All posts by Tom Canfield

What mix of stocks should you have before retirement?

How do you set your mix of stocks and bonds before the start date of your retirement? Patti and I officially started our retirement plan in December 2014. That was the first year we took a full withdrawal from our nest egg for our spending in 2015. I decided on a mix of 85% stocks during retirement. (I recommend you decide on a range between 75% and 85%, and you’ll find my logic in Chapter 8, Nest Egg Care [NEC].) How should we have been invested prior to that date? The purpose of this post is to describe my thinking on your decision on your mix of stocks vs. bonds prior to retirement. My basic conclusion: your retirement nest egg should be invested 100% in stocks for most all years prior to retirement.


== How to Invest ==


Let’s knock off this checklist:


You’ll invest in financial assets – stocks and bonds. Stocks and bonds have a long record of real growth – returns over time that are greater than inflation. Stocks return about 7% per year and bonds return about 2.6%. (I average the real returns for long-term and intermediate return bonds.) Non-financial assets, real estate and commodities as examples, are components of the calculation of inflation. They keep pace with inflation; they don’t outdistance it; in general, they have no or very low real return over time.


• You’ll invest in index funds. You MUST be a low-cost investor in retirement, and you must be a low-cost investor before retirement. The only way to reliably keep most all the market delivers is to invest in index funds. Patti and I predictably keep +99% of what the market delivers to investors before consideration of costs; the weighted average of our investing costs is 0.05%.


Your mix of stocks will be greater before retirement than in retirement. I’d work backwards from your decision on mix of stocks and bonds in retirement. In Nest Egg Care I picked 85% for Patti and me. That means I should have owned more than 85% stocks in all the years before our first full withdrawal for spending. If you pick 75% as your mix for your retirement plan, you should own more than 75% stocks.


== Retirement >10 years from now = 100% stocks ==


I argue that you should be 100% stocks in all but the last ten years before the start of your retirement plan. I judge that mix gives you by far the best odds of having more throughout the period of full withdrawals from your nest egg for your spending in retirement.


An example: The official start of our retirement plan was December 2014; that was the first date we took a full withdrawal – our Safe Spending Amount – for spending in an upcoming year. (See Chapter 2, NEC.) That would have meant that I should have been 100% stocks up to December 2004. (We were.) I could then transition to the mix at the start of our retirement plan that I get from my decisions from Nest Egg Care: 85%.




== The odds of MORE in 10-years ==


How do I judge that you should be 100% in stocks if you are 10 or more years before the start of your retirement plan? I build the historical sequences of 10-year returns for stocks and for bonds and compare the two. Here are questions I would ask:


1) At the average of the sequences of returns, how much more might you expect from stocks relative to bonds? Is this a meaningful difference?


2) Stocks and bonds are variable in return. Your portfolio won’t always grow in real spending power in 10 years. How often do stocks return more than you started with over 10 years? Is that more or less frequent than bonds?


3) Since stocks are more variable in return, we’d expect 10-year periods where bonds outperform stocks. How often did bonds do better than stocks? How much better?


== 76 sequences of 10-year returns ==


I compiled the cumulative increase in real spending power for 76 10-year return periods. It’s the same data that I used for this graph for cumulative real returns over time.


Source: Stocks, Bond, Bills and Inflation. Ibbotson, et. al.


I show the calculations for the increase in real spending power for all the 10-year sequences in this PDF. I started my analysis with the 10-year period ending the year I was born, 1945. That means I’m not including the unusual returns for stocks and bonds 1926-1935, basically during the Great Depression. I used Intermediate bonds in the comparison; I think that’s the closest to what we hold when we invest in bonds.


== Here are my findings ==


• You can expect (using the average) that you will have about 85% more total spending power from stocks than from bonds at the end of 10 years. That’s a lot! I average the results for the 76 return periods and find that stocks more than doubled in real spending power, while bonds increased by about 25%. The growth portion from stocks was 5.5 times that of bonds.



• Stocks returned more than you started with more often than bonds. Stocks returned more than you started with in 66/76 cases: I translate that to the odds of 87 out of 100. Bonds returned more than you started with in 45/76 cases: 60 out of 100 chances. (I highlight these years on the PDF.)


I flip those numbers: stocks returned less than you started with in 13 of 100 chances; bonds returned less than you started about three times more often, 40 of 100 chances.


It’s better for bonds if one looks at the return periods ending the last 35 years; that’s the most favorable period for bond returns; they started their climb out of decades of 0% cumulative return. In the last 35 years, bonds always returned more than you started with in the prior 10 years; stocks returned less than you started with in three cases. Those three cases hold parts of two the four worst patterns for stock returns since 1926: the very steep declines in 2000, 2001, 2002 = -42%; and 2008 = -37% real return.


• Bonds returned more than stocks in 15 out of 100 cases: bonds returned more than stocks in 11/76 cases. The detail is on the PDF. In those cases, bonds returned about 40% more than stocks. Most all of those cases were when stocks returned less than 0% over the ten years. (Those are periods in the 2000s and those in the 1970s; the steepest decline for stocks since 1932 was 1973, 1974 = -49% real return.) The two best 10-year sequences for bonds relative to stocks were the two 10-year periods ending in 2008 and 2009: bonds returned twice as much as stocks.



• Stocks returned more than bonds in 85 of 100 cases: stocks returned more than bonds in 65/76 cases. In those cases, stocks doubled the return from bonds.



== What do I conclude ==


For me, the odds clearly favor stocks. I see no reason to hold bonds for a 10-year holding period. I’d recommend that if you are ten years or more years from retirement, you should be 100% invested in stocks. That gives you the clearest odds to have more at the start of your retirement plan and thereafter. Then, transition in a way that feels comfortable to you from 100% to your design mix at the start of your retirement plan.


If you think about it a bit differently, you’re not making one 10-year decision on your total portfolio. You could think of your portfolio as divided into many future holding periods. In our example, the shortest holding period is ten years. You’re really making a number of decisions as to how to invest small slices of your portfolio; each slice has a longer holding period.


Let’s assume Patti and I had Nest Egg Care and worked through our retirement plan in 2004, planning our first full withdrawal in late 2014 for our spending in 2015. Let’s assume we found that in 2014 we would sell 4% of our portfolio for our spending. (It was actually 4.4%, but it’s simpler to use 4% in this example.) I could have viewed that I had a 4% slice of our portfolio in 2004 that had a 10-year holding period. I’d assume the next year – late 2015 – we’d sell a second 4% slice; that slice would have an 11-year holding period. And so on. I’d have a total of 25 slices with holding periods ranging from 10 to 35 years.


The odds more obviously favor stocks and not bonds as the holding period lengthens. For example, there is no case where bonds outperform stocks if the holding period is 18 years or more. If I thought that way, I’d be much more confident in holding 100% stocks – or maybe 96% or 92% – if I was ten years from retirement.


== I didn’t have the end point in mind ==


I had no financial retirement plan until Patti and I were basically retired. That’s when I dug into FIRECalc to figure out our Safe Spending Rate (SSR%) and the decision for our mix of stocks and bonds. I couldn’t work back from my decision on mix in retirement to figure out the mix before retirement or the transition path to get me there.


