Course Summary

Financial planner and market theoretician Jim Otar debunks common misconceptions concerning distribution portfolios.

This course is accredited by IIROC, FPSC, The Institute for Advanced Financial Education, and the Insurance Council of Manitoba. Please see Accreditation Details for more information.

Some of the most common precepts of retirement planning don’t hold up under close scrutiny. Here are seven misconceptions, and how they could hurt your clients.

1.  Betting on Asset Allocation

Claim: “Asset allocation contributes over 90% to a portfolio’s success”

The first serious look at the importance of asset allocation was the study by Gary P. Brinson, Randolph L. Hood, and Gilbert L. Beebower in 1984. The authors analyzed data from 91 corporate pension plans with assets of at least $100 million, over a 10-year period beginning in 1974. In the literature, this is generally referred to as the “Brinson Study.” Subsequently, the analysis was expanded to include an additional ten years of data and “Determinants of Portfolio Performance II” was published in the Financial Analysts Journal, January/February 1995.

Their conclusion was that the components of the difference in success of a portfolio are:

  • Asset allocation: 93.6%
  • Security selection 2.5%
  • Other: 2.2%
  • Market timing: 1.7%

Here is the problem: The findings of the Brinson study cannot be applied to individual retirement portfolios for the following reasons:

  • The dynamics of cash flow in a pension fund are entirely different from those in an individual retirement account. A pension fund has a continuous inflow of money over time. In an individual retirement account, inflows of money occur mainly during working years. After retirement, there are usually no more inflows, only outflows. Mathematically, a pension fund is an “open-perpetual” system; an individual retirement account is a “closed-finite” system.
  • When and if there is a shortfall in a pension fund, contributions can be increased to meet it. On the other hand, with an individual retirement savings, there is usually no such opportunity.
  • In an individual retirement account, once withdrawals start, the adverse effect of “reverse dollar cost averaging” becomes important. In a pension fund, since there is a continuous inflow of money concurrently, this is insignificant.
  • In an individual retirement account, inflation is important. Withdrawals must be increased over time to maintain the same purchasing power for the retiree. In pension funds, there is no such concern; as inflation goes up, salaries and pension contributions increase. Also, many pension funds have limits and constraints on how the retirement payments are indexed, if at all. Individual retirees holding their own saving accounts do not have that choice; their expenses must be met.
  • The Brinson study does not include two of the most important components of the success or failure of distribution portfolios: withdrawal rate and sequence of returns. If you do not include the most important factors in the analysis, then less important factors – such as asset allocation – become most important.
  • Another factor is portfolio management costs. For an individual retirement portfolio, it is significantly larger than typical pension funds.
  • The timespan of the Brinson study is twenty years. This is not only too short, but it covers a single secular bullish trend, arguably the “luckiest” 20-year time period over the entire twentieth century. The study’s data misses significant adverse events that happened during secular bear or secular sideways market trends.

Figure 1: Time period covered in the Brinson study

Time period covered in the Brinson study

Claim: “Lowering a portfolio’s volatility increases its life”

Traditionally, asset allocation manages portfolio volatility within a client’s risk tolerance, which is the vertical axis in Figure 2. However, asset allocation has little or no effect on a portfolio’s life, reflected in the horizontal axis.

Figure 2: Components of the portfolio value versus time

Components of the portfolio value versus time
There are three factors that affect the horizontal axis (i.e. a portfolio’s longevity):

  • withdrawal rate;
  • sequence of returns; and
  • inflation

Until all of these factors are dealt with, asset allocation does not help longevity much.

Take a 65-year-old investor, retiring this year. He wants to plan until age 95. His retirement savings are valued at $1 million. He needs to withdraw $60,000 each year, indexed to actual inflation. On the equity side, he expects a 2% average dividend yield and pays 0.5% management fees.

Let’s look at how his portfolio would have performed if he were to start his retirement in any of the years between 1900 and 2000. We aftcast six different asset mixes:

Table 1: The impact of asset allocation for various withdrawal rates

Asset Mix
(Equity / Fixed Income)
Probability of Depletion by Age 95Median Portfolio  depleted at Age
100% Equity68%87
80 / 2067%87
60 / 4074%87
40 / 6078%86
20 / 8091%86
100% Fixed Income95%87

This table shows that regardless of asset allocation, the median portfolio depleted at ages 86 or 87. If you want asset allocation to be an effective tool, find ways of reducing the withdrawal rate to below sustainable (see the course, Purpose-Driven Sustainable Withdrawal Rate): delay retirement, save more, spend less, find a part-time job, downsize, rent basement, etc.

