<THE FOOLISH FOUR>

Let's Talk Money, Part 3
by Ann Coleman
(TMF AnnC)

Reston, VA. (September 25, 1998) -- Monday we talked about starting the Foolish Four and Wednesday we talked about how long it would take you to become a millionaire. Today let's take a brief look at what the Foolish Four can mean for you when you retire.

Conventional wisdom tells us that when you retire you need to be very careful with your money, maybe shift into fixed income securities like high-grade corporate bonds or US Treasury securities. That may indeed be the best course for many people, especially those whose Insomnia Index is high. A strong case can be made for putting one's retirement stash in the safest possible investment and then forgetting about it -- just cash those interest checks as they come in and play another round of golf.

But there are alternatives that many retirees might want to consider. A more aggressive strategy makes it quite possible to continue to build wealth while enjoying a very comfortable retirement.

I've been playing with various scenarios all day and one thing has become alarmingly obvious. You need to make very careful and conservative assumptions when projecting returns.

For example, I ran the numbers for a million dollar account using the average returns of the Foolish Four for the last 30 years. I took out $150,000 at the end of the first year and then increased that amount each year by 4% for inflation. Talk about a comfortable retirement! After 20 years, the account had over 3 million dollars in it and the annual withdrawals were over $300,000.

What's that they say about things that sound to good to be true? The numbers are right -- but that scenario still sent up alarms.

Reality check. I ran the same scenario using the actual returns starting in 1968. The account went broke in 10 years. Whoa! What happened? Well, the '73--'74 recession, for one thing. And for several years in a row, the returns were well below the current average returns, which benefit from our recent remarkable bull market. The strategy back in the '60s simply didn't support the large withdrawals.

That's what you get when you try to apply long-term results to a short time frame. And that's why the Wise talk about investing in fixed income securities.

But are bonds the only safe alternative? Even during this period, the sixties and seventies, when the strategy (and the market in general) was not performing like it has in recent years, was there a safe alternative to bonds?

Sure, there was. I wouldn't be writing this column if there weren't.

I changed one parameter, and the result was staggering. I reduced the initial payout to $70,000. That's a 7% payout -- higher than the historical average for 30 year treasury bonds. I kept the four percent yearly increase in the annual payout and used the actual returns starting in 1968. But this time the account stood at $1.8 million after 10 years and the annual payout was up to $92,000. (For those of you attempting to recreate this scenario with your spreadsheets, it's important to note that the annual payout comes at the end of the first year, not the beginning.)

I would never suggest that a retiree rely entirely on stock market returns, but chaining oneself to a fixed return investment out of fear that the market will underperform is also risky. In this case, the risk is that of inflation. Even with a conservative inflation rate of 2%, after 20 years of fixed income your buying power is cut by one-third. So a nice $70,000 payout only buys $50,000 worth of life.

The options are truly endless, but let's look at one scenario. It guarantees a minimum payout for half of your retirement account and protects your cash from inflation (and provides a few extras) with relatively predictable stock market returns from our most conservative and stable scenario, the High Yield 10 (Dogs of the Dow). By using the actual returns instead of the average annual return, I am deliberately testing these strategies under very adverse conditions, by the way.

I'm going to assume a low bond rates and use the actual returns from the High Yield 10 for the past 10 years. In this scenario, half your million dollars generates $25,000 a year (5%) guaranteed, and the other half generates $40,000 the first year and almost $60,000 a year by year 10. Even though by year 10, the principal in the account has dipped to $430,000, (the early years were rough), by year 20, the stock half has recovered and grown to $650,000 and is generating $87,000 a year for a total income, including the interest from the bond fund, of $112,000 a year.

In this scenario, we start out with income higher than one could get from a fixed income security and both the annual income and the principal grow. Now, that's a comfortable retirement.

Fool on and prosper!

Current Dow Order | 1998 Dow Returns

What Happened to Robert Sheard?

09/25/98 Close

Stock Change Last -------------------- UK +1 3/16 42.13 IP +1 9/16 48.44 MO - 3/8 45.94 EK -1 1/2 80.88

Day Month Year FOOL-4 +0.69% 11.25% 12.70% DJIA +0.33% 6.50% 1.52% S&P 500 +0.19% 9.11% 7.66% NASDAQ +1.35% 16.30% 11.03% Rec'd # Security In At Now Change 12/31/97 206 Eastman Ko 60.56 80.88 33.54% 12/31/97 289 Int'l Pape 43.13 48.44 12.32% 12/31/97 276 Philip Mor 45.25 45.94 1.52% 12/31/97 291 Union Carb 42.94 42.13 -1.89% Rec'd # Security In At Value Change 12/31/97 206 Eastman Ko 12475.88 16660.25 $4184.38 12/31/97 289 Int'l Pape 12463.13 13998.44 $1535.31 12/31/97 276 Philip Mor 12489.00 12678.75 $189.75 12/31/97 291 Union Carb 12494.81 12258.38 -$236.44 CASH $754.73 TOTAL $56350.54