Fortunately, my historical pattern of investing paid off. I’d been 100% stocks for decades, and I was 100% in stocks in 2004. Without thought, I remained 100% in stocks until the start of our retirement. I just changed in a matter of weeks in late 2014 from 100% stocks to 85% stocks.



My lack of transition or glide path did not hurt. Over the ten years, stocks increased by 70% in real spending power while bonds grew by about 30%. Stocks should have outperformed 80 of 100 times, and they did in this case. But working backwards from 2014, stocks outperformed bonds for every holding period. My transition from 100% to 85% could have not been better.




Conclusion: Nest Egg Care helps you make the key decisions for your financial retirement plan. One is your mix of stocks and bonds. I recommend you pick between 75% and 85% in Chapter 8. I picked 85% for Patti and me. This post asks, “What mix of stocks should I have before retirement?” It is always more than your mix at the start of retirement. This post examines the odds of having more in 10 years from stocks rather than bonds. My view is that you should be 100% in stocks all years up to 10 before the start of retirement. You can transition from 100% – changing your mix bit by bit – to get to your design mix at the time you take your first full withdrawal from your nest egg for spending.


How do Fidelity index funds compare to Vanguard’s?

Every January, I complete the Morningstar nine-box display of returns for segments of the market: the box is a matrix of annual returns by company size category (Large, Mid or Small Cap) and investment style (Value, Blend, or Growth). I did not realize that Fidelity has a similar lineup of funds for each box. In this post I compare the nine-box using Fidelity funds with Vanguard funds. I conclude that returns for their index funds in each of the nine boxes are very similar but not identical: they aren’t trying to track the identical benchmark indices. I also add an update on returns for US total stock market funds. Patti and I own one of these, FSKAX.


== The style box and 2020 returns ==


Last January I displayed 2020 US stock returns for the nine-box using Vanguard funds:



In 2019 Fidelity added four funds that complete their offerings in the nine-box. I did not realize that I could fill the nine-box with returns from Fidelity funds for 2020. I duplicate the nine-box using Fidelity funds:



The returns from the two do not exactly match. The Fidelity fund was greater return in five cases and the Vanguard funds was greater in four cases. The differences are due to two factors:


1) Fidelity and Vanguard aren’t trying to match the same benchmark indices for the boxes. Fidelity tries to match benchmark indices structured by S&P Dow Jones. Vanguard tries to match indices structured by CRSP. (Morningstar shows mutual fund performance compared to benchmark indices structured by Russell.) The three index companies have slightly different definitions of the stocks that comprise a box. They’d differ on the number and specific companies in their large cap growth index, as an example.


2) Fidelity and Vanguard both try to overcome the inefficiency from having to hold some cash for potential redemptions and overcome their expense ratio. The expense ratio for the Fidelity funds are about .025% less than Vanguard’s for each fund. They may use techniques that may employ derivatives, for example. They are better at this task in some years than others. Their tracking error – how close they exactly come to the benchmark they are trying to match – varies year-by-year.


== Two common indices they track ==


I find two rigidly defined – or pretty rigidly defined – indices that they both try to match.


• The S&P 500 index is precisely defined – the composition of companies that comprise the 500, the weight of each, and the timing of new additions and deletions. Returns for their 500 funds are almost identical. Fidelity’s lower 0.025% lower expense ratio has been in place since August 2018.



• The S&P Dow Jones and CRSP indices for US Total Stock Market have to be almost identical; they both have to track the same total number of stocks and should calculate identical weights. Vanguard follows more stocks in its fund than Fidelity. Fidelity uses a sampling method for the 150 or so smallest capitalization stocks. Returns for Fidelity and Vanguard are very close.




That 0.03% difference in annual percentage return for the past decade translates to a small difference in portfolio value. The difference over a decade is is about $100 per $10,000 invested. That averages to $10 per year; that would translate to $100 per year per $100,000 invested.



This dollar difference is over a period of real returns that were about 75% greater than expected returns: about 12.6% real return vs. 7.1% expected return. I would expect the dollar difference to be much smaller at expected returns.


Patti and I own FSKAX. I think Fidelity’s expense ratio was greater than Vanguard’s for years, and that could explain the difference for FSKAX’s lower 0.03% return rate. I will stick with FSKAX. It’s my only Fidelity fund for all that I have at Fidelity. I think I owe them its small expense ratio – even if that nets me a little less return.


== Six US total stock market funds ==


I displayed performance results for five US total stock funds in my post this April. I did not include Fidelity’s US total stock market fund with 0% expense ratio, FZROX. It’s close to having a three-year history now. I add it to the list and show the cumulative return for six funds for almost three full years. FZROX cumulatively has returned about 0.10% more than FSKAX. The slightly greater return probably reflects its slightly lower expense ratio and good fortune in its sampling of the smallest securities that it does not own.




Conclusion: I did not realize that Fidelity has a line up of index funds that fits into the nine-box of segments of the market, the matrix of funds by focus of capitalization of stocks it holds (large, medium or small cap) and classification of the nature of the stocks a fund holds (value, blend or growth). I compare the Fidelity funds with Vanguard’s. Returns for each box are very similar, but they differ because they aren’t trying to match the exact same benchmark index. I also update a display from early April that now shows the returns for six US total stock market funds.

How many years does it take for you to pay out 100% of today’s portfolio value as fees?

Many of my friends don’t have the inclination, confidence or basic spreadsheet skills to be self-reliant investors. They hire a financial advisor so they don’t have to deal with what are very simple tasks for us nesteggers. The time they’d invest to gain modest skills to become self-reliant is likely worth $100,000s. This post expands on a post of three weeks ago: purpose of this post is to describe how to calculate the impact of investing costs on expected future portfolio value. In the example in this post, an investor will effectively pay out ALL of today’s total portfolio value in fees in 25 years.


== The correct way to judge added fees ==


You can’t just look dollar fees paid per year. While the fees you pay are a small percentage of your total assets, they are a much larger percentage of the expected return rate of your portfolio. Your net return rate is lower. The dollar difference from the lower rate grows exponentially. Given enough years the dollar difference in your portfolio will equal the current value of your portfolio.


You should look at it this way: you’re transferring a piece of your portfolio each year to financial professionals – to an advisor and/or to highly paid fund managers if you’re not a nestegger, only investing in index funds. You’re missing the accumulated growth of each piece that you transfer. In concept those professionals invest what you transfer to them each year in a portfolio just like yours without their costs. They accumulate wealth. The amount they accumulate will be many more times the annual payments you make to them. Their gain in wealth is your loss in wealth.


The correct questions to ask are, “What lower percentage return rate do I get to keep because of my investing costs? What’s the impact of that lower return rate in terms of lower portfolio value over time? Am I really getting that much value for what I am paying?”


== Add your total Investing Cost ==


When you invest in a mutual fund or ETF and when you hire an advisor, you incur fees that the financial industry charges fees as a percentage of assets under management, abbreviated as AUM. (You can find advisors who simply charge an hourly fee, which seems a hell of a lot fairer to me; I’ll discuss this in a future post.)


Most folks who hire an advisor think that cost is small – “just 75 basis points,” as a friend of mine told me. Several of my friends have NO IDEA what they pay; this makes ZERO sense me, since the fees are right at the top of their household expenses.