The truth about asset allocation: it’s is an effective tool to manage volatility. However, if the withdrawal rate is larger than 4%, don’t bet on asset allocation for converting a red-zone client into a green-zone client. (see the course, Lifelong Retirement Income – The Zone Strategy).

2.  Equities and inflation

Claim: “Over the long term, equities always beat Inflation.”

Sometimes they do, sometimes they don’t. It depends on what the long-term (secular) trend is and which equity index we are looking at.

Secular Bullish Trends: During the last century, there were three long-term bullish trends: 1921-29, 1949-66, 1982-2000, covering 43% of time. During these periods, inflation was low and equity markets overcame inflation readily.

Because Canadian markets are more commodity oriented, they underperformed U.S. markets during these time periods, as depicted in Figure 3.

Figure 3: Inflation, DJIA and TSX in secular bullish trends (1921-1929, 1949-1966, 1982-2000)

Inflation, DJIA and TSX in secular bullish trends
Secular Bearish Trends: This is when inflation is either very low or negative (deflation). However, losses in a bear market overwhelm any positive effect of deflation (i.e. reduced withdrawals). During the deflationary time period between 1929 and 1943, neither Canadian nor U.S. equity markets were able to beat inflation.

Secular Sideways Trends: There were two secular sideways trends last century: 1900-21 and 1966-82. Generally, inflation peaked towards the end of these trends, forcing the retiree to withdraw more from her portfolio for the rest of her life. During these time periods U.S. indices lagged inflation miserably.

Figure 4 depicts inflation, the DJIA and the TSX. Note that historical data for the TSX index does not start until 1919, therefore, there is no graph for TSX for the 1900-20 secular sideways trend.

Figure 4: Inflation, DJIA and TSX in secular bearish and sideways trends (1900-1921, 1929-1949, 1966-1982)

Inflation DJIA and TSX in secular bearish and sideways trends
During the 1966-82 period, Canadian and U.S. markets behaved differently. Since a large component of the Canadian equity market includes commodity type companies, they outperformed U.S. markets during inflationary time periods. Even though neither index was able to beat inflation, Canadian equities did much better. U.S. equities experienced a double whammy of bad sequence of returns and high inflation, whereas the Canadian equity index experienced a much milder bad sequence of returns and relatively good inflation protection.

Make sure you are not holding excessive amounts of U.S. and other foreign equities in retirement portfolios. Many in the financial industry argue that since Canada is only 3% of the world economy, therefore you need to allocate a large chunk of assets to foreign stocks. In this case, size is not as important as quality. Financial statements and disclosures of Canadian companies are likely more reliable than elsewhere. Also, most Canadian companies have significant amounts of international business, which is your de-facto international diversification.

The truth about equities and inflation: Equities do not always beat inflation, but Canadian equities do better than others. No more than 10% to 15% of the portfolio should be allocated to foreign equities. Also consider allocating up to 10% to real return bonds.

3.  Making Assumptions on Average Growth, Inflation and Life Expectancy

Claim: “Assume a 5% annual growth rate and 3% inflation over the next 20 years”

The main difference between a Gaussian and a non-Gaussian mindset is this: the Gaussian mindset uses averages in calculations. The non-Gaussian mindset uses extreme outcomes and avoids averages in decision-making.

In the financial media, you will invariably see articles that say things like this: “If his average portfolio grows 5% annually and the inflation is 3% per year, assuming he lives until age 85 (his life expectancy), he should be able to withdraw $30,000/year from his $500,000 portfolio….”

Here is how this assumption manifests itself on the chart:

Figure 5: Forecast using average 5% growth rate, 3% inflation, 6% initial withdrawal rate

Forecast using average 5% growth rate, 3% inflation, 6% initial withdrawal rate
Here are flaws of using average assumptions:

Average Life Expectancy: This is the age at which half the cohort will be dead and the other half survives. If you design for the average life expectancy, you are in effect planning only for half of your clients.

