Week 33 - Rainy Day Fund in Retirement

Situation: It’s expected that retirement savings will be gradually depleted in retirement. But how do you deal with the unforeseen and unexpected expenditures that can upset an ongoing financial plan and derail your retirement savings?

This situation requires a backup plan--we need a “Super Hero” to step in and help. In an earlier blog (Week 15), we explained the importance of having a Rainy Day Fund and described the type of investments we would use to create such a fund. We can’t emphasize enough the importance of keeping contributions to the Rainy Day Fund on track throughout our prime working years; our 30s, 40s, 50s and right up into retirement.

The Rainy Day Fund that we suggest you establish is equally divided between Lifeboat Stocks and inflation-protected Savings Bonds, or “ISBs” (see Week 15). What this will achieve is that, by 10 yrs into your retirement, at least 50% of your stock holdings will be in Lifeboat Stocks (Weeks 8 & Week 23) instead of the 33% called for in our Goldilocks Allocation retirement savings portfolio (Week 3). This is important because Lifeboat Stocks are also termed “defensive”, meaning they don’t collapse in value during a bear market. Think about it. Having a bear market hit you two years into retirement might mean you’ll have to return to the workforce whether you like it or not.

Looking at the 2012 Master List (Week 27), we find 13 stocks representing “defensive” industries (health care, consumer staples, communication, employment services, utilities):

             ABT, KO, JNJ, MDT, PEP, PG, WAG

             WMT, ADP, BDX, HRL, MKC, and NEE.

And this is good because we can use these 13 stocks as candidates for our Lifeboat Stock designation (as defined in Week 25). Presently 12 of these 13 companies are relatively free of concerns. [The exception is ADP which has been bid up to a price (P/E=20) not justified by its low return on assets (ROA=3.6).] Seven of the remaining 12 are “Buffett Buys” from Week 30 (HRL, JNJ, MDT, WAG, BDX, WMT, NEE) but the remaining 5 also warrant Lifeboat Stock designation (ABT, KO, PEP, PG, MKC).

If used as 10+ yr DRIP investments with regular purchases in fixed amounts, any of these 12 stocks will more likely than not have a total return beating an S&P 500 Index fund AND show less depreciation during a bear market.

Since 7/1/02, for example, only MDT and WAG failed to do as well or better (in terms of regular DRIP investments) than the Vanguard S&P 500 Index Fund (VFINX); PG and JNJ DRIPs returned the same as VFINX (4.6%/yr). That’s 8 wins, 2 losses and 2 ties. With respect to price depreciation during the credit crunch from 10/07 to 4/09, all 12 of these stocks held up better than VFINX, which fell 47.6% vs. 21.6% for the 12 Lifeboat Stocks. Wow. Those ranged from an 18.8% gain (WMT) to a 48.9% loss (MDT).

To give you a concrete idea of what you accomplish by investing in Lifeboat Stocks to create a Rainy Day Fund, I will use my own Rainy Day Fund as an example. I created my fund on 7/1/02 using a quarterly investment of $630. I split this into $300/qtr for ISBs and $330/qtr for Coca-Cola (KO) in a dividend re-investment plan. As of 1/31/12, the $11,700 that I spent buying ISBs had grown to $14,278.34 (3.9%/yr) and the $12,928.55 that I spent on KO had grown to $18,476.95 (6.7%/yr). The result is that my Rainy Day Fund returned 5.4%/yr. For the sake of comparison, if we use a virtual $11,700 investment made in VFINX (Vanguard’s S&P 500 Index Fund) over this same period of time, it would have grown to be $14,847.98 (4.64%/yr). Inflation (Consumer Price Index) grew at a rate of 2.3%/yr. Therefore, my Rainy Day Fund had an after-inflation return of 3.1%/yr. This is a typical after-inflation return for a generic 50:50 stock:bond investment since 1970--after pricing in the tax benefits from owning Savings Bonds (Week 15).

Bottom Line: Every retiree would be smart to not only have a Rainy Day Fund going into retirement but continue adding the usual amounts after retiring. This could be the only unencumbered asset remaining in her portfolio to meet unexpected emergencies. It’s a real Super Hero that can step in and save the day!

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com

Week 1 - An Introduction to Our Blog

Who benefits from reading our ITR blog every week?

That would be the recently burned, casual investor - let's say a career woman who thought of herself as being risk averse (until the recent crash). She doesn't hold an MBA or work in a bank but does find investing to be a fascinating and useful hobby. She expects an asset will pay her rental income, interest, or a dividend, so she cannot be called a speculator. She may have owned a capital appreciation stock mutual fund but probably learned her lesson in the recent downturn. You would find her in a casino only to use the bathroom, or have a meal washed down with iced tea, and on a brokerage office Risk Questionnaire, she will score as a solid "growth & income investor". Her investment style is probably "capital preservation", where her main strategy is to protect her core investment monies.