Total Investing Costs also include fund fees – their expense ratio.  Actively managed funds have higher expense ratio than the index funds that we nest eggers have in our portfolio. An advisor likely designs a portfolio with at least some actively managed funds. That’s a bet that these fund managers can somehow beat the market to more than overcome their higher costs; we nest eggers know that that’s a poor bet – that’s playing a worse than a zero-sum game. When we add cost to find our total investing costs, we have to assume active fund managers just match market returns before consideration of their costs, and therefore total Investing Costs have to include 100% of their expense ratio.


My “just 75 basis points” friend sent me his recently redesigned portfolio, and I calculated 0.30% as his weighted expense ratio for his funds. I’ll therefore use his total Investing cost of 1.05% in this example (0.75% + 0.30%). I compare that to ~0.05% that we nest eggers spend.


== Direct reduction in your return rate ==


Your investing costs are a direct reduction in the gross return on your portfolio – the expected return before consideration of any investing costs. (The percentage costs likely works out to a little bit lower net return to you than that simple subtraction, but let’s go with that.)



We need to find the impact of that added one percentage point cost on the future value of a portfolio. I’ll use my mix of 85% stocks as the base case for the example: the future expected real return rate using low-cost index funds is 6.4%. One percentage point added cost lowers the net return rate to 5.4% – a 16% reduction in the expected growth rate for this portfolio.


I use long run historical average real returns for future expected returns. I average expected returns for Long Term and Short Term bonds; almost no one owns a portfolio of solely LT bonds.


== The differences compound ==


I did two calculations in the post two weeks ago to find out how much portfolio value I was giving up over time: I used Excel’s Future Value calculation for two different returns rates and subtracted the two to see the difference in portfolio value over time.


In our example, the amount paid in a year – 1% of a starting $100,000 equals $1,000 – may not look that significant for a few years. The effects of compound growth are small. The growth portion of a portfolio in five years is small relative to the initial $100,000.



In five years our 6.4% return portfolio has grown by ~$36,000. The 5.4% portfolio has grown by $30,000. The percentage difference in the growth portion is close to the 16% return difference, but the difference in total portfolio value is less than 5%. The $6,000 dollar difference in portfolio value seems reasonable compared to that starting $1,000/year fee. In effect our investor has paid out 6% of his initial portfolio as fees.


Time and compounding magnifies the difference in returns. The growth portion in 20 years is roughly double the initial $100,000.



In 20 years, the 6.4% return portfolio has grown by $244,000. The 5.4% return portfolio has grown of $185,000. The difference in the growth portions is 24%. The difference in total portfolio value is now 17%. The $59,000 dollar difference in value means that our investor, in effect, has paid out 59% of his initial portfolio as fees.


I can add more years in the calculations and find that in a bit more than five more years – +25 years from the start – the difference in portfolio value equals today’s portfolio value in spending power. Our investor has effectively paid out ALL of today’s portfolio value in fees.



(I would get the same answers when I fight through the logic and math of calculating the future value of the growing stream of fees paid – Future Value of Growing Annuity or FVGA.  An explanation is here and a calculator is here. The logic of the calcuation is much clearer to me when I do it my way – subtracting the difference in future values.)


== What’s value? ==


Folks have to decide on the value they will get from added investing costs. I think you cannot assume value – net returns greater than index funds – from actively managed funds. A non-obvious cost of advisors is their tendency to put investors in actively managed funds that will return less than index funds. I see the biggest advantage of advisors as preventing folks from making bad mistakes. A friend told me she sold all her stocks in her retirement accounts right before the election, and by the time she got back in the market, she missed 10% return. That’s a bad mistake that will compound to much lower portfolio value in the future. An advisor who would have prevented her from doing that would have provided real value.



Conclusion: The fees an investor chooses to pay that are greater than about 0.05% AUM almost certainly result in lower future portfolio value: the added percentage cost is a direct reduction in the return rate that the investor would otherwise receive. In effect, an investor is transferring a bit of wealth potential from his or her portfolio to financial professionals: in concept they invest it and the amount grows to their future wealth, not yours. This post describes the way to calculate the impact of fees on a portfolio. In the example, an investor effectively pay out ALL of his or her initial portfolio as fees in 25 years.

Part 2: Is your retirement portfolio at its peak value for the rest your life?

Two weeks ago I read this article “The Long-Term Forecast for US Stock Returns = 7.5%”. When I adjust for the assumption for inflation, the article forecasts a ~5% real annual return for stocks vs. the historical average of ~7%. That’s 30% lower ((5-7)/7). The purpose of this post is to explain how this and other forecasts are telling us to “Throw away what you think is normal based on history. It’s a very different, far less attractive future.” I also want to explain what 5% real return for stocks means for the decisions for our financial retirement plan.


Here’s the answer to the question for those of us who are retired: assuming long-run, real returns for stocks will be about 5% (And the forecasts are 0% real return for bonds.), your portfolio value today is AT OR NEAR ITS PEAK FOR THE REST OF YOUR LIFE. Your retirement portfolio WILL NOT GROW in real spending power over time, because the expected return rate for your total portfolio is LESS THAN the percentage you withdraw each year for your spending. But I conclude, as I explain later, those forecasted, lower return rates do not affect your age-appropriate Safe Spending Rate (SSR%; Chapter 2, Nest Egg Care [NEC]).


Example: if I use 5% for the future real return rate for stocks and the 0% predicted for bonds, the expected return rate for my investment portfolio is 4.3%. If you have a lower mix of stocks than Patti and I have, your expected return rate would be less.



Last December Patti and I withdrew 4.85% for our spending. (We’re older than most!) That’s zero chance for depletion in 15 years assuming we’re starting now on the Most Horrible return sequence for stocks and bonds in history. We withdrew more than the 4.3% expected real return on our portfolio.


I would therefore expect this year that I we would NOT earn back in real spending power what we withdrew last December for our spending in 2021. When I calculate for our Safe Spending Amount (SSA) this coming December, I’d expect that Patti and I will only be able to adjust our current SSA for inflation (See Chapters 2 and 9, Nest Egg Care.) I’d expect that pattern – no real increases in our SSA – to repeat in future years, and I’d expect our portfolio to decline in real spending power over time. (The return on our portfolio is good so far this year; we’re on track to earn more than we withdrew last December.)


I conclude that if the future is 5% real return for stocks, we all need to be happy with our current SSA, because we won’t see much of a real increase. (Patti and I are happy! Our SSA has increased in real spending power by 32% over the last six years. See here.)


== The studies of future returns for stocks ==


On this sheet that you can download I list a number of studies that forecast future returns. The forecasts haven’t changed much for a number of years. My summary is that 5% real return for the long-run average for stocks is about the average of the predictions. The prediction for bonds is about 0% future real return.


I sketch the predicted rates for stocks and for bonds on a graph. I start the new trend lines in 2015, roughly when all these predictions started. The cumulative return lines for stocks and bonds started on the predicted return lines, but both are above their predicted trend lines now. Over time the new trend lines depart widely from the historical averages.


The forecast from the studies show a departure in the long-run average returns for both stocks and bonds. I assume the studies think that departure started in 2015 for this display.