A better way of managing longevity risk is using an age beyond which the survival rate is 10%. That means using 95 as the age of death for male clients and age 97 for female clients or couples as a minimum.

Average Portfolio Growth: In real life, there is no such a thing as average growth rate; it only exists in statistics:

  • One bad sequence of returns can turn an otherwise great track record to a dismal one.
  • Studies on investor behavior show consistently that an average investor lags the average market performance by a factor of several percent.
  • It is also well documented that most funds do not beat the market index.
  • During retirement, withdrawals cause a reverse-dollar-cost averaging effect, which can reduce annual returns by up to 2%.

A better way of managing this risk is to ignore average growth rates totally. Instead, make sure that the probability of depletion does not exceed 10% at the age of death using actual historical numbers, i.e. the aftcast.

Average Inflation: One of the largest risk factors during retirement is inflation. Here, just as with the growth rate, the average is meaningless. Historically, inflation was higher than the average slightly over 50% of the time. Using the average exposes the retiree to a significant inflation risk. Plan in such a way that the loss of purchasing power does not exceed 10% for essential expenses throughout retirement.

Figure 6 depicts the aftcast and the forecast with unsustainable withdrawals based on assumptions using averages. The aftcast shows that these withdrawals are definitely unsustainable even if the age of death was 85.

Figure 6: The aftcast and the forecast, unsustainable withdrawals

The aftcast and the forecast, unsustainable withdrawals
When we change the age of death to 95 and keep the probability of depletion to under 10%, as we should, then the sustainable withdrawal becomes $18,000/year, 40% lower than the $30,000 calculated earlier using “averages” (Figure 7).

Figure 7: The aftcast with sustainable withdrawals

The aftcast with sustainable withdrawals
The truth about using the averages: They apply only to large groups and they should never be used for individuals.

4.  Frequent Rebalancing

Claim: “Frequent rebalancing reduces volatility”

When it comes to rebalancing, most investment professionals believe “often is better.” Rebalancing is done supposedly to reduce volatility. But does it? How does it affect portfolio longevity? Let’s answer these questions.

Volatility has two components. The first component is short-term, random fluctuations, generally within a one-year time horizon. Every second, every minute, every day, some event happens somewhere in the world that influences investor psychology. As investors make trading decisions, markets move up or down. This is how random volatility is created.

The second component of volatility occurs over the longer term. Markets respond to the collective expectations of investors and a trend forms. As these expectations become more and more popular among investors, security prices move further with that trend. Gradually, extremes are created and they are invariably followed by a trend in the opposite direction.

If you consider one year as short term, then rebalancing annually (or more often) cannot reduce volatility. Rebalancing can reduce volatility only after an observable trend. An observable trend can occur for two reasons:

  • After a cyclical market trend, which typically lasts four years; or
  • If withdrawals are high, that in itself creates a downtrend in the portfolio value.

When does a portfolio experience an observable trend? There are several known market cycles: the 54-year Kondratieff cycle, 10-year decennial cycle, and the 4-year U.S. presidential election cycle, to name a few. We focus on the U.S. presidential election cycle as it is the shortest market cycle that is meaningful to retirement planning.

Let’s look at an example: Steve, 65, just retired. He has put aside $1 million for his retirement, with $400,000 in equities and $600,000 in fixed income. He needs $50,000 in income each year, indexed to inflation.

Figure 8: Retiring at the start of the 1921 secular bull market

Retiring at the start of the 1921 secular bull market
Figure 8 shows the portfolio value if Steve were to retire in 1921, the beginning of the first secular bull market of the last century. The green line shows the portfolio value if rebalanced every four years at the end of the U.S. presidential election year. The red line shows the portfolio value if rebalanced annually. At the end of 30 years, Steve was one million dollars richer if he rebalanced every four years at the end of the U.S. Presidential election year than if he rebalanced annually. The volatility was about the same for both. Imagine that: your client makes more money, and you make more trailer fees for less (rebalancing) work!

