Early Retirement: Investing

by Philip Greenspun, updated March 2008

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If you retired with a pension, you don't need to worry too much about investing. If you received a lump sum from, for example, selling a business, you have to come up with a strategy for living comfortably for the rest of your life off that lump sum. Inflation and uncertainty as to the number of years remaining in your life are the two big complications. Suppose that you have $5 million in cash and wish to die penniless. How much can you afford to spend every year until you die? If you expect to live 50 more years and the money is in a non-interest bearing checking account, it seems as though you can spend $100,000 every year.

One problem with this approach is that in 50 years, inflation might have rendered $100,000 nearly worthless. Median U.S. family income in 1970 was $10,000. A family who earned that much in 2006 would be very poor indeed. A second problem with this approach is that you might still be alive after 50 years, when your bank account has reached zero.

The traditional way of dealing with uncertainty of life expectancy is to dump the risk off onto a life insurance company by buying a "life annuity". You hand over the $5 million to an insurance company and they promise to pay you a fixed amount every month for the rest of your life. In October 2005, the typical annuity posits an interest rate of 4.125% and would pay $282,000 per year. How can the insurance company afford the risk that advances in medical technology will keep you, and most of their other customers, alive until age 150? The same company also sells life insurance, in which they start paying policyholders when a customer dies. If the average person lives longer, the insurance company will lose money on the annuities it sold but make extra money on the life insurance it wrote.

One problem with the typical annuity is that it pays a constant nominal amount every year, which leaves you exposed to inflation risk. You get $282,000 this year, the price of a house in the Midwest. You get $282,000 fifty years from now, which might be the price of a Diet Coke. The right annuity for an early retiree would be one that pays out the same amount of purchasing power every year, an amount that, in nominal dollars, would rise annually with the Consumer Price Index. Some companies, including Vanguard, are beginning to offer inflation-adjusted annuities, but the ones that I've seen accomplish the inflation adjustment with Treasury Inflation-Protected Securities (TIPS), bonds that yield very little beyond the inflation adjustment. Finally, there is the problem with any annuity that the insurance companies tend to charge high fees. Annuities make more sense for older retirees.

If you're in your 40s, one way to approach the problem is to assume that you'll live to age 95. If you are still alive at 95, you can reverse-mortgage whatever real estate you own and put that into an annuity. Your marginal utility of income at age 95 should be fairly low. Your health care will be paid for by the federal government under Medicare. You're probably not going to be flying helicopters, riding horses, taking African safaris, and engaging in other expensive hobbies.

Given that you're investing to spend 40 or 50 years from now, what is the best strategy for protecting against inflation? Stock ownership provides excellent inflation protection. It is impossible to say whether $1 million will have any significant value 40 years from now, but a one percent ownership interest in General Electric, for example, would make you a rich person now and should make you a rich person in 40 years. Blind investment in stock indices, or "public equities", were a great road to wealth from World War II right through 2000. This kind of investment is problematic right now due to two factors. First, everyone else has figured out how great stocks are and bid up the prices to the point where returns are unlikely ever to reach the heights of the past. Second, corporate managers are taking an ever-greater percentage of corporate profits out as personal salary, either with bonuses or stock options.

How do the serious professionals do it? The October 3, 2005 issue of Fortune magazine carries a "wall street: special report" called "The Money Game" by Marcia Vickers. This details the investment strategies of David F. Swensen and Jack R. Meyer, who managed the endowments of Yale and Harvard, respectively. While most mutual funds that pick stocks underperform indices, both schools have consistently earned a much better return than the stock indices. How did they do it? Here are their allocations:

Domestic Equity15%14%
Foreign Equity15%14%
Private Equity13%17%
Fixed Income (bonds)27%5%
Real Assets23%25%
Absolute Return (hedge funds)12%25%

Note that Harvard's total is 105 percent because of leverage, i.e., situations in which they've borrowed money to purchase investments. Conspicuously absent from these portfolios are heavy investments in American companies run by Harvard and Yale graduates. "Domestic Equity" are publicly traded stocks such as GE and Microsoft. Harvard and Yale have faith that their graduates will make a lot of money for themselves, but no faith that they will make money for their shareholders.

Both Harvard and Yale love to own real assets directly. A "real asset" could be land underneath an office building or an oil well. If you don't have tens of millions to invest, mirroring this approach could be very time-consuming. Suppose that you own land or a building and the tenant refuses to pay. You have to hire a lawyer or management company to collect the rent. Of course, you probably own some real estate already: the house or condo in which you reside. Unfortunately, this is an unproductive asset whose recent run-up in price comes from an unsustainable bubble. Serious long-term investors prefer to own commercial property, such as shopping malls. You can buy into this asset class through a publicly traded real estate investment trust (REIT) or a Vanguard mutual fund owning multiple REITs. One advantage of an REIT over a traditional company is that the managers aren't as prone to looting. If rents in a city go up, the managers of the REIT don't say "rents in our office buildings went up, it must be because we're such management geniuses so we're paying ourselves a $200 million bonus plus granting ourselves 10 percent of the company in stock options."