== Worse over next 5 to 10 years ==


All the studies predict corrections for stocks over the next decade to get back the cumulative return lines back to their trend lines. Most of the studies imply that stocks are over-priced by about 30%, meaning a 3-percentage point deficit in return over a decade to interest the trend line.


One of the forecasts of returns is not credible in my view. That’s -7.8% real annual return for stocks over the next seven years. That’s worse than the Most Horrible seven-year return sequence in history. And the economic forces during that period were particularly bad.


This sequence of returns is much worse than the second worst seven-year sequence of returns.


== How do they calculate 5% real return for stocks? ==


The general logic for the predictions is the same; none of them give enough details to know exactly how their model works or clearly describe impact of the factors. Each implies a logic that generally follows my text here. I think my text is clearer than any of the descriptions I read in those reports:


• “You shouldn’t base the future on the simple extrapolation of the 95-year average of 7% real return for stocks. That’s not a logical way to predict the future.


• “We built a model that identifies what drives stock returns. The fundamental drivers of returns have been corporate profitability and growth: these two drive the ultimate cash return to investors: dividends and cash returned in the form of retiring outstanding shares.


• “The future economy and company profitability are very different from the past. A key change, for example, is that economic growth – the real growth in Gross Domestic Product – is forecast to grow at 2.3% per year in the future as compared to 3.1% for the past 70 years. (I have no idea as to their assumptions on corporate profitability and I think that would have a much greater impact on future return than growth.)


• “When we put our forecasts for the key inputs into our model, our model tells us that you should expect 5% real return for stocks in the future, not 7% as in the past.”


== Where’s the beef? ==


How good are the models? How accurate have they been? Should we believe what they say? The general logic for the models makes sense to me, but the models lose credibility when the actual results vary WIDELY from the predictions. These predictions for about 5% real (or lower) returns have been around for more than five years. Real stock returns have been about 2½ times the predicted returns over the past six years.



In 2016, one of these studies forecast 0% probability that a portfolio would earn 5% real return over the decade. The real return rate for the first 4½ years has averaged 11% per year.


NONE of these reports acknowledge that actual results have been far better than their forecasts. I’d like a study to clearly state something like this: “Stock returns over the past five years have been at more than twice our predictions, and we’ve changed our model to reflect that. We now forecast ….” Or, “Stock returns over the past five years have been more than twice our predictions. We are sticking with our model, and the explanation of the return difference is that we believe stocks are now GROSSLY over-valued – by more than 50%! Stocks need to drop by about 35% from the current level to be in line with our predictions. Here’s how you know that stocks are grossly over-valued: …..”


== Implications for my plan ==


Nothing about these studies tell me to change the decisions for my retirement plan. For example, I am not going to lower the amount we withdraw for our spending. I will NOT CHANGE the age-appropriate Safe Spending Rates (SSR%) that I display in NEC. (See Chapter 2 and Appendix D, NEC.) I used 4.85% last December for our spending in 2021; I will use – actually test to see if I can use – 5.05% for this upcoming year.


Your age-appropriate SSR% is based on the assumption that you will face – starting NOW – the Most Horrible sequence of stock and bond returns in history. The cumulative real return for that sequence was 0% for stocks and 0% for bonds for 14 years. I argue that there is nothing in these forecasts that suggest we should assume a return sequence worse than that one.


But if I thought the future was 5% stock returns and 0% bond returns are the future, I’d double down on LOW, LOW investing costs. A cost of one percentage point/year is 23% of the growth at 4.3% expected portfolio return (-1/4.3). That’s a Big Bite. I can’t get much lower investing cost than I am now, about .04%.


The expense ratio of VXUS declined by .01% from the last time I looked at this!


== Those in the Save and Invest phase: UGH ==


We older folks have lived through decades averaging about 7% real return rate for stocks. If it’s a 5% future real return for stocks, younger folks have to save 70% MORE what we had to save to be as well off as we are. The Rule of 72 tells us that stocks double in real spending power in +14 years years at 5% as compared to  every ~10 years at 7%. Money invested at 5% grows ~3.5X in 25 years. Money invested at 7% grows ~6X in 25 years.




Conclusion: A number of studies forecast the future real return for stocks is 5% (or less) relative to the historical 7% real return rate. They’ve forecasted this new normal for a number of years. They’ve not been accurate: real stock returns have averaged more than double their forecasts. But the forecasts could be right.


This post explains that if the forecasts are right, you likely are at the peak of portfolio value for the rest of your life. Your withdrawal rate – your age-appropriate Safe Spending Rate (SSR%) you get from Nest Egg Care – will be greater than the expected return rate on your portfolio. You typically will not earn back the amount you are withdrawing each year.


This post explains that a long-run average 5% real return rate is not a disaster: it does NOT mean we should withdraw less for our spending. That lower average future rate does not threaten the number of years we can plan for ZERO CHANCE of depleting our portfolio.

Part 1: Is your retirement portfolio at its peak value for the rest your life?

Last week I read this article “The Long-Term Forecast for US Stock Returns = 7.5%”. The article assumes 2.5% future inflation. That means the forecast translates to ~5% real return for stock vs. the historical average of ~7%. That’s 30% lower ((5-7)/7). I can find similar predictions – some from five years ago – that are much lower than the 5% rate. Wow! Those predictions are saying, “Throw away what you think is normal based on history. It’s a very different, worse normal in the future.” I’ve assumed that the future is close to the past, but we need to understand the implications of both of these scenarios. This post discusses what we might expect if the future is like the past: new normal = old normal. That’s clearly a more comfortable future. Next week I’ll discuss those studies that forecast a new normal that is much lower than 7% real return for stocks: that will be uncomfortable!


Here’s the answer to the question: assuming future real returns roughly match the historical real 7.1% return rate for stocks, your portfolio value today is NOT its peak value for the rest of your life. Your retirement portfolio will grow in real spending power over time, because the expected return rate for your total portfolio is greater than the percentage you withdraw each year for your spending.


Example: the expected real return rate for our investment portfolio is 6.4%. Last December Patti and I withdrew 4.85% for our spending (We’re older! That’s zero chance for depletion in 15 years assuming we’re starting now on the Most Horrible return sequence for stocks and bonds in history.).



I expect this year to earn back what we withdrew in December and add 1.5% in real spending power. When I calculate for our Safe Spending Amount for next year, I’d expect that Patti and I will have more than enough for our current Safe Spending Amount (SSA; see Chapters 2 and 9, Nest Egg Care.)


Obviously, annual returns and sequences of returns for stocks and bonds vary from their long-run average rate. Returns were such that Patti and I earned back more than we withdrew in four of the last six years. Those years resulted in a real increase in our SSA for the following year. We didn’t earn back enough for a real increase in two years. (See here and here.)


== The past is 7.1% real return for stocks ==


You’ve seen this graph before. The long-run average, real annual return rate for stocks is 7.1%. That’s the average from 1926-2020; the rate would be slightly greater if I added the data from 1871. Clearly 7.1% is not a law of physics, but that’s a lot of history that I’ve viewed that as a pretty darn accurate predictor of the long-term future.



If we think the future will be like the past, we’re making the underlying fundamental assumption that corporate profitability in the future will be similar to the past: profits provide the cash that companies invest back into their business to keep pace with the growth of the economy and to pay out cash to shareholders in the form of dividends or stock buy-backs; buy-backs today are greater than dividends. That seems to be a reasonable assumption.


