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Perma-shills have been claiming of late that the stock market is now trading at an enticing valuation. Their main evidence for this, as they are fond to claim, is that the forward Price to earnings multiple is 12 times next year’s earnings for the S&P 500. And, of course, a 12 PE multiple makes stocks cheap and the overall market a buy.

But for investors who want to accurately assess that number, there are two issues they should be aware of. First, the PE ratio isn’t a good measure of the near term direction for the market. And second, nobody knows what the forward PE will actually be. Some pundits like to use that forward looking number because, when corporate earnings are projected to rise-as they almost always are-the PE ratio will look better.

So let’s get into some real numbers that will help determine if the market is indeed cheap.

For Q1 2010, the PE ratio on the reported trailing twelve month earnings for the S&P 500 is 15.5. Historically speaking, the average PE ratio on the S&P is about 15 times earnings. So therefore, if one isn’t promoting an ebullient guess as to what earnings will be in the future, the market is currently just fairly priced on a PE basis. Also, the PE ratio on an inflation adjusted average over the previous ten year period has ranged from 4.78 in December of 1920 to 44.2 in December of 1999. With such a wide range of valuations, it is difficult at best to make a case to buy or sell stocks solely on a PE basis. There are other factors like; the direction of inflation and interest rates that are necessary to consider when evaluating the PE ratio.

Some market cheerleaders also like to use the inverse of the PE ratio called the earnings yield when comparing stock prices to bonds. They say; with the current earnings yield being 6.4% and the Ten year note yielding around 3% that stocks are a great value. Again, there are problems here too. Firstly, investors don’t earn the earnings yield as they do with dividends. And as mentioned, the earnings yield is merely the reciprocal of the PE ratio. The fact that the yields on government bonds are significantly below the earnings yield on stocks is merely an indication of the egregiously overvalued state of the U.S. debt market.

Rather than pick one or two statistics like the forward PE ratio or the earnings yield to convey an opinion on stocks, here are several important facts that will help you decide the future direction of the market.

A good metric to determine the valuation of stocks is the dividend yield. The current dividend yield on the S&P is a paltry 2.1%. The historical average dividend yield is a much greater 4.36%. The lowest dividend yield was 1.11%, which was reached in August of 2000. The highest dividend yield was 13. 84%, this was achieved in June 1932. Therefore, on a dividend yield basis, the market is currently significantly overpriced. To add salt in the wound of those low yielding stocks, tax rates on dividends are scheduled to increase significantly in 2011. Maybe that is the reason why all the cash sitting idle on corporate balance sheets isn’t being sent back to investors in the form of dividends?

According to the Investment Company Institute, mutual fund cash levels are at a decade low. Cash levels as a percent of assets reached a cyclical high of 12% in 1991. Today, that ratio is less than 4%. With mutual funds already nearly fully invested where will the money come from to take stocks higher?

The Fed’s balance sheet is at a record high $2.3 trillion. The unwinding of that balance sheet will send interest rates on their $1.1 trillion In Mortgage Backed Securities (MBS) soaring and will thus further damage the real estate market, stifle earnings growth and depress GDP growth. The Fed must also find buyers for all that MBS debt. This will crowd out investments that would have normally been made into stocks.

Household debt and the Gross National debt have never been at or above 90% of GDP at the same time. For the first time in U.S. history, that is the case today. Along with the massive deleveraging that still lies ahead for both the public and private sectors, the Treasury must auction off close to $9 trillion in debt each year to cover our ballooning deficits and to satisfy rollovers. This will further crowd out investments that could have been better placed into the stock market.

Once you view the real numbers on PE ratios and dividend yields it is hard to make an argument that stocks are cheap. And given the low levels of cash that exist at mutual funds and the crowding out of private investments that is taking place from the government, investors will find it difficult to assume the market can produce a sustainable rally of any real significance.

