<FOOLISH FOUR PORTFOLIO>

Retirement Disasters
and once again, why use Dow Trusts?

by Ann Coleman (TMF AnnC)

Reston, VA (May 7, 1999) -- Wednesday we looked at how a retirement scenario might play out using our most conservative Dow Investing Strategy, the High Yield 10. I set up a spreadsheet to follow a $1 million dollar retirement portfolio that provides a cash payout each year starting at $50,000 the first year and increasing by 4% each year. The results were very impressive, but what happens if your worst fears come true?

If your darkest fear is plunking all your money down when things are looking rosy and getting whacked by a 1930s-style depression immediately with no chance to grow some wriggle room into your portfolio... well, you'd be eating cat food in 11 years. No getting around it, folks, a portfolio can't sustain a large cash payout in the face of losses like 8.42% in 1929 followed by losses of 24.90% and 43.34% in the next two years. (I'm using the returns of the Standard & Poor's 500 Index since our Dow numbers don't go back that far.)

Of course, it's unlikely that you would need to increase your payout each year under such circumstances. We didn't have inflation back then, we had deflation. Unfortunately, holding at $50,000 only puts off the Little Friskies for two more years. The payout is still too high in the face of those losses.

But if you tightened your belt and took in boarders, living on $30,000 a year from 1931 (obviously you wouldn't have known to reduce your income right away) through 1945, your million-dollar portfolio would have recovered by 1960. Yep, 30 years to rebuild the portfolio. But you'd've been living on its proceeds through the depression and two wars. It's a safe bet that you wouldn't have outlived your money.

For the record, I think such a scenario is highly, highly unlikely. And I should point out that if you manage to get a few good years in before disaster hits, you are protected as long as you don't get overconfident and increase your payout (which can be tempting when the market is strong). In the example I am using, anyone starting in 1926 (when our S&P records start) could simply drop the inflation factor whenever the portfolio was under one million, and they would have gotten safely through the depression with a $50,000 per year income.

What's the next-worst-case scenario? Starting in January of 1973 was not exactly propitious timing. The S&P lost 14.66% that year, followed by a bigger loss of 26.47% in 1974. Devastating as that is, using the S&P 500's returns and our original premise of a $50,000 payout increased by 4% per year, you still don't run out of money. Your account does drop down as low as $557,000 by the end of 1974, but by 1986 you're back to the million-dollar mark, and by the end of last year, you would be closing in on $3 million.

Using the higher-return High Yield 10 and starting in 1973, you barely dip into your capital, because the High Yield 10 didn't lose money in those frightful years. It was up 4% in 1973 and 1% in 1974.

But the High Yield 10 did have one particularly bad year -- in 1966 it lost 18%. What if you had started then? You'd take a hit, no doubt about it, but your account never drops below $770,000. By the end of 1975 you are back to the million-dollar mark and never drop below it again (so far, at least). The secret is to not get greedy.

One can play endlessly with such scenarios, but it is always clear that if the markets stay really bad for more than two years in a row, life could get worrisome. If I were staring retirement in the eye, I might put half my stash in US government bonds for the first several years just to buy some peace of mind. Of course, that could be an expensive purchase if it means giving up the kind of returns we've been getting lately, but retirement should be about kicking back and relaxing.

It does worry me, though, when I encounter folks who think that bonds are the only option for retirees. It is in the nature of markets to go both up and down, so if you fear the worst, you have to also assume that, over time, the best will come along as well.

(If you would like to see a tidied up version of the spreadsheet I used to develop these scenarios, you can download it by clicking here. It only comes in one flavor -- You will need Excel 5.0 or higher, or a conversion program, to run it.)

I know what you're thinking. That High Yield 10 looks pretty good -- so should I take advantage of the Dow Unit Investment Trust that so many brokerages offer? These trusts work much like a mutual fund, but they are restricted to a small number of tightly defined stocks. Many brokerages have set them up to follow the High Yield 10 or High Yield 5 strategies. The brokers are happy to do all the work of picking the stocks and buying and selling them for you. Sounds like a kick-back-and-relax kind of plan.

The problem is that these trusts will cost you far, far too much. Their management fees are based on a percentage of your account balance. The lowest I've seen is 1.25% a year (and it gets that low only after you pay a sales charge to buy in). I would assume that large accounts might qualify for a discount, so let's assume you only have to pay 1%. For a retirement account like the one we've been talking about, that would be $10,000 for just the first year! You can do it yourself at a discount broker for less than $100 per year. Calculating dividend yields is just not that tough -- or use Strategy Stocks.

But it costs you far more than that in reality. Using the scenario shown Wednesday, pulling an additional 1% of the balance out of the account each year would cost you over $300,000 in fees by the end of the twentieth year, but that's small potatoes. You see, since that money wasn't in your account to compound, the account balance is almost $1 million lower after 20 years. And it gets worse as the years pile on.

Let's see, a discount broker would cost you less than $2,000 over 20 years at today's rates. Two thousand dollars vs. one million dollars -- $2,000 or $1,000,000? Which would YOU rather pay?

I think most people could learn to use a discount broker for that kind of payoff.

Fool on and prosper!

Today's Stock Lists | 1999 Dow Returns

05/07/99 Close

Stock Change Last -------------------- CAT -2 3/16 63.19 JPM - 7/16 134.88 MMM + 3/4 92.88 IP - 3/4 57.13

Day Month Year History FOOL-4 -1.15% 2.12% 31.67% 33.63% DJIA +0.77% 2.25% 20.54% 20.06% S&P 500 +0.97% 0.74% 9.74% 10.00% NASDAQ +1.27% -1.54% 14.18% 15.75% Rec'd # Security In At Now Change 12/24/98 24 Caterpillar 43.08 63.19 46.67% 12/24/98 22 Int'l Paper 43.55 57.13 31.17% 12/24/98 9 JP Morgan 105.51 134.88 27.83% 12/24/98 14 3M 73.57 92.88 26.24% Rec'd # Security In At Value Change 12/24/98 24 Caterpillar 1034.00 1516.50 $482.50 12/24/98 22 Int'l Paper 958.12 1256.75 $298.63 12/24/98 14 3M 1030.00 1300.25 $270.25 12/24/98 9 JP Morgan 949.62 1213.88 $264.26 Dividends Received $29.45 Cash $28.26 TOTAL $5345.09 </FOOLISH FOUR PORTFOLIO>