Can You Afford To Retire?

Thanks go out to a colleague, who wishes to remain anonymous, for the following:

A front-page article in yesterday's Wall Street Journal drew a grim picture of fading retirement dreams as the damage to investors' portfolios from the twin forces of slumping stock prices and falling property values—"unprecedented in recent decades"—has prompted millions of baby boomers on the verge of retirement to reassess their plans.

Our initial reaction was that if Americans are indeed shifting their consumption patterns in response to changes in their portfolio wealth, that's a good thing. Imagine what would happen if recently-retired workers collectively decided to spend freely on motorboats and foreign travel while their investment portfolios experienced significant losses or diminished interest income. We would likely see a flood of articles in the financial press scolding retirees for living beyond their means in financial fantasyland. Adjusting portfolio withdrawal rates in response to realized investment results is what thoughtful investors such as David Swensen (chief investment officer of Yale University) recommend to address the inevitable conflict between current spending demands and long-run preservation of purchasing power.

Our second reaction was that the real story has less to do with falling asset prices and more to do with investors making questionable or ill-informed choices. The article cited four examples of people grappling with retirement financing to illustrate the problem: • A 30-year IBM veteran who has watched his 401(k) and IRA account balance decline 20% for the year to date and put his retirement plans on hold. • A husband and wife in their fifties who each earned good incomes working for various technology firms. Only two months after retirement, the husband has begun testing the job market, citing worries due to "gloomy economic conditions." • A Florida dentist and his wife who have put off dreams of retirement aboard a 44-foot catamaran and continue to work. • A Hewlett-Packard executive who has delayed retirement citing "wave after wave of bad economic news." We don't find such stories surprising. But if these individuals are representative of most of those confronting problems in planning for their retirement, it appears to us that the principal factors contributing to their distress are inappropriate asset allocation policy and lack of diversification. Based on information contained in the article, all of them could have benefited from better financial decision making. • The IBM executive who lost 20% in his 401(k) and IRA account has sharply underperformed the broad market. For the first quarter of 2008, total return was -9.45% for the S&P 500® Index and -9.15% for the MSCI All Country World ex US Index. Total return for a globally diversified 60/40 balanced portfolio (which strikes us as more appropriate for someone claiming to be agitated about short-term fluctuations) was -4.68%.1 • According to the article, the software executive is a multimillionaire who scoured numerous retirement planning books for ideas and constructed detailed spreadsheets to compute future spending needs. But spreadsheets can't predict how an individual will feel in response to unexpected events and a single month of poor stock market results (January 2008) was so unnerving for this individual that reading the financial pages of the morning newspaper became a stressful event. Any investor who becomes this anxious after one month of falling prices has the wrong asset allocation policy or a misunderstanding of the behavior of equity markets. The article mentions that he has recently increased his allocation to money market funds. This may be a good decision, but with yields on US Treasury bills recently setting a 50-year low, the potential for diminished income associated with reinvestment risk cannot be dismissed. • The Florida dentist purchased two condominiums in 2005 for $800,000 with the intention of selling them in two years to help fund the purchase of an expensive yacht. Based on recent sales activity of similar units, the value of the properties has declined by 20%. We see two problems: purchasing real estate with a two-year time window is best described as speculating, not investing. Moreover, the purchase of a single property type in a single city is the definition of a concentrated investment strategy, and in this case it performed poorly. In contrast, for the period July 2005 through March 2008, total return for a diversified portfolio of income-producing properties was over 19%.2 • The Hewlett-Packard executive whose mutual fund portfolio lost 12% in January 2008 must have owned some volatile ones. Total return in January was -4.49% for the Dow Jones Industrial Average, -6.00% for the S&P 500® Index, -6.82% for the Russell 2000 Index and -9.24% for the MSCI All Country World ex US Index. The single Dimensional mutual fund managing to squeak out a loss in excess of 12% for the month was the Emerging Markets Small Cap Portfolio (by six basis points). Once again, an investor rattled by one-month fluctuations should revisit his allocation policy. We don't wish to dismiss investor concerns lightly. The ideal retirement income solution—a generous stream of guaranteed inflation-adjusted annuity payments—does not exist outside the limited scope of the Social Security system. Investors are faced with a series of confusing tradeoffs in an effort to approach this desired result. The examples cited by the Wall Street Journal offer compelling evidence that even among knowledgeable and successful individuals, making expensive mistakes with respect to key financial decisions is all too easy.

Barrett, Emily. "Short-Term Treasury Yields Touch 50-Year Lows." Wall Street Journal, March 21, 2008. Dow Jones Wilshire data provided by Dow Jones Indexes. Levitz, Jennifer. "Americans Delay Retirement As Housing, Stocks Swoon." Wall Street Journal, April 1, 2008. MSCI data copyright MSCI 2008, all rights reserved. Russell data copyright © Russell Investment Group 1995-2008, all rights reserved. The S&P data are provided by Standard & Poor's Index Services Group. Swensen, David F. Pioneering Portfolio Management. New York: The Free Press, 2000.

1DFA Global 60/40 Portfolio Class I. 2DFA Real Estate Securities Portfolio Class I.