The only disclaimer here is if the Fed embarks on another doubling of its balance sheet in an attempt to crush whatever life is left in the value of the U.S. dollar. Then, in that case the market may rally in nominal terms. But you had better own precious metals and the companies that pull the stuff out of the ground if you want to earn a positive return after inflation.

Michael Pento is Chief Economist for Delta Global Advisors and a columnist at greenfaucet.com.

© 2010 RIJ Publishing LLC. All rights reserved.

Here’s a well-kept secret: the Social Security Administration today offers one of the best investment options anywhere. This great deal allows individuals to add to the Social Security annuities that they already qualify for at age 62. Since the classic pension plans that used to provide workers with private annuity payments until death are fast disappearing, this option gets more valuable by the day.

This add-on, like the basic Social Security annuity, is as insured as an investment can get, doesn’t fluctuate with the stock market or economic downturns, and rises in value along with inflation. The rate of return is decent too.

So where’s the rub? This option is buried in Social Security’s overlapping and confusing provisions. That’s why so few people who could really use this extra protection end up understanding, much less buying, it.

My suggested reform: daylight this hidden concoction of provisions and convert it into an open, understandable, and far more flexible option. Doing so would favor saving and reward work while better preparing elderly people for their very high likelihood of living to age 80 and beyond. And it needn’t cost anything.

How? As part of a broader Social Security reform of the retirement age. Instead of confusing notions of early retirement at 62 and normal retirement at 66, surrounded by formal “earnings tests” and “delayed retirement credits,” adopt a simpler annuity option. (Stay tuned for some definitions of terms, but keep in mind that the very fact that most people misunderstand how all these provisions interact proves the need for reform.)

Under my plan, the Social Security Administration would simply tell people their benefit at a specific retirement age (either an earliest age or a “normal” age). Then it would show a simple set of penalties or bonuses for withdrawing money or depositing it with Social Security. It could fit on a postcard.

Although not essential, I would sweeten the deal for people who not only delay benefits but also work longer and pay extra taxes. With this additional option, the penalties would be higher and the bonuses greater for workers than nonworkers. For instance, the employee portion of Social Security tax could be credited as buying a higher annuity. These extra bonuses could be financed by making the up-front benefit available at the earliest retirement age a bit lower for higher-income beneficiaries who stop working as soon as possible. This combined strategy backloads benefits more to later years when people are older and frailer, and it encourages work—an approach I have advocated, as does Jed Graham in his recent book, A Well-Tailored Safety Net.

The simple, easily understood bonuses would basically be annuities with higher payouts than standard Social Security benefits. They could be purchased whether a worker quit work or not. As people can today, many would purchase these fortified annuities by forgoing all their Social Security checks for a while. But, unlike today, they could also specify how much of their Social Security check they would forgo or send a separate check to Social Security.

How would the poor fare under this new approach? To protect them, let’s increase minimum benefits under Social Security so most lower-income households end up with higher lifetime Social Security benefits—regardless of what other reforms may be undertaken. Say, for example, we accept the additional option of lowering the up-front benefit for those who totally stop work as soon as possible in their 60s by 10 percent but bump up a minimum benefit to $900. Then someone who used to get more than $1,000 could get less in those early years but has a great option for beefing up the annuity in later years. Someone formerly getting $1,000 or less would not lose out at all, even in early years of retirement.

Helpful employers (or 401(k) account managers, financial planners, or banks) could help workers take advantage of this great annuity option. As one example, they could easily map out a range of schedules for drawing down private assets or taking partial Social Security checks for a couple of years in exchange for better old-age protection—higher annual, inflation-adjusted payments—in later years.

Setting up a similar payout trade off today is sometimes possible if you’re not easily discouraged, but you wouldn’t get much credit for additional taxes. In fact, you can even send back Social Security money received in the past to boost future benefits. (Who knew?)