Figure 9 shows Steve’s portfolio value if he were to retire at the beginning of 1929, the beginning of a secular bear market. At the market bottom of 1932, Steve’s portfolio experienced a smaller loss when rebalanced every four years than if he rebalanced every year. The portfolio that was rebalanced every four years provided Steve with 30 years of income. On the other hand, if rebalanced annually, the portfolio would run out of money after 21.5 years. Rebalancing every four years on the presidential election year increased the portfolio life by a respectable 40%.

Figure 9: Retiring at the start of the 1929 secular bear market

Retiring at the start of the 1929 secular bear market
Similar analysis  for all years between 1900 and 1999 demonstrates that:

  • Portfolio volatility was about the same whether you rebalanced annually or once every four years on the presidential election year.
  • In secular bull markets, rebalancing too often generally stunted portfolio growth.
  • In secular bear markets, rebalancing too often compounded losses. Synchronizing the rebalancing activity with the U.S. presidential election cycle preserved one’s capital during black swan events more effectively.
  • In secular sideways markets, portfolio longevity was not correlated to the frequency of rebalancing.

The truth about rebalancing: Rebalancing too often can hurt portfolio longevity. If the withdrawal rate is below 4%, then rebalancing once every four years (at the end of U.S. presidential election year) can provide a better outcome in retirement portfolios.

5.  The Value of Geographical Diversification

Claim: “Over the long term, higher risk means higher return.”

This is often not true. Geographic diversification is a good thing. It helps the investor take advantage of trends in different parts of the world. However, in many cases it does not pay off. As a case in point, let’s take a look at emerging market funds.

In the early 1990’s, many emerging market funds were born. Some funds had good research teams, some got lucky. They appeared attractive at first. In the heyday of booming markets, many investors placed some of their money in these funds. After twenty years, which is a long time horizon, here is the bottom line: The average total return of emerging market funds (as of end of September 2014) was 3.97%. If you include the attrition effect (funds that were shut down in the interim, hiding their paltry performance), you would be lucky to show a 2% total return over that same 20-year time period.

It is true that some emerging market funds made 70% one-year return at the end of February 2000. However, they lost more than 50% (one-year return) at the end of November 2008. Keep in mind that  you need a 100% return after a loss of 50% just to break even. Therefore, it is likely not worth taking that kind of risk for an average buy-and-hold investor. Unless you are an excellent market timer and a seasoned technical analyst, you would have no hope of benefitting from this type of diversification, either in the short or long term. Instead, an average Canadian dividend fund would have given you about 10% average annual return over the same 20-year time period.

Claim: “Diversification prevents losses”

Say you only invest in developed economies. Here is the problem: when it comes to geographical diversification, black swan events usually occur in unison. You will not see a market-meltdown in one developed economy while another one is thriving.

Let’s look at an example: A 65-year old retiree has $1 million; $400,000 in equities and $600,000 in fixed income. He needs $60,000 indexed income each year. Our question is: if he is unlucky, when does his portfolio deplete?

Let’s look at four different equity indices in the U.S., Canada, England and Japan.

Figure 10: The equity portion is invested in USA (S&P500):

The equity portion is invested in USA (S&P500)

Figure 11: The equity portion is invested in Canada (S&P/TSX):

The equity portion is invested in Canada (S&P-TSX)

Figure 12: The equity portion is invested in England (FTSE):

The equity portion is invested in England (FTSE)

Figure 13: The equity portion is invested in Japan (Nikkei 225):

The equity portion is invested in Japan (Nikkei 225)
We observe that, regardless of which equity index was used, the unluckiest retiree would have run out of money at age 79.

Taking this further, if you were to diversify equally into these four geographies, the unluckiest person would run out of money at age 80 (Figure 14). In this case, diversification would have added one year to the life of the portfolio, and it was still unable to prevent the portfolio’s premature demise.

Figure 14: The equity portion is allocated equally in four indices:

The equity portion is allocated equally in four indices
The truth about geographical diversification: it is generally good to diversify geographically in developed markets, because it adds value during “normal” markets. However, when the withdrawal rate is larger than 4%, diversification does not prevent losses, nor adds much to a portfolio’s life. Don’t tell your clients diversification can prevent losses.

6.  The Promise of Leveraging

Claim: “Borrowing to invest will pay off”

Some investors borrow money to invest because they either believe that the odds are on their side, or someone convinces them to do so. What they fail to see is, when you borrow to invest, bad sequence of returns can appear more often.