== Returns should migrate toward the 7.1% trend line ==


Points on the solid line of cumulative returns should migrate toward the 7.1% rate – toward that dashed trend line on the graph. When a point on the solid line is above the trend line, future returns will be lower than 7.1% to reach the dashed line. When a point on the solid line is below the trend line, future returns will be better.


== Where are we now and what does it mean? ==


The data point at the end of 2020 is slightly above the trend line. I calculate that it is 4% above the line.



If the solid line hits that 7.1% trend line ten years from now, the cumulative return from the end of 2020 to the end of 2030 will be 4% less than value of 7.1% return compounded for 10 years. That works out to 6.7% real return over that holding period. That’s going to translate to a an expected return for our total portfolio that’s still above our withdrawal rate until we are well into our 80s: our portfolio is not at its peak value.



For those in the Save and Invest phase of life, I’d assume the long-term 7.1% real return rate applies for each year’s savings that you hold for long holding periods. Following the Rule of 72, investors in stocks can expect a doubling in spending power about every ten years. I’d still think of it this way: a 40-year-old person who saves this year (2021) will spend that in the 25th year from now (2046). The amount then would be about 6X in today’s spending power, the result of 2½ doublings.




Conclusion: If you believe the future is similar to the past, you believe the long-run future real return rate for stocks is ~7% per year. Stocks dominate your portfolio, and the expected return rate on your total portfolio is less than you are withdrawing each year for your spending. At expected return rates, your portfolio will grow in real spending power and you will calculate to a greater Safe Spending Amount in future years.


The cumulative return for stocks from 1926 to the end of last year is slightly above its long-run trend line. The future return rate to get back to the trend line is slightly less than 7.1%.

I switched financial advisors this week. What was my thinking?

Several of my friends have separated from their financial advisors and became a self-reliant investor. It’s pretty simple for us nest eggers, since our total portfolio is only four index funds. I have never hired a financial advisor for our money. But I separated this week from an advisor I hired almost nine years ago for a Trust where I am trustee. In essence, I’m the Trust’s financial advisor now, and that’s the responsibility that the Trust agreement assigns to the trustee. The key advantage of the switch is that I won’t pay myself the advisory fee that I have been paying. The purpose of this post is to describe my thinking as to why I made that change: what appears now as a small, almost inconsequential advisor fee results in a MUCH SMALLER portfolio value over the very long run.


== Trust and trustee ==


Patti’s brother and his wife set up the Trust in 2006. It held option shares in a privately held company. He was CEO. I agreed that I would be trustee. It had no dollar assets. The option shares just sat there. The trust is a structured as a generation skipping trust, meaning the objective isn’t to provide money to the three children but to their children. The trust will have a very long life; it terminates on the death of the last of the three children. That’s likely more than 60 years from now: the youngest daughter is 24.


The company was sold in 2012, and the option shares turned into real money! I had to invest it. I was concerned that I might have a liability, and I wanted an advisor to provide some sort of check on my decisions. I hired a very good guy, Mike, who agreed with a low-cost index fund approach: he recommended a fairly complex portfolio that a study he cited said would outperform the market. Everyone wants to beat the market, and I bought into this in 2012. The Trust’s portfolio had a total of 13 moving parts – individual securities (ETFs). This splitting of the total market of stocks and bonds into many segments is fairly standard fare for advisors. I show the ten slices for stocks.



== Portfolio tilts and rebalancing ==


The US stock portfolio was weighted or tilted to value stocks and to mid- and small-cap stocks, for example. Over the past nine years, the exact opposite tilts would have returned more. No tilting would have returned more.


At least once a year, Mike would rebalance the portfolio to get close to the design percentages for each of the 13 securities. For example, the design mix of large-cap value (ETF = VONV) is 52% relative to 48% for large-cap growth (EFT = VONG). If VONG’s returns were greater than VONV’s, Mike would ask and I would agree that he should sell VONG and buy more VONV to bring the portfolio mix back to the original design mix. The thinking is that you want to sell when something has grown faster than its long-run average (“sell high”) to buy something that has grown slowly (“buy low”). That’s a lot of moving parts that one is trying to bring back to a design mix each year.


This approach sounds great, but in practice – ignoring the impact of paying taxes on capital gains incurred – that rebalancing tactic is no improvement over just holding the blend fund ETF = VONE that holds all the stocks held by VONV and VONG. I summarize the returns from a spreadsheet I made that tracks returns over the past +ten years. The Trust would have slightly more today if it just held VONE rather than the mix of VONV+VONG rebalanced at the end of every year.



== Capital gains taxes ==


The annual rebalancing meant that the trust incurred capital gains taxes every year: we were always selling some ETFs – and in some years a bunch of ETFs – and incurring gains just to rebalance. Those gains would be analogous to gains distributions that you can get from actively managed funds: you aren’t getting any more money from them; you are simply paying gains taxes now and not deferring the tax when you actually sell your holdings for your spending. Paying gains taxes earlier than you otherwise could lowers your ultimate after tax proceeds: I calculated in this post that this is not a big penalty – a small fraction of one percentage point per year – but it is a penalty that is not being offset from greater return.


== My liability as trustee and the fee ==


When I first thought about switching from Mike, I reread the trust agreement. I have NO personal liability as to how the money is invested or the fees charged! I think this is standard language in trusts like these: “No Trustee shall be liable for any mistake or error in the administration of the Trust which does not amount to gross negligence or willful misconduct.” I really did not need whatever I thought a financial advisor offered as liability protection.


Mike’s fee to be advisor was at the very low end of what most in the industry charge. I certainly can’t complain about the small percentage. To heck with the percentage. I kept looking at the increasing amount of the fee; it’s not a tax-deductible expense to the Trust.


Mike took on the trust account for a dollar fee that I presume made him happy in 2012. Over the +eight years, the Trust has more than doubled in value, and therefore Mike’s fee has more than doubled. Has the work effort doubled? No. Does he have some sort of greater financial responsibility now that merits a greater fee than then? I don’t think so.


I think about the effect of compound growth and fees over the lifetime of the Trust. The Rule of 72 tells us the portfolio – based on its mix of stocks and bonds – will double in today’s spending power roughly every 12 years, and therefore Mike’s fee is doubling in real spending power every 12 years. The trust will exist for 60 more years or five doublings from now – a factor of 32. Mike has one doubling of fee under his belt. Does it make sense for Mike (or his firm, since the trust will outlive me and Mike) to be eventually be paid 64 times the spending power the original fee? No.


== The right way to look at it ==


Looking at the fee is not the right way to look at it. It isn’t the amount of the fees; it’s fact that fees lower the net return rate for the portfolio. The compounding of a slightly smaller net return rate spells a big difference in portfolio value. The question is: does a small difference in return rate from the advisor fee have a significant impact on portfolio value over time? Spoiler alert: it’s HUGE given the long life of the trust.


I first have to get to the expected after-tax return rate difference: it works out that I need to compare portfolio growth at ~5.9% real return per year vs. ~5.6%.