Too bad most people believe that if they hit age 62 in 2010, the “earnings test” they face is a “tax” up to the age 66 that reduces benefits by 50 cents for every extra dollar they earn between $14,160 and $37,680. But that’s what they think, and they calculate this “tax,” add it to their other tax burdens, and quickly decide that they’re better off retiring. Yet, that’s not really right. In truth, if they forgo some benefits now, they have just bought an additional annuity, and their future annual Social Security benefits go up permanently by roughly $67 for every $1,000 in Social Security benefits they temporarily forgo for one year.

Today, those age 66 to 70 have different options than when they were younger than 66. This only adds to the confusion. They no longer must purchase the annuity (face the earnings test) if they work, but they are free to take a delayed retirement credit—this time, $80 in every future year of retirement for each $1,000 of Social Security benefit forgone for one year . But they often don’t realize that they don’t need to start benefits at retirement. By living off other assets awhile, even a month or more, they can convert some of their riskier assets into a higher Social Security annuity asset.

Just to further complicate things, Social Security administrators often tell people to “get your money while the getting is good” when, in fact, it’s risky to draw down benefits too soon when one member of a typical couple is likely to live for 25 or 30 years after age 62.

The type of reform I’m proposing could never be timelier. Had more older individuals taken advantage of this simplified option before the stock market crashed, they’d be a lot more secure today. Similarly, folks retiring today with many of their assets tied up in either risky or very low return investments could sleep better if they take this option.

Why wait? Let’s redesign and simplify the Social Security super-structure surrounding retirement ages, related earnings tests, and delayed retirement credits. Let’s help more retirees build up additional annuity protection in old age, make more transparent the advantages of delaying benefits, reward better those who work longer and pay more taxes, and create simpler and more flexible options for depositing different sums of money to purchase larger annuities in Social Security.

The Government We Deserve is a periodic column on public policy by Eugene Steuerle, an Institute fellow and the Richard B. Fisher Chair at the nonpartisan Urban Institute. Steuerle is also a former deputy assistant secretary of the Treasury. The opinions are those of the author and do not necessarily reflect those of the Urban Institute, its trustees, or its sponsors. 

© 2010 RIJ Publishing LLC. All rights reserved.

Ron Smith, a New York-based actuary who once worked in Vanguard’s 401(k) division, applied for a patent last January for a simple but revolutionary retirement income distribution tool that uses only mutual funds and not insurance or derivatives. 

But that’s almost all he’s willing to say about it right now, pending discussions with major mutual fund providers about licensing his intellectual property, whose service mark is LISA, for “Lifetime Income Stream Accounts.” The e-press release that his startup firm, Ovacurrus LLC, broadcast this week was coyly cryptic.

“Obviously, since we filed for a patent, we think it’s unique,” Smith, a graduate of Brown University, told RIJ over the phone. “But I can’t tell you more in detail. The people who may eventually be our clients have agreed not to discuss it. So it wouldn’t be appropriate for me to talk about it.”

 One could only speculate at whether this announcement constituted rumor or news. Could Smith’s brainchild be a high-tech tease, like cold fusion? Or a cheap, benign and versatile remedy like Simple Green? 

The latter, Smith claims. He said it is related to target-date funds, would be a Qualified Default Investment Alternative for 401(k) plans, can provide direction during both the accumulation and distribution phases, and would add only a basis point or two to the cost of the underlying fund investments.   

“This is not an annuity product,” he said. “It involves no derivatives, no hedging. But it does allow you to accomplish the same goals in a mutual fund environment. There are some market volatility controls in place, but it doesn’t tie money up. You can change your mind. You can change your mind.” It’s not a new kind of payout mutual fund, either, he said.

So what is it? “As details come out, it will seem pretty intuitive. There are no gravity-defying effects going on. Most people will say, ‘How obvious.’ They will be more likely to say, ‘Why didn’t I think of it?’ than ‘This guy’s an alchemist.’ But it’s only obvious if you look at things different from the way people have been looking at them.

“It’s an approach to providing lifelong retirement income without insurance products, using traditional investments. The product is designed for the person who wants $10,000 one year, $10,200 the next year and $10,400 the next, and so forth, using relatively traditional mutual funds.  You couldn’t walk into a mutual fund company and do this today, but a Fidelity or a Vanguard could have these types of products fairly soon,” he added.