Hedge funds are the subject of the May 24, 2004 Forbes cover story "The Sleaziest Show On Earth" that begins "Hedge funds will suck in $100 billion this year from an ever-broader swath of investors. Pretty good for a business rife with exorbitant fees, phony numbers and outright thievery." Suppose that a hedge fund promises to return, say 20 percent annually, regardless of whether the market goes up or down. Can this be sustained? If so, consider the situation of the managers of General Electric. As of October 29, 2005, finance.yahoo.com shows that GE has a return on equity of 17.62 percent annually. If the managers of GE believe the claims of the hedge fund managers, the best thing that they could do for GE shareholders would be to sell all of GE's businesses and put the money into the hedge fund returning a risk-free 20 percent. Even Microsoft only shows a 12.6 percent return on assets and 19.93 percent return on equity. Only Google, the world's fastest company to reach $1 billion in revenue, beats the hedge fund geniuses, with a return on equity of 22.8 percent.

Why do hedge funds have a good reputation? The Forbes article notes that "Yes, some funds have racked up stunning results. Others have gone bust. The winners you hear about. The others just disappear from the performance databases. No surprise there: Reporting of performance is voluntary." Conceivably there are some market inefficiencies that enable, in 2005, a genius fund manager to outperform the market. If you park your money in this manager's fund, however, it is likely that the inefficiency and arbitrage opportunity will be discovered by other managers eventually. Your fund will stop performing. Your genius manager will take the $300 million in fees that he or she skimmed off and retire. You will have to look for somewhere else to invest your nest-egg. Harvard and Yale have the advantage that they employ full-time staff to seek out and evaluate the best hedge funds. They have the further advantage that they can negotiate fees down to something much more reasonable.

David Swensen, Yale's money manager, is one of the more sensible current writers on the subject of investing, the author of Unconventional Success : A Fundamental Approach to Personal Investment and Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. He affirms the basic truths from Malkiel's classic Random Walk Down Wall Street. Swensen's advice for personal investors can be summarized as follows:

Swensen's book on personal investment is a bit disappointing for early retirees because his maximum time horizon is "10 years and beyond".

Being an Active Investor

With so much money chasing the obvious investments, and therefore such low expected returns, you might think that it makes sense to become a more active investor. Is this how you want to spend your retirement? Staring at a computer screen and picking stocks? Remember how boring day traders were at cocktail parties in the 1990s? Do you want to be like that? [Remember that Swensen says that at best you'll probably do about 1-2 percent better per year than someone who simply bought an index fund.]

The only time that it might make sense to be an active investor is if it throws you into contact with interesting new people. If you love aviation, for example, buying a flight school, helicopter charter service, or airport gas station could be fun. If you love gizmos and engineers and have a high tolerance for delays and disappointment, being an angel investor in a new tech company might make sense.

Money Market Funds: Don't Chase Yield

Sold a company or an asset and need to park the money for awhile in a money market fund? Pick the lowest yielding money market that you can find. The only way that a money market can generate higher returns than Treasury Bills is by taking risk. Money markets that take risk have occasionally blown up and been unable to maintain their $1 per share price. Investors have lost as much as 90 percent of their money in what they thought was a risk-free fund. If someone offers you a high-yielding money market, drill down into the fund's holdings and you may find a lot of stuff that you don't recognize. The Vanguard money market funds are a safe bet with very low expenses and a reasonable yield. The caveats with Vanguard are (1) that their Web site is clunky, and (2) their Flagship service for rich people (more than $1 million invested at Vanguard) is tremendous less effective and efficient than their Voyager service for the upper middle class. I managed to deal with caveat #2 by downgrading my account to "Voyager Select" from "Flagship".


I've written an older page on investing, which is not specific to retirees.

If you came here via a search engine, you might want to go back to my main page on early retirement.

Text and pictures copyright 2006-2008 Philip Greenspun

Reader's Comments

Thanks for writing this introductory page. A few comments for debate or clarification:

On annuities: One strategy that may make sense for cautious people is to buy a fixed immediate annuity at retirement with only a part of their assets (a third, for example). This will give them a fixed and reliable income stream, and in turn may (psychologically) free them up to put the remainder of their assets in higher-return investments such as stocks.

On real assets: Your investment choices here are much better than they used to be, and include choices you didn't mention such as the new availability of ETFs that are based on real assets such as metals, commodities, etc. These should only be used for a small fraction of your asset allocation mix, but are useful for further diversification. (Despite the fact that many are currently using them for speculation right now.) The REIT comments are right on the money, and I think everyone should have REITs in their asset mix except for people who own income-producing real estate directly.

On mutual fund companies: "criminally minded" might be a bit much, and you have painted with too broad a brush, but I agree about Vanguard and TIAA/CREF. The DFA funds are a quite different beast but also could be included for their intelligent approach and reasonable (overall) fee structure.

Longleaf Partners Fund, which you mention specifically, have now reopened to new investors. Also in the same trustworthy vein are Dodge & Cox which just re-opened their stock fund, and any of the funds at Third Avenue.

-- Tim Rowles, June 11, 2008

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