Given the mix of stocks and bonds, the expected return rate for the portfolio is ~6.4%. The ETFs have a weighted expense ratio of .1%. (That’s higher than the .04% for my portfolio, because the small segments are more costly to manage.) I’ll deduct another .5% for the annual taxes the trust will pay on dividends and interest: my simple estimate is 2% dividend rate and 23% tax rate. I get to ~5.9% return rate. Now I’ll subtract a REALLY LOW advisor fee of just .3% to get ~5.6%. I now can compare the effect of two return rates.


== It’s A BIG DIFFERENCE over the life of the Trust ==


The difference in portfolio value from .3% difference return rates is almost inconsequential for many years. If the portfolio had $100,000 at the start of this year, the difference in value at the end of the year – assuming the expected return rates – is just $300 in today’s spending power: this isn’t worth worrying about. At five years the difference is $1,900; still no big deal. If the start was $100,000, I can easily overlook the cumulative $2,000 difference in value.



The difference in portfolio value keeps growing to MUCH MORE than the $2,000. In 40 years when the when the children are roughly retirement age – their children might be in their 30s – the difference in portfolio value equals today’s value in spending power. If the Trust has $100,000 today, that means there would be $100,000 less in real spending power from the advisor fee. In 50 years, it’s twice that. It’s more than four times in 60 years. It’s a HUGE difference.



= My discussion with Mike ==


I called Mike. I wanted to visit him at his office and tell him face-to-face, but he said he really wasn’t going into the office and wouldn’t go in for a while. I erred in telling him what I was thinking of doing without the preliminary of telling him what a good guy he has been over the last nine years. He was not happy with my decision, and placed a mild guilt trip on me. “Your account is one of the very best performing accounts I have. It is by far the best performing portfolio relative to other trust accounts that I have with banks as trustees.” Yep, I’m sure all that is true. But that’s not the point. The difference is portfolio value without his fee is HUGE. And my calculation ignores the effect of added gains taxes from all the rebalancing.


I think we parted on somewhat friendly terms. I followed up with a nice email of thanks after I opened the account for the trust at Fidelity. (That was a simple. The whole process to transfer all the holdings will take about five business days.)



Conclusion: If we think we are a self-reliant investor, we can invest without the aid and expense of a financial advisor. I recently decided not to use a financial advisor for a trust where I am trustee. This post discussed the basic reasons: but the simple reason is that the impact of what anyone would agree is a small advisor fee has a very outsized effect on future portfolio value. Without the fee, the trust will grow – in today’s spending power – to several added multiples of its current value.

What’s the effective capital gains tax rate? Isn’t it really more than 15%?

The capital gains tax rate is really is more than 15%, because the calculation of gain does not adjust your cost basis for inflation. When you pay tax on capital gains, you are paying tax on the real component of gain and on the inflation component of gain. How much are we hurt by paying tax on inflation? In this post I conclude that the federal tax rate on the real component of capital gains is about 19%. Over time, this effective rate declines.


== Ordinary tax brackets and inflation ==


You pay tax once on ordinary income – wages, interest and withdrawals from your traditional IRA as key examples – for your spending or for money that you save and invest in your taxable account. Income tax brackets adjust for inflation. If you earn the same real amount of dollars, you won’t be pushed into a higher marginal tax bracket; you aren’t paying more real tax just because of inflation.



For example, the start of the 22% tax bracket for 2021 for married joint filers is about $81,050, and it was $80,250 for 2020. The IRS announces these changes to the start of tax brackets every November. The IRS uses a different method for inflation than used for Social Security’s Cost-of-Living-Adjustment for gross benefits, and the IRS’s percentage change for tax brackets is less.


== It didn’t used to be this way ==


I’m old enough to remember that the tax brackets for ordinary income did not adjust for inflation for many years: Patti and I would get pay increases that might not total to more than the percentage that inflation increased. But because tax brackets did not adjust for inflation, more of our income would be taxed at a higher marginal tax rate. Inflation, not real increases in our earnings, simply pushed more and more of our income into higher tax brackets.


The IRS took a greater percentage of income from all taxpayers prior to 1977 without real increases in their earnings, leaving them all with less real spending power. This is NOT A GOOD THING, and I think this decline in real spending power for families factored into this period of the most horrible sequence of stock returns in history.


Here’s an example: A couple who earned the right at the top of the 19% tax bracket in 1968 and earned that same real amount for the next nine years found that about 40% of their income was taxed at 22% or 25% marginal rates in 1976. (See here for history of tax brackets.)


Here’s the detail: our couple had $8,000 in taxable income in 1968, right at the top of the 19% marginal tax bracket. I restate the $8,000 in 1968 to $58,700 spending power last December. Assume our couple earned that same real amount, $58,700 each year. The top of the 19% tax bracket did not adjust for inflation; it was really lower year after year. By 1976, the start of the top of the 19% bracket had fallen 39% in real spending power to $35,800 in today’s dollars – 45% of what it is today. Taxes were unfair and high!



== Capital gains don’t adjust for inflation ==


I’m sure you’ve got this: you paid income tax once to get the money that you invested in a mutual fund, ETF or stock. You pay tax on the gains when you sell for your spending. When you calculate your gain, amount you paid for an investment does not adjust for inflation. Your gain therefore includes two components: the real return component and the inflation component. You’re paying tax on both.


How much is the penalty of paying tax on inflation? Is it as bad as it was for wage earners in the late 60s and early 70s?


== My conclusion: you’re paying perhaps 19% not 15% ==


I think I’ve thought this through correctly. I use a simple example of a stock with no dividends, 7% real return from increase in price, and 2% inflation. I’ll assume those add to 9% nominal total return per year. That means 2/9 of your total gain is inflation; you are paying 29% more (2/7) than you would if there were no inflation or if your cost basis was adjusted for inflation. In effect, you are paying 19% rate on your real return.


The effect of inflation on your real tax rate is smaller with longer holding periods. You are paying less than 29% more over time. That’s because 2% inflation compounds more slowly than the 7% real. Inflation is a smaller portion of total gain. You are paying less than 19% tax rate on your real return over time.



Inflation at 2% grows more slowly than 7% real return. The inflation component is less of the total return over time.


I played with the inputs to the table to see how that 19% rate changes: lower inflation lowers the effective tax rate: inflation has averaged about 1.7% over the past ten years. If inflation is more than 2% in the future, the effective tax rate will be higher. If your real return rate is lower, inflation becomes a larger percentage of the total and the effective tax rate is higher. But as I play with the numbers, you have to assume extremes – lousy real returns or very high inflation, as examples – to move very far off the generalization that your effective federal tax rate on the real component of capital gains is roughly 19%.



Conclusion: The calculation of capital gains tax does not adjust your cost basis for inflation. You are paying tax on the real component of gain and an inflation component of gain. You are paying more than the 15% rate you’d pay if there was no inflation. I calculate in this post that you are paying roughly 19% on your real return.

What does PSERS do to improve its investment returns?

I went CRAZY this week thinking about PSERS – Pennsylvania’s School Employees Retirement System. I wrote about PSERS two weeks ago, but I couldn’t get it out of my head this week. Why? PSERS is committed to an investment strategy that we nesteggers would not AT ALL attempt. PSERS attempts to beat a simple benchmark of index funds for their $60 billion (!) portfolio. I dug into the details of PSERS relative performance this week and found it to be much worse than I thought. The purpose of this post is to show what happens if you don’t set a clear benchmark for performance and measure your performance against it. The post shows another example of the folly of trying to outperform what the market gives to all investors over time.


