Sunday, January 12

Week 132 - What kind of returns can you expect after taxes and inflation?

Situation: Here you are, constantly worrying about whether you’ll have enough retirement income. Here at ITR, we want to give you as many options to consider as possible, along with pluses and minuses for each. Since true profit is the net of “gains” minus “expenses” it’s very important to consider what various retirement options are costing you, in real time. These costs are something that mutual fund managers and TV "experts" are loath to discuss, to say nothing of those infamous hedge funds. 

In this week’s blog, we want to boil this down to your likely “take home pay” for Plan A vs. Plan B vs. Plan C. We can start right up front by subtracting rates for taxes (25%) and inflation (2.4%) from Total Returns over the past 10 and 17 yr periods. Then we can subtract transaction costs, which better be a lot less than the 2%/yr spent by the average retail investor if you've been following our style of investing.

Plan A is the “plain vanilla” plan consisting of 50% in the lowest-cost S&P 500 Index fund (VFINX) and 50% in the lowest-cost intermediate-term investment-grade bond index fund (VBIIX). Looking at the Table, 17-yr returns for Plan A averaged 7%/yr and 10-yr returns averaged 6.1%/yr. (Note: you would have had to do some rebalancing every few years in order to maintain a 50:50 ratio.) The transaction costs or “expense ratio” for this plan are incorporated in the returns for each of the mutual funds, ~0.25%/yr. Subtracting 25% for taxes and 2.4% for inflation leaves you gaining an average of 2.9%/yr over the past 17 yrs, or 2.1%/yr over the past 10 yrs.

Plan B is the "balanced fund" plan, consisting of 100% in either the Vanguard Balanced Index Fund (VBINX, a computer-run fund kept at 60% stocks and 40% bonds) or the Vanguard Wellesley Income Fund (VWINX, a managed fund kept at ~60% bonds and ~40% stocks). Looking at the Table, 17-yr returns for VBINX averaged 7.4% and 10-yr returns averaged 6.8%. As in Plan A,transaction costs for these Vanguard funds are ~0.25%/yr. For VBINX, subtracting 25% for taxes and 2.4% for inflation leaves you gaining an average of 3.2% after 17 yrs and 2.7%/yr after 10 yrs. For VWINX, returns, net of all 3 costs are 3.7% after 17 yrs and 2.7% after 10 yrs.

Plan C is the do-it-yourself plan consisting 50% of Plan A and 50% of 8 large-capitalization “hedge stocks” (see Week 126). Turning to the Table, we see that those hedge stocks returned an average of 9.9%/yr over the most recent 17 yrs and 10.2%/yr over the most recent 10 yrs. The expense ratio (Column O) for building those DRIPs at computershare is 0.9%/yr. After subtracting 25% for taxes and 2.4% for inflation, average returns come to 5.0%/yr after 17 yrs and 5.3%/yr after 10 yrs; then subtract 0.9%/yr for transaction costs and you’re left with 4.1% and 4.4%. Combining those net returns 50:50 with the net returns from Plan A leaves you gaining 3.5%/yr after 17 yrs and 3.2%/yr after 10 yrs for Plan C.

In terms of reward, Plan C is superior but VWINX is a close second. In terms of risk, the three plans also differ. For example, note the losses sustained during the 18-month Lehman Panic (Column D in the Table): 20.3% for Plan A; 28% (VBINX) and 16% (VWINX) for Plan B; 16.2% for Plan C. Risk is also reflected by the 5-yr Beta values (Column I): 0.5 for Plan A; 0.94 for VBINX and 0.58 for VWINX in Plan B; 0.45 for Plan C. Note: Returns are as of 12/31/2013; red highlights denote metrics that underperform VBINX.

In terms of risk, Plan C is superior but VWINX is a close second. Plan C also fits well with your workplace retirement plan, since almost all such plans offer an investment-grade bond fund and a stock index fund as options from which to choose. Then you can use your IRA for investing in the hedge stocks.

Bottom Line: All 3 of these plans are conservative, in that they’re designed to conserve your resources through any but the worst of financial calamities (nuclear war, global pandemic). For example, all but one of the 8 hedge stocks in Plan C is a “Lifeboat Stock” (see Week 106). Risk has been avoided except in the case of the computer-run balanced fund (VBINX), which is 60% stocks. Over the past 5 yrs of remarkable growth in the stock market, that part of Plan B has outperformed the other options (see Column G). VBINX is our benchmark, referenced in every blog, because it is not subject to human error and is largely hedged anyway, given its 40% bond index component. Daily rebalancing prevents any momentum in either stocks or bonds from skewing the fund in either direction.

The most important message that we’d like to leave with you is that transaction costs need to be accounted for, and avoided where possible. Warren Buffett has made this clear on several occasions. For example, at the 2004 Annual Meeting of Berkshire Hathaway shareholders he said, when asked about the best way to invest for retirement:

 “Among the various propositions offered to you, if you invested in a very low cost index fund -- where you don't put the money in at one time, but average in over 10 years -- you'll do better than 90% of people who start investing at the same time."

Risk Rating: 4

Full Disclosure: I own stock in all 8 of the companies at the top part of the Table.

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