When you borrow money to invest, you are in effect declaring that you are smarter than the market over the long term. You are also declaring that you are smarter and/or luckier than those who lend you the money.

What does history tell us? Let’s work through an example to demonstrate the effects of leveraging.

Bob is 30 years old. He has $100,000 in his portfolio, which is aggressively invested: 100% in the S&P500. For portfolio growth, use the historical index return plus dividends, less his portfolio costs, which are 0.5%.

He decides to borrow $100,000 to enhance the return of his investments. He pays only the interest, which is paid out of his portfolio. The interest rate is equal to the 6-month CD yield, plus 3%. At the end of 10 years, he is planning to pay back the loan principal from the portfolio as well. To keep things simple, we assume that there are no margin calls.

Scenario 1: The starting year is 1990. If he were to invest his own money only without borrowing, his investment would have grown to $491,811. With leveraging, it would have grown to $647,550, after paying back the interest and principal.

Figure 15: Net Portfolio Value with and without leveraging, starting in year 1990

Net Portfolio Value with and without leveraging, starting in year 1990
Scenario 2: Let’s use 1973 as the starting year. With leveraging, Bob’s net assets shrunk from $100,000 in the beginning of 1973, to $53,588 in the beginning of the year 1983, a decrease of $46,312.

The total cost attributable to leveraging is $129,369, calculated as the lost profit of $82,957 if he had not borrowed to invest, plus the loss of $46,312 due to leveraging. This is not a good outcome, as depicted in Figure 16.

Figure 16: Net Portfolio Value with and without leveraging, starting in year 1973

Net Portfolio Value with and without leveraging, starting in year 1973
We do the same scenario analysis for each year since 1900 and display it graphically, Figure 17 shows the outcome.

Figure 17: Pre-tax cost-benefit: leveraging versus no leveraging:

Pre-tax cost-benefit - leveraging versus no leveraging
Here are some statistics:

  • Number of winning years: 59
  • Number of losing years: 39
  • Average win amount: $103,145
  • Average loss amount: $47,790
  • Median Profit due to the leveraging: $25,318
  • Worst-case loss: $129,369

The truth about leveraging: Borrowing to invest is generally a bad idea for individuals. The odds are usually against the investor because black swan events happen more often than we think for the borrower. Sequence of returns and onset of higher interest rates can devastate even the best-laid leveraging strategies. Advise clients to start eliminating all debt when they’re within 10 years of retirement. If at all possible, they shouldn’t go into retirement owing any money.

7.  Omitting the Stress Test

You completed the perfect retirement plan, but that doesn’t mean you’re finished; there’s one final step: You need to put it through a stress test.

Many clients worry about how much cushion they will have if unexpected events happen. There are many different types of stress events. These are the most important:

  • Sudden and permanent loss of assets
  • Increased withdrawals from the portfolio
  • Higher-than-normal inflation
  • Clients live longer than planned for
  • Equity returns can be lower than historically experienced
  • Conventional bond yields lower than historically experienced

You cannot just assume how much weight you need to place on each one of these possibilities. You need good knowledge of your client’s circumstances, so arrange an honest and open discussion with your client about anything that can go wrong.
Let’s look at an example to demonstrate how this process works:

Bob and Jane are both 65, just retired. They need an annual income of $90,000, indexed to CPI. Their annual CPP and OAS benefits add up to $31,000. So, they need $59,000 annually from their savings. Their asset mix is 40% equities and 60% in fixed income, rebalanced annually. We use the S&P/TSX index as our equity proxy. For fixed income, they hold conventional bonds that pay a 1% premium over and above the historical 6-month CD rates. Their total investment assets are $3.2 million.

Figure 18 shows their income carpet, which is a year-by-year, age-by-age depiction of income adequacy. It is all green, meaning they were able to receive the income they needed without any shortfall based on actual market history.

Figure 18: Income Carpet – Current Scenario

Income Carpet – Current Scenario
Now, we start our stress-test discussion with Bob and Jane.

