Retirement Income Considerations

Very few advisors talk about how to be invested **in** retirement, mainly about how to invest **for** retirement. If we buy into the progressive age target maturities concept of Vanguard Funds (and similar plans at all the major US mutual fund families), we start in our 20's to 40's with a fund containing 70-90% stocks and eventually end up with a bond fund or funds plus a small residual portion of stock funds. If you are young, making money, and very busy with life, just sticking the money into a target maturities plan is an excellent idea to get started, e specially in 401K or IRA plans.

But whether you go on auto-pilot, learn to invest, or use an advisor, how do you live off the money you've accumulated and invested when you no longer have employment income?  "Retirement" is not my favorite word. I know people in their 20's who are retired in the sense they have no employment income and are living off their net worth. If you won a large state lottery at any age or inherited a large estate, you would also likely be "retired". A better title than "retirement income" would be "living off your net worth", and this can occur at any age if your net worth is sufficient to generate enough income for life. So the basic issues for us are: 1. Living off 2. sufficient net worth 3. for life.

Right now in early October 2007 you can earn a bit over 5% per year in a conservative money market fund (MMF) in which there is very little risk of ever losing any principal of your net worth. My favorite is Vanguard's Prime Money Market fund paying 5.03%. This rate is NOT guaranteed and in fact has been dropping several basis points (one one-hundredth of one percent, or 0.01%) per week since the FED dropped its rates by one half percent to 4.75%. MMF rates will slowly continue to decline as their assets are rolled over to newer short term fixed income instruments. But for purposes of this this discussion, assume you could make 5%. A  million dollars in a MMF would get you $50,000 per year with virtually no risk of dollar loss at any time but with the risk that your interest rate, and hence income, could decline.

Right now bank Certificates of Deposit (CD), government insured up to $125,000 per account per bank, range from 4.45% for a six month CD to 4.66% for a five year CD. These rates dropped from 4.52% and 4.82% respectively two weeks ago. http://www.bankrate.com/brm/search/story-investing.asp So your million dollars would get you $46,600 per year for five years had you bought an average five year CD on Friday last week. And it would be fully taxable. Which brings up the fact that municipal bonds are a great comparative value right now. They are government bonds of cities and counties and states, and governments  have the power of taxation to pay their bonds. Vanguard's AAA insured municipal fund (6.9 year duration and with no AMT bonds) currently pays 4.62% on current price and is totally free of US Federal income tax and partly free of state income taxes. $46,200 per year Federal tax free is equivalent to $54,118 for someone in the 15% tax bracket or $61,600 in the 25% bracket. Vanguard also has an AA and an A muni bond fund with higher yields and slightly higher risk. I have been buying some of each of the two latter funds this year on bond market plunges.

So that's what you can get on a million dollars without too much effort or risk. If you also have US Social Security retirement payments or a corporate or government pension, this may be sufficient. A million dollars sounds like a lot of money, but $45,000-$50,000 per year of investment income doesn't sound like enough to many people and their budgets. If you are older, have no debts, have good health and other insurance, and either own your home or have a low long term rental lease, it may be enough. Otherwise you may have a problem.

But there are other risks. I see the world currently in a longer term inflationary period for probably at least another decade, perhaps two decades. We saw gold going over $750 recently and the  US dollar sinking to a new all-time (modern) low. (The US dollar had its all-time low during the US Civil War when it was virtually worthless for several years.) The real challenge for someone living off their capital in this current era is to retain purchasing power after inflation, currency debasement, falling interest rates, and taxes. US Federal income taxes are now at very low historical rates, due to policies of Presidents Reagan, Clinton, and Bush. That is likely to change after next year's elections. Given inflation, a falling dollar, falling rates, and the likelihood of higher taxes in the future, $50,000 on a million dollars of capital may not be sufficient.

It is much harder for someone living off their capital to keep purchasing power into the future than it was for the generation which retired  in the early 1980's. Twenty to thirty year US Treasury bonds at that time paid 14% or more, not 4.5% as they do now, and inflation, though high, was then falling and would fall for years. We are at the other end of the interest rate and inflation spectrum or cycle now.

Look at an inflation calculator to get a feel for what future inflation would require you to earn per year to give you the same buying power as $50,000 will buy you in 2007. http://www.calculatorweb.com/calculators/inflationcalc.shtml Assuming an average 3% rate of inflation, you would need $67,196 ten years from now. Since we are in an inflationary era and will be for quite some time, the rate could be higher. An annual rate of 5% would require $81,445 income ten years from now. That would be quite a challenge for someone living on income from capital!