== Set a benchmark ==


We nesteggers understand the concept of benchmark. The simplest benchmark for a portfolio has to be the average that the market gives to all investors for stocks and bonds. Heck, the purest nesteggers hit that benchmark year after year because we only invest in stock and bond index funds that gives us what the market delivers – less a tiny investing cost.


I illustrate the benchmark for stocks and bonds in the graph; you’ve seen a this graph before. The real expected return – the average, long-run nominal returns adjusted for inflation – is 7.1% per year for stocks. For this post I average the real return rates for long-term and intermediate-term bonds and get 2.6% real return rate.


The long-run average real return rate for stocks is 7.1%; 3.1% for long-term bonds and 2.2% for intermediate-term bonds


Your benchmark for your portfolio is determined by your decisions on your mix of stocks vs. bonds. (See my logic and decisions in Chapter 8, Nest Egg Care [NEC]). Using the 7.1% and the 2.6% and my decisions on investing cost, the expected return for my portfolio mix is 6.4% real return per year.




We nesteggers understand that actual returns we’ll get over time wiggle around those straight trend lines on the graph. The actual historical return rate for stocks, for example, for a number of years is the slope of a straight line drawn between the two years on wiggly line. The straight line you draw between two points rarely parallels the 7.1% line; steeper slope is greater than 7.1% and shallower slope is less than 7.1%. I wrote about my 8.7% real return rate on the steeper slope from 1985 to 2021 here.


== PSERS trailed by 2.6 percentage points/year ==


All investors should annually compare their performance to a benchmark. This post has the benchmark I suggest you use for calendar 2020 for your portfolio. If you are invested in similar index funds as mine, of course you nearly match this benchmark.


To compare with the returns for PSERS, I constructed the returns for index funds that match my benchmark portfolio for 12-month periods ending each June 30; that’s the fiscal year end for PSERS. (I use Morningstar to find returns for any security for any period in the past.) My detailed spreadsheet compares PSERS’ annual returns to the returns for the benchmark. PSERS trailed the benchmark return in seven of last 10 years and trailed by an average of 2.6 percentage points per year. UGH.


Yep. It’s busy and tiny, but it shows PSERS lags its benchmark by 2.6 percentage points per year over the past decade. That deficit means its portfolio ten years ago is 26% smaller than it should be: perhaps $15 billion shortfall.


That deficit adds to a 26% deficit in cumulative returns for the portfolio at the start of the 10 years. When you are working with a portfolio the size of PSERS’, that translates to perhaps a $15 billion shortfall over a decade! (That’s the calculation using time-weighted returns. With the additions from current employees and employers and withdrawals for retiree benefits, the money-weighted return and dollar impact will be different.)


== Benchmark return worth $20? billion ==


PSERS is a defined benefit retirement plan and has a large unfunded pension liability. (It’s another story as to how that happened.) Accountants forecast the future stream of payments PSERS will make over the lives of all their participants and then discount them to the present value using, in PSERS case, a real return rate of 4.5%. That rate calculates the total needed was $107 billion as of last June 30; PSERS had $58 billion and therefore was $49 billion short. That $107 billion is sensitive to the assumed discount rate used. The accountant’s report shows that one percentage point more – 5.5% real return – would slash $10 billion from the unfunded portion, and the 6.4% benchmark is another .9 percentage point. The benchmark is slashed by ~$20 billion if PSERS just matches its benchmark.


== Evidence: Can PSERS outperform? ==


PSERS is committed to an investment strategy geared to beating the returns it would obtain from a simple portfolio of stocks and bonds. We nesteggers don’t try to do this, but let’s ask again, “Will this strategy work?” I think the one can only conclude, “NO”. Here are the problems:


• There is no long-term data to set the expected return from certain of PSERS asset classes and therefore there is no overall expected return rate for the portfolio. This report lists its assets classes, and several of those  would throw me for a loop if I was trying to figure out the expected return: its asset classes: “risk parity” is 8% of assets; absolute return” is about 10% of its assets; commodities 8%; infrastructure 3% that is separate from real estate, “master limited partners” is 2%. If you can’t set a benchmark for the expected return rate for an asset class, you can’t possibly construct your overall expected return rate, and you can never judge how well your choices within each asset class are performing.


• The evidence from ten years of PSERS’ performance shouts, NO. Underperformance is consistent. There is no pattern – no hint, I’d say – to suggest the portfolio will outperform. If this were your portfolio, you’d stop and change direction. If you were on the investment committee for any investment fund, you’d stop and change direction.


• The evidence from the results of 705 college and university endowment funds loudly shouts, NO. These endowments have a lot of smart people trying to beat the performance of index funds. The recent report by NACUBO shows that the better of them – those at the 75th percentile of performance – lag the benchmark of index funds by 2.2 percentage points per year. That is just UGLY in my opinion.


The top (75th percentile) of endowments lag a simple benchmark by 2.2 percentage points/year over the past ten years.


It’s some sort of group-think for PSERS and all those endowments that results in their sticking with broken investment strategies.


PSERS has to get off its broken investment strategy. The start is that any new investments have to be invested in a portfolio that matches the benchmark. It may take years to unwind much of its illiquid investments, but that’s the only way to bring its fund back to health.



Conclusion. I was obsessed thinking about PSERS this week even though I wrote about it two weeks ago. A detailed comparison of PSERS’ performance shows it lags a simple-to-match benchmark of performance by 2.6 percentage points per year. That deficit is costly: a shortfall in what it could be now of perhaps $15 billion and what it could be in the future of another $20 billion. $35 billion. I see NO EVIDENCE to suggest that PSERS or 700 university or college endowment funds should be trying to beat simple benchmark that we nesteggers hit every year.

What’s the history of inflation, and might history foretell the future?

I posted last week about the latest calculation of 4.2% annual rate of inflation, May 2020 to May 2021. This is greater than the Federal Reserve’s long-term objective of expectations of annual inflation to be “well anchored at 2 percent”. Is 2 percent a reasonable objective? The purpose of this post is to describe the patterns of inflation over the 95 years from 1926 through 2020.


Inflation has averaged 2.9% per year, but that’s not been a steady rate. We had a long period of deflation – inflation below 0% – and two other periods where inflation averaged 2½ times the long-run average. The key takeaway for me, though, is the long, stable period of inflation for the past 39 years. Does this mean we have learned how to control inflation? I’d like to think so, but perhaps that’s wishful thinking.


== Average inflation, 1926 through 2020 ==


What’s the history of inflation? I gather the calendar-year inflation data from this site. Inflation for the 95 years from 1926 through 2020 has averaged 2.9% per year: both the simple average and compound average growth rate round to 2.9%. It took ~$14.50 at the end of 2020 to equal the spending power of $1 at the start of 1926.


== I divide the history into five periods ==


I show a summary table and a graph of annual inflation rates.




What does the summary table and graph show? I highlight five periods: one is a 15-year period where we averaged deflation; two periods – adding to 23 years – are high inflation, averaging over 7.5% per year; and two periods – adding to 54 years – are modest-to low inflation, averaging less than 2.7% per year. The last 39 years is the longest period of stable inflation, and the last 13 have been low inflation.