The ITR target investor is one who finds the information provided about stock mutual funds to be inadequate. While bond mutual funds describe investment style in terms of both the credit risk and average time to maturity (risk of loss in value of long-term bonds due to inflation), similar information can be difficult to ascertain with stock mutual funds. Even when a company issues bonds, as most do, it is difficult to access that information. This is probably because many companies issue bonds that carry high credit risk and have long maturation periods. Standard & Poor's (S&P) rates each company's common stock and bond portfolio but that information is not required in a stock mutual fund prospectus. Managers of stock mutual funds like to invest in riskier stocks because in a “bull market” those stocks make the fund perform better than the relevant benchmark index. This is good for advertising because it suggests that the fund manager is a brilliant stock picker. But such is not the case: in a “bear market”, losses will be greater than for the benchmark. This is why the large majority of stock mutual funds lost more in 2008 than the standard benchmark – the S&P 500 Index, which lost a whopping 37%. And that 37% loss is just too great for our ITR reader. Having been burned, she will now shy away from stock mutual funds and wants to learn to invest directly in company stocks on her own.

This is best achieved by using a company's Dividend Re-Investment Plan (DRIP). Using a DRIP keeps trading costs low (you don't pay fees to a broker) and allows you to capture the power of compound interest through automatic re-investment of dividends. A monthly electronic purchase plan results in “dollar-cost averaging”, giving a certainty of buying cheaply during market down-turns. This type of an investment strategy lets our ITR investor develop a portfolio of 5-10 stocks with dividend re-investment, just as a bond mutual fund manager reinvests interest payments.

Now the problem for our investor becomes one of concentration: holding fewer than 50 stocks in a portfolio exposes the portfolio to market risk. There are two things that offer protection. One is to confine purchases to stocks that carry S&P Quality Ratings of A- or above, and the second is to choose only those companies that have increased dividends annually for at least 10 years. Stock in dividend-paying companies has been shown to hold up better in market downturns, thus some "insurance" is obtained by choosing stocks that yield more than an S&P 500 Index Fund (an example is SPY, an exchange-traded fund; current yield 1.8%).

Stock market risk can also be reduced (or hedged) using two other tools: diversification of holdings across industries, and by investing in other markets: foreign stocks, bonds (both US and foreign), rental properties and commodities markets. Problems arise though: commodity futures contracts pay no interest or dividends, and charges are steep, making these instruments suitable only for short-term investing by expert traders. Rental properties also carry significant charges. Unless one owns a Class A apartment building in a growing town, rental income isn't going to help in a stock market crash because occupancy will likely fall. Risks from owning a single apartment building can be diffused by owning a real estate investment trust (REIT) that invests in a number of Class A apartment buildings in different regions of the country, but value will still fall in a difficult economy. Thus, REITs are not a useful asset for someone who emphasizes capital preservation.

Let's take a closer look at companies that produce, package, transport, and market commodities. Some of these have S&P Quality Ratings of A- or better, yield as much or more than SPY, and have increased that payout annually for at least 10 years. (Whoa! Now our investor is tuned in . . .) These companies have found a way to develop raw commodities and consistently produce reliable streams of cash flow for reinvestment (after dividends are paid to stockholders and interest to bondholders). The major traditional commodities with a regulated "futures" market include corn, soybeans, wheat, live cattle, lean hogs, cocoa, coffee, sugar, gold, silver, copper, crude oil, heating oil and natural gas. There are 6 companies meeting our criteria that manage these feedstocks as their primary line of business. A future blog will identify and discuss these companies. All 6 had a 10-year total return of at least 7.7%/year, whereas, the median total return of a Fortune 500 company over that period was 6.7%/year (Fortune Magazine, May 23, 201, volume 163, no. 7, pp F2-F32) and the total return for the S&P 500 Index was 1.3%/year (moneychimp.com). However, commodity producers like these 6 companies suffer during stock market pull-backs, such as the one we've just experienced. A future ITR blog will discuss how to manage this risk.

Commodity markets are priced in dollars and globally sourced, which is the main support for their investment value. Therefore investments that are tied to a commodity represent a hedge against dollar depreciation. For that reason alone, it is worthwhile to buy stock in companies that can pass changes in valuation along to end-users. Future installments of our blog will address other key inputs to the economy that behave similarly, such as electricity.

Bottom Line:  Our weekly ITR blog will provide you with tools that allow you to become your own fund manager. We know it’s a complicated undertaking and difficult for new investors to feel comfortable with these concepts. Each week we will post our take on the topics we’ve introduced to you and provide further analysis and tools for you to use in managing your portfolio.


Click this link to move to Week 2