So now we recognize that we have investment risk, interest rate risk, tax increase risk, currency risk, and inflation risk.  I seriously recommend reading my post on annuities.http://twocents.blogs.com/weblog/2007/08/annuities.html   My family has an immediate annuity using approximately 20% of our total invested net worth.  Annuities are a simple and effective way to invest some part of your money if you are near to or in retirement, since you can insure against part of all of the listed risks with an immediate annuity, even inflation risk, for a cost. Today you could buy a $999,999 annuity (the highest amount Vanguard's annuity calculator will permit on-line http://www.aigretirementgold.com/vlip/VLIPController?page=RequestaQuote) for a male who would be 65 years old next January 1 which would start monthly payments for life on January 3, 2008 and be inflation-protected for your entire remaining life. The monthly payment would be $5,150.93 or $61,811.16 per year, and it would be adjusted for inflation each January. 81% would be tax-free, if after tax money is used tobuy the annuity, as that amount would represent return of capital.  All income wouyld be taxable if purchsed with tax-deferred IRA or 401K funds. As you will see in my annuity post, the drawback of annuities is that you will not be able to leave any of your annuitized capital to an heir. Your only risk is  that the insurance company issuing the annuity goes bankrupt. For a single person with no heirs at age 65 or older, the inflation-protected annuity is appealing for its simplicity, risk protection, and tax savings if purchased with after tax money.

Including your spouse so that whichever of you survives the other would have the same inflation protection for his or her lifetime reduces the initial monthly payment dramatically to $3,333.69. So unless you have an insurance policy for the spouse that would enable her or him to buy an annuity upon your death, this won't work for a married couple. But the example above shows what an annuity can do. I have chosen to use only about 20% of my funds to purchase an annuity, at least for now.

One can always buy additional annuities as one gets older depending upon interest rates and estate matters. And the older you are, the higher your annuity payment monthly since your life expectancy is less. If you are 70 when you buy the $1,000,000 inflation-protected annuity for yourself, you would get $6,381 per month for the first year, and for 100% joint survivorship benefits for a husband and wife, both aged 70, you would get $4,687 per month the first year. Bear in mind that annuity payouts vary with your age at the time you buy the annuity and vary with the interest rate at the time you buy it, so the numbers I mentioned are for illustration only, as of this past week.

We've looked at money market funds, five year CD's, municipal bond funds, and annuities as uncomplicated ways to generate income to live on from one's capital. Right now we can get from $45,000 to $62,000 per year on these methods with a million dollars of capital. Is there any way to get more than that? Could I get $100,000 per year? Yes, maybe, but it will take a lot of skill and effort and increased risk to do so compared to the uncomplicated methods, especially if you need the income THIS YEAR. You could increase the income part by judiciously choosing higher yield income funds with long term success rates, and you could get some tax protection with higher yield municipal funds and some inflation protection with careful selection of proven low volatility stock funds augmented with some smaller portion of specifically inflation-proof sectors such as energy and metals funds.

US stocks as measured by the Dow Jones 30 Index have historically returned 8.04% capital gain since 1932, as of Friday, and another 3% with dividends, while the US compounded inflation rate as measured by the Consumer Price Index is 3.51% annually since 1932. This is why we buy stocks: to beat inflation. But stocks don't do it every day or every month or year or put after tax income on your table in the same amounts as needed. Gold has returned 4.27% compounded annually since it was revalued at $35 by President Roosevelt in 1934. So gold has kept up with US inflation, at least before taxes and holding costs, but not as well as the Dow Jones 30.

However, in an overtly inflationary period gold does better than inflation: from January 1, 1975, when it became legal for American citizens to own gold for the first time since Roosevelt's early first term, through the end of 1980, the compounded rate of inflation (CPI) was 6.11% and gold compounded at 22.3% for the same period. This is not to say that gold will always do that. But gold has compounded at an annual rate of 15.70% since January 1, 2001 to Friday while the US CPI has compounded at a rate of 2.69%. Of course, changes in the dollar also impact the value of our dollar-denominated assets, and the US Dollar Index (versus the currencies of our trading partner nations) has declined at a compounded yearly rate of 4.93% since January 1, 2001! For simplicity's sake if we add 4.93 to the CPI rate of 2.69, we get 7.62% for currency and inflation risk from January 1, 2001 to Friday, September 28, 2007. But the Dow Jones 30 only rose 3.83% or, with dividends reinvested , 5.91% per year (before tax, if applicable) which is 1.71% per year less than the inflation and currency loss!