Sudden and Permanent Loss of Assets: There are many reasons for a sudden and permanent losses:

  • the portfolio loses money; they switch everything to cash just before markets start recovering, and lose any opportunity to recover from that loss.
  • they might have to move to a nursing home
  • they might have an unforeseen liability
  • they might have to help their children beyond what they already planned

Keep in mind, portfolio fluctuations do not count as sudden and permanent losses. As long as the asset mix is kept the same, Bob and Jane’s portfolio will eventually recover from fluctuations. However, if they panic and move all their investments to cash (or near cash) after a large loss, then the opportunity to recover from that loss is forfeited and they now have a permanent loss. Bob and Jane promise to stay with the plan.

They plan to stay in their home until death. However, it is possible that they have to move to a nursing home during the last eight years of their lives. Therefore, this is a good time to stress test this possibility.

Their current housing and food expenses are $40,000/year. The private assisted-retirement home costs $90,000/year. They do not have living-care insurance coverage. They would have to come up with an additional $50,000 per year for eight years. The total is $400,000 and that is about 13% of their current portfolio value. If they both have to move to the retirement home at the same time, then they can sell their current home to help finance this expense. However, if only one of them needs to move, then they might not be able to sell their home.

Bob and Jane decide to stress test a sudden and permanent loss of 13%.

Need to increase the income taken from the portfolio: This can happen for many reasons; the usual suspects are: home care, permanent disability, and the need to take care of children or grandchildren.

Bob and Jane think that it is possible that they might need a live-in helper in case of a serious disability. This might cost them an additional $20,000/year, a 22% increase from their current income need of $90,000/year.

Bob and Jane decide to stress-test a 22% increased income.

Future inflation higher than historically experienced: What if future inflation turns out to be higher than what we have experienced during the 20th century? Bob and Jane would need larger cost of living adjustments to their withdrawals during their retirement.

Bob and Jane decide to stress-test a 0.5% higher inflation than in the past.

Living longer than planned for: In Bob and Jane’s plan, the age of death is 95. Mortality tables indicate that there is about 7% chance that Bob would be still alive beyond age 95. Jane has about 14% chance that she would survive beyond age 95. They say both of their parents lived until their late 90s. They are a bit worried about “living too long” and outliving their assets.

Bob and Jane decide to stress-test an additional 4 years beyond age 95.

Future equity returns lower than historically experienced:What if the future performance of equities turns out to be worse than what we have experienced during the 20th century? In that case, Bob and Jane’s assets would not grow as much as we aftcasted in their plan.

Bob and Jane decide to stress-test equity returns that are 0.5% lower than in the past.

Future conventional bond returns lower than historically experienced: In our aftcast, we used historical 6-month CD interest plus 1% as our bond yield. On the current yield curve (at time of writing), this approximates a bond portfolio with about a 6-year maturity. What if the future performance of bonds turns out to be worse? What if North American bond markets exhibit a similar pattern to Japanese bond markets of the last 20 years or so?

Bob and Jane decide to stress-test bond yields that are 0.5% lower than used in their plan.

Summarizing Stress Factors: Bob and Jane need to see the impact of following events happening concurrently:

  • A sudden and permanent loss of 13%; and
  • An immediate 22% increase of income taken from the portfolio; and
  • An inflation that is 0.5% higher than historically experienced; and
  • Live until age 99 (additional 4 years); and
  • Future equity returns 0.5% lower than historically experienced; and
  • Future conventional bonds yielding 0.5% lower than planned.

Figure 19 depicts the resulting income carpet. With all the stress events in place, the aftcast indicates a shortfall of income after age 95 only in one of the 81 starting years. This information is very comforting for Bob and Jane because this is a very small probability that they can readily accept.

Figure 19: Income Carpet – After Stress Test

Income Carpet - After Stress Test
The truth about stress tests: No plan is complete until you have a detailed discussion with your client about various unexpected events and then do a stress test incorporating these events.

Now that you’ve finished reading Seven Deadly Sins of Distribution Portfolios, complete the exam to receive your CE credits. If your score is 85% or higher, send an e-mail to jim@retirementoptimizer.com with your name and proof of your score (a screen shot will do) to get a free retirement calculator based on aftcasting and a free, read-only pdf copy of Jim Otar’s 525-page book, “Unveiling the Retirement Myth.”

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