A $1.6 million difference!
These are simply two options. There are many more depending upon your risk tolerance and your situation. You can call us at (858) 569-0633 for a complementary 20-minute consultation to address your unique circumstances and what might be a possible fit for your additional buckets.
So, even when bear markets happen (and they always do sooner or later), it doesn’t have to be an unbearable situation for your retirement. (Pun 100% intended.)
How To Avoid Catastrophic Losses ... Automatically
The “math-and-history-based” platform we use provides a feature you will rarely find despite how incredibly useful it can be … something called a stop-loss. It automatically sells the equity portion of the investment account when the “basket” of eleven sectors drops by 10% from their all-time high. It also automatically sells bonds if the bond “basket” retreats 4% from its “high-water mark.”
Fun fact of the day: there are only 11 sectors that make up the entire $22 trillion U.S. economy. That’s it. Only 11. And this platform allows us to invest across the entirety of the U.S. economy. Pretty darn clever!
I like to use the analogy… if you never drive fully into the ditch, you won’t have to get pulled out of the ditch! It’s the same thing here. A 10% loss might sting, but it’s not like watching your portfolio plummet by -36.59%, as happened to the Vanguard S & P 500 Index fund in 2008 and -18.1% in 2022!
The stop-loss prevents you from catastrophic losses, which also helps you sleep better at night, knowing that your principal is protected. As one who has seven figures invested in this platform myself, I can say personally this is a great comfort to me at this stage of life and career!
Then, it automatically buys back into the equity sectors when the market rebounds from its bottom. It uses a specific percentage recovery threshold developed from analyzing the fourteen recessions since World War II before reinvesting.
The advantage of a stop-loss is that it eliminates the need to watch your accounts daily and check their performance. Having a stop-loss protects your principal before that stop-loss kicks in. It won’t keep your account from going negative at times, but it does provide downside protection that just isn’t there in 99.9% of other investment platforms.
The automatic re-entry provision also takes the worry out of watching your account daily, wondering when you should return to equities. While nothing is perfect, the math behind this exit and re-entry approach has had a positive return (and significantly reduced the negative impact of volatility) far more often than not.
OK, But Show Us The Math! (Or The Money!)
I have an engineering friend who has been a long-term investor in the Vanguard S & P 500 Index Fund. I asked him how he handled the volatility of the S & P index. He said, “Well, R. J., that’s a good point, but I know that if I just hold on long enough, it will recover.”
He’s right, but let’s examine recent history to see if there is a better way than “holding on for dear life” through significant drops in the equity market.
Let me walk you through this chart. We start out in 2002 with Option #1, and in that year, the market went down 22%. (I might add that the two prior years were also negative for returns.)
Then, in 2003, the market bounced back and did very well, up +28.32% and so forth! You can see the wild swings up and down over time. As my friend noted, if you have time to wait for recovery, you should be fine. Now, you may be on heart medication for all the anxiety suffered through those ups and downs, but your account over time should (and heavy on the “should”) be OK. And, as long as you have not also begun smoking to calm your nerves, your health should recover also!
But let’s assume you are in retirement mode and making withdrawals from your account. Let’s assume a withdrawal rate of 5% per year of the starting account value (5% of $1,000,000 or $50,000.) So, you get your $50,000 out, but because of the negative return in 2002, you would have also lost a chunk of your portfolio in that first year of income withdrawals.
Side note: For more on safe withdrawal rates read our previous article, How Much Can I Withdraw From My Retirement Account(s) & Not Run Out of Money?
Fortunately, because of the great returns in 2003 – 2007, your portfolio would have grown back to a value of just over a million dollars. But unfortunately, not for long!
Boom! 2008 happens. Now you’re WAY down. You are smoking, drinking, sleeping in late, no longer calling your parents on Sundays, etc. Bad news! Your income, instead of being $50,000, drops to $31,000 that next year … a 40% loss in just one year! Ouch! That conversation with your spouse would be pretty tough, too! And, it is especially hard not knowing what investment returns to expect in subsequent years.
The S & P will bounce back at some point … but when? Recent history shows the S & P Index returns had a robust recovery in most years following 2008, but it took over six years to have the principal return to $1,000,000.
There was another negative year in 2018. But, by the end of 20 years, you would have received your target income of just over $50,000/year or a little over a million dollars over the 20 years. And your $1,000,000 would have grown to be worth $2,157,135 at the end of 2021!
What a ride!
Looking back on 2008 now, some tend to treat it dismissively. “We just gritted our teeth and didn’t watch the news for twelve years.” But, I can assure you, if you were retired and taking income during that time, it was a massively scary time! There were many pointed conversations about whether or not to reduce income withdrawals. And, to reduce the wild swings in the market meant substantially reducing returns to invest in more stable asset classes. How much of a reduction in income? What investment allocations? Lots of questions to ask with no clear direction.
Compare all that angst to the platform I use for the equity and bond portion of assets for my wife and me and the vast majority of our clients. You will see it on the right side of the chart above, as indicated in “Option 2.”
First of all, look at how consistent the income stream is. Not to say it’s perfect. Every investment platform will have good years and bad years. That’s why it is so important to compare returns over at least a 20-year time period. How has the investment platform you are considering performed through various mini-market cycles vs. other platforms?
While none of us want to lose any money, a -8% or -10% loss any given year won’t take you out of the game. But, if you lose -36% in one year, that could completely destroy your ideal retirement dream.
Also, because the income stream is so consistent with Option #2, we would have 60% more income over twenty years—$1.6 million vs. $1 million. Not only that … but our $1,000,000 would have grown to $2.7 million in the Option #2 bucket vs. $2.1 million in Option #1.
You can see the income from NOT making the three mistakes above still surpasses “white knuckling” through the tough years.
And, if that was too many words and you skipped to the bottom, here are the takeaways on how to protect your money against volatile markets.
- Always use a 20- or 30-year lookback when considering new investment strategies
- Minimize catastrophic losses because they impact your portfolio more than gains
- Have multiple “buckets” of income to let your retirement portfolio recover
So, to summarize all the above into one sentence, over time – preferably 20 years or more – money just grows faster when it doesn’t need to recover from major losses … Imagine That!™
Imagine That!™ is a complimentary monthly newsletter provided by Wealth Legacy Group®, Inc. that addresses various topics of interest for high-net-worth and high-income business owners, professionals, executives and their families. Sign up to receive our monthly newsletter here.
R. J. Kelly, Wealth Legacy Group®, Inc. – July / August 2024
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