This is precisely why I said above that for inflation/currency insurance we need a "careful selection of proven low volatility stock funds augmented with some smaller portion of specifically inflation-proof sectors such as energy and metals funds". We want funds that have demonstrated they can go through a bear market without losing or perhaps even gaining, and we want exposure to sectors which benefit from inflation and currency loss of purchasing power. You can get this insurance very simply with US Double Eagle one ounce gold coins which you can keep at your bank or in a safe at home or your office. You could have bought them for $255 in 2001 and Friday before last they could have bought for $785. I wouldn't recommend going out and buying 100 of them all at once for $78,500, but if the idea of owning the coins appeals to you, buy one or more a month from now on no matter the price. There are reputable coin sellers in all major cities and the prices are available to you over the internet so you know the going price.

Vanguard Precious Metals & Mining Fund, which I also own, is now closed to new investors unless you have an account at Vanguard over $500,000 and commit to buying $100,000 of VGPMX. For the past 14 years VGPMX has a compounded annual increase of 13.1% despite a devastating bear market for metals between 1996 and 1998-1999. If you look at the rate for VGPMX since the 1998 low, the compounded rate is 30.25% per year, and from the beginning of 2001, as above, it is 33.70% per year. That is double the rate of increase for the metal gold in bar or coin form.

I prefer the full range of metals companies to gold stocks alone, something I learned to treasure from the late Paul Sarnoff in the 1990's. If you can't buy VGPMX or don't want to, look at USAGX Precious Metals & Minerals which has a similar approach to VGPMX. USAGX has risen a bit more than VGPMX since January 1, 2001 (37.19%). I also own VGENX (Vanguard Energy Fund) which has compounded at 23.21% per year since January 1, 2001. My gold metal, the metals fund, and energy fund are currently approximately 10% of my total assets, but even that small percentage (10%) increases the total return over my complete assets by 2-3% per year. It may not sound like a lot, but if you look at a compound interest rate table over long periods, several percentage points really makes a difference. However, owning them removes 10% of your funds from earning interest for you, so that is a limiting factor if you are living off your capital. It is an insurance policy for inflation and currency loss, but the insurance isn't free of cost.

You can also increase your return above inflation and currency losses by including several stock sectors  and by foreign country stock or fund selection. From 2000 to 2007 US small caps and mid caps outperformed large caps, and most international stock markets outperformed US markets. One of my favorite long term funds is SGENX (First Eagle Global Stock Fund). It holds both US and foreign funds and has a splendid record going back to the late 1980's. Using the same date of January 1,2001 it is up 17.62% compounded while the Dow Jones 30 with dividends reinvested is up 5.91%.  This is just one example of how sector selection can increase long term returns, but you have to know when to make a sector change. Right now US large caps are a bargain, especially for someone from outside the US, and foreign stocks are not generally the bargains as they once were. However,as with metals and energy stocks, different US sectors and foreign stocks go through periods of favor andf disfavor and often at different times. So some diversification can help. Or if you are lucky or a good speculator and want to spend some time doing that in retirement, it can help. Of course if you aren't good or lucky you can lose. Unfortunately I see more and more retired people compelled to try to speculate to increase yields for current living.

My goal is simply to show that sector selection can help. In the 11 years that both the Vanguard Total US Stock Market Fund (VTSMX) and Vanguard Total International Stock Fund (VGTSX) have been available, VTSMX has compounded at 9.32% and VGTSX at 8.75%. VGTSX did much better from 1996 to 2000, and VGSTX has done much better since 2003. You could try to time when to emphasize US stocks and when to emphasize foreign stocks, or you could always own some of each fund in whatever size or percent of total funds you see as appropriate. Vanguard and other fund families have "funds of funds" which will even do that for you at fairly low cost. VFIFX has this makeup:

1 Vanguard Total Stock Market Index Fund 72.1%
2 Vanguard European Stock Index Fund 10.5%
3 Vanguard Total Bond Market Index Fund 9.8%
4 Vanguard Pacific Stock Index Fund 4.7%
5 Vanguard Emerging Markets Stock Index Fund 2.9%
Total — 100.0%

This fund even pays a 2% dividend.This fund is just an example of how taking it easy would work toward "insuring" against inflation and currency and sector risk, and is not a recommendation as such.