1. The 15-year period from 1926 through 1940 was a period of deflation. The cumulative deflation over this period was about 20%. Three straight years in the Great Depression – 1930, ’31 and ’32 – added to -24% deflation! If you were lucky to be employed in those years and received a 20% pay cut, you were ahead in real spending power!


2. The seven-year period 1941 through 1947 was high inflation. Inflation averaged 7.6% inflation per year. These are the War years. The peak year for inflation was the first year after the end of the War, 1946: 18%; three years later, deflation was -2%!


3. The 18-year period 1948 through 1965 was low inflation. Inflation averaged 1.7% per year.


4. The 16-year period 1965 though 1981 was high inflation. Inflation averaged 7.5%. Inflation added to 25% for the two years 1979-80. You would have needed more than 25% increases in pay just to get ahead in real spending power.


1965 also was the start of the worst sequence of real stock returns in history. Stocks did not exceed their 1965 level, measured in real spending power, for 17 years. The MOST HORRIBLE sequence for combined stock and bond returns started in 1969: we nesteggers always use that worst case to determine our Safe Spending Rate (SSR%; see Chapter 2, Nest Egg Care [NEC].)


5. The 39-year period from 1982 through 2020 is modest to low inflation. Inflation averaged 2.7% over this 39-year period. Inflation exceeded 6% in two of the 39 years but was sharply lower the next year. This is the longest period of modest to low inflation. Inflation in the last 13 years has averaged 1.8%.


== What’s this mean? ==


Heck, I don’t know what this means. I do know that I don’t want events that rock the boat, and a sharp increase or decrease in inflation – actually the long-term expectation for inflation – would be an event that rocks the boat. Spending habits change based on the outlook on future inflation:


• Folks tend not to spend if the outlook is deflation – money is getting more valuable; prices are falling; things are going to cost less if we wait. That drop in spending is going to hurt the economy.


• The opposite is true if the outlook is high inflation – folks tend to buy anything NOW since money is rapidly losing value; prices are increasing; things will cost a lot more in the future. That increase in spending is going to artificially fuel or overheat the economy, and it will crash later when folks run out of new things to buy.


I’d like to think this past 39-year run of modest-to-low inflation – and especially the last 13 years – is a good predictor of the future: I’d like to think “they” – meaning the Federal Reserve, I guess – know to control inflation. But I’m not an economist and have no insight as to whether that might be true.


The good news: with our worst-case planning and decisions following the steps in NEC, we know our annual Safe Spending Amount at least maintains its real spending power over time. We also know our spending rate is safe: we should be confident that we will NOT RUN OUT OF MONEY no matter what hits us in the future.



Conclusion. This post looked at the long history of inflation, 1926 through 2020. Inflation has averaged 2.9% per year, but we’ve had long stretches of deflation and high inflation – average rates 2½ times the long run average. Inflation has been the most stable in the last 39 years, and has been consistently low in the last 13. We investors like stable and low inflation. I’d like to think that the last 39 years tell us that “they” know how to avoid big changes inflation, but I have no idea if that is true.

How bad must inflation be to be worrisome?

We all have read about recent increases in inflation; the annual inflation rate in April was 4.2%, the highest in 13 years. How concerned should we be? The purpose of this post is to simply remind us of how bad inflation was in the period of the MOST HORRIBLE sequence of real returns for stocks and bonds in history: the sequence of returns starting in 1969. That’s the sequence of return we nesteggers use to get our age-appropriate Safe Spending Rate (SSR%) and then our annual Safe Spending Amount (SSA). (See Chapter 2, Nest Egg Care [NEC].) Inflation was a contributor to those poor returns: but the damage then was from from inflation that averaged 9% per year for many years and reached a peak of more than 13% in one year.


I contend that we’d have to lose complete control of inflation, and it would have to triple or quadruple to have a SERIOUS impact on our financial retirement plan: by SERIOUS I mean that inflation and other economic events put us on a sequence of return that could lead to depletion of our portfolio. That’s SERIOUS!


== The Federal Reserve anchor of 2% inflation ==


Last September the Federal Reserve announced its target of inflation of greater than 2% since inflation has not reached 2% for several years. The Social Security increase for cost-of-living adjustment has averaged 1.3% over the past six years, for example. The Fed’s goal is for “longer-term inflation expectations [to] remain well anchored at 2 percent”.


The annual inflation rate 0f 4.2% in April raised some alarm bells. This rate may adjust downward and even if it didn’t, a 4.2% rate is FAR LOWER than the rate of inflation that damaged both stocks and bonds in the MOST HORRIBLE sequence of stock and bond returns in history.


== The MOST HORRIBLE sequence of returns ==


The MOST HORRIBLE sequence for stocks started in 1969. I’ve displayed the worst sequences of returns here and discussed the 1969 sequence here and here. That sequence is so bad that a retirement portfolio declines to its tipping point: withdrawals for spending combine with poor returns; portfolio value declines so much – less than half its initial value in spending power – that higher-than-average returns can’t heal it. A portfolio spirals in value to the point it can no longer support a withdrawal for annual spending.


That 1969 sequence in a Retirement Withdrawal Calculator drives the most critical decision for our financial retirement plan. For example, at the start of our retirement plan in December 2014, Patti and I picked 19 years for ZERO CHANCE of depletion. This led to our Safe Spending Rate of 4.40%: an annual withdrawal of $44,000 in constant spending power relative to $1 million initial portfolio value. (See Part 1, NEC.)


I highlight the first 14 years of the MOST HORRIBLE sequence of returns starting in 1969 in the graph below. I show a table of real returns and inflation for the 21-years 1962-1982 here.



Here are my observations from the graph and table:


The cumulative returns for both stocks and bond were below 0% for the 14-year period starting in 1969. Stocks declined 10% in real spending power and bonds declined almost 20%. This period is most unusual because it contains the steepest sustained declines for both stocks and bonds in history.


This period also contains the period of the most rapid increases and highest levels of inflation in history: inflation averaged 2.1% in the six years 1962-1967; inflation doubled to average 4.6% in the five years 1968-1972; inflation doubled again to average 9.3% in the nine years 1973-1981.


== What’s this mean to me? ==


We retirees DON’T WANT TO RUN OUT OF MONEY. We can’t control the stock and bond markets, and we may suffer a decline in our portfolio. I’m personally not concerned about a decline in our portfolio. A bigger and bigger portfolio was never an objective, although we do have more after six years of withdrawals for our spending. But we all should fear a sequence of returns that duplicates the effect of the MOST HORRIBLE sequence of returns in history. That would really hit hard. Increasing and high inflation was a contributor to those HORRIBLE returns, but I think we are far, far from those levels.



Conclusion: We’ve had a long period of low inflation. Last fall the Federal Reserve announced a target of more than 2% inflation and the long-term anchor of 2% per year. Inflation increased in April to 4.2% annual rate; some have raised alarms. This post looked at inflation during the period of the worst real returns for stocks and bonds in history: inflation increased from about 2% to a peak of more than 13%. That’s been the steepest increase and highest level of inflation in history. We’re not anywhere that rate of increase or high levels now. I’m not going to be concerned about inflation for a good while.