I'll show you how I deal with the yield or income dilemma of how to increase yield above money market or muni bond levels in a larger part of my total retirement portfolio. I have written about this before, but this is my current thinking over the past few months as living off income from capital looms. The chart shows six specific funds that are easily bought, and the table shows some statistical information on those funds compared to a universe of interesting funds and in which funds identified by a red arrow are owned by me to some extent.

I own a fairly large portion of both VWIAX/VWINX (Vanguard Wellesley Income and LSBDX/LSBRX(Loomis Sayles Institutional Bond), both of which I have written about on several occasions at this blog. These two come in greater than $100,000 and less than $100,000 minimum versions. The only difference between the two versions is that the greater than $100,000 versions get a reduced cost fee since they are said to cost the fund less to administer in one lump sum than scattered amongst many smaller accounts. The differences are not great. you can read about these funds and most others at http://www.morningstar.com .

Vanguard Wellesley is about 68% intermediate term domestic and foreign corporate and Treasury bonds and 32% higher dividend blue chips stocks  with a few foreign stocks. Wellesley's current yield is 4.55% for the $100,00 version which is about that of a CD, but its 14 year compounded return is 8.67%. This is an income fund which generates capital gains in excess of the long term inflation rate. Since it began in 1970, Wellesley returned a compound annual return of 10.66%. That is during some horrendous bear markets and some great bull markets for both stocks and bonds. It's a rock.

Likewise, Loomis Sayles Bond Fund LSBDX has been around since May 14,1991 (in my data base) and has compounded at 11.32% per year! It suffered a maximum draw down of 9.18% during its existence and Wellesley 10.17, compared to the  Vanguard S&P500 Fund which had a maximum draw down from 2000 to 2002 of 47.51% with a compounded annual rate of 11.10! 20% of the volatility with the same return allows me to sleep better. The current yield of Loomis is over 6% with a fairly defensive posture in this year of interest rate danger. Loomis Sayles is a bond house and this fund covers the whole bond universe from US Treasuries to emerging market sovereign bonds and corporate bonds, with high yield domestic bonds as well. The managers have most of their own assets in this fund, always a good sign. So this is a bond fund with capital gains potential even during recent years when capital gains have been rare in bonds.

A third major holding of mine, but not as large as Wellesley and Loomis Sayles, is T R Price's Spectrum Income Fund (RPSIX). This is somewhat like Loomis Sayles but more conservative and with 15-20% in stocks. It is less volatile than the other two with a smaller long term return (7.16%) and currently yielding 4.47%.

Another area of bonds I have researched over the past few months is US closed-end foreign income funds. Closed ends (CEF's) trade like ETF's and some have been around for decades. Unlike ETF's they are not index funds, and they often trade at substantial discounts to their net asset values, unlike ETF's. To investigate these interesting funds, look at http://www.etfconnect.com and click on closed ends or use the search function. I've found three funds which are unleveraged (no preferred shares) or lightly leveraged, have relatively low costs for managed funds, are  discounted to n.a.v., and pay a decent yield. Two of them pay monthly, and the other quarterly. They are Alliance Bernstein High Yield Global (AWF, 7.52% yield), Templeton Global Income (GIM, yield 5.27%), and Templeton Emerging Markets Income  (TEI, yield 7.18%). GIM is obviously the most conservative and least volatile of the three. The advantages are higher yield and the currency hedge against the US dollar. I have small positions in these and would only buy more on future pullbacks. I wouldn't buy a whole lot of these as Loomis and T R Price and Wellesley do a very good job with far less price volatility.

The chart shows the major income funds and their total returns (with dividends reinvested). The table shows a number of funds ranked in decreasing order of their annualized returns since 1993. The six income funds I have discussed are in the colorized boxes, and other funds I own are only noted by the red arrows. These are either income funds or "inflation protection" funds with excellent records during bull and bear periods. Note that the "ulcer index" measures downside volatility or "sleep-ability" when owning them. The lower the UI the better one sleeps. UPI gives you some idea of how well the managers "add value" given the risk of their own ulcer index rating.

With a mixture of these funds in retirement plans plus some of Vanguard's municipal bond funds and other inflation protection funds in post tax accounts, I am able to generate approximately 5% total income returns. Then as time goes by, I plan to cash in annually some part of the inflation protection funds and stocks and gold, as needed.