In looking for licensees, Smith is talking to mutual fund companies with early-adopter rather than fast-follower product development cultures. “For the fund companies, this would be an attractive alternative to guarantees or annuities.”

“Insurance companies that have large mutual fund operations may be interested in this. They’ll have to come to grips with whether they want creative destruction to enter the picture. If they try to protect their franchise, we’ll be a competing product. Or we could be a complimentary product. But we’re not focusing on the insurance companies,” he told RIJ.

“It will involve some tool building, so that investors can use it directly. For plan sponsor recordkeeping systems, some modest adjustments may be necessary. This will work for active 401(k) participants as well as retirees. It’s designed to be a QDIA. It also fixes a lot of the issues that people have with TDFs. It’s not just a tweaked version of the 4% systematic withdrawal method.”

LISA addresses longevity risk, capital markets risk and inflation/interest rate risk. It doesn’t help address the problem of under-saving for retirement (as life annuities can), except to the extent that it can guide 401(k) participants during the accumulation stage.

“One of the criticisms of the current 401(k) plan design is that you have 30-year-olds contributing six percent of their pay and maximizing the company match and thinking that’s all they need to do. They don’t understand what their deferrals and matches will provide in terms of retirement income. In a straightforward manner, LISA translates the person’s balance of $50,000 or so at age 30 or 40 into an income stream at age 62 or 65, and suggests appropriate ways to invest it until then,” Smith said.

“Today’s calculators can tell a 30-year-old that if you save 6% and it grows at 8%, you’ll have $800,000, for instance, at retirement. But they can’t’ tell you what the purchasing power of $800,000 will be after inflation. For the 65-year-old with $500,000, LISA says, here’s the income that $500,000 will provide. It also recommends ways to invest the assets. It acknowledges that you have to be at least partly invested in equities during a 20-year or 30-year retirement. The opportunity costs of being invested entirely in bonds at age 60 are just too high.”

Smith hopes to complete one or more licensing deals for LISA in the next six months. “Overcoming the ‘not invented here’ barrier [at fund companies] can be a problem, and people have heard the ‘new and improved’ claim so often that there’s a natural level of skepticism,” he told RIJ. “But I’m hoping that as companies do feasibility studies, it could be in place by year-end 2010.”

 © 2010 RIJ Publishing. All rights reserved.

Economists and financial planners often disagree, and one divisive issue involves the 4% rule for safe retirement withdrawals.

Every few months, an economist demonstrates that setting a retirement income strategy based on 4% inflation-adjusted withdrawals makes no sense.  He or she usually argues that lifetime spending patterns should maximize utility, and that such patterns might look very different from an inflation-adjusted withdrawals strategy. 

The financial planning community rarely comments on these arguments, perhaps because economists’ papers are too technical for most planners. But, in this article, I’ll attempt to do so. My goal is to explain the financial economists’ arguments in a non-technical but in-depth way, and to respond to their criticisms from the perspective of a financial planner. 

I’ve analyzed two financial economics papers on withdrawal strategies. The first paper, The 4% Rule—At What Price?, was published in three years ago by Jason Scott and Nobel laureate William Sharpe of Financial Engines, Inc., and John G. Watson of Stanford, but has recently received attention in the financial planning press.  

The second paper, Spending Retirement on Planet Vulcan: The Impact of Longevity Risk Aversion on Optimal Withdrawal Rates, was published in March 2010 by academics Moshe Milevsky and Huaxiong Huang of the Individual Finance and Insurance Decisions Centre in Toronto. Both papers challenge the 4% rule, but from quite different perspectives. With apologies to the co-authors, I’ll refer to these papers as Sharpe and Milevsky.       

The 4% rule

First, let’s define the 4% rule. Formulated by financial planner William P. Bengen in 1994, this guideline recommends a 30-year strategy of withdrawing 4% (pre-tax) of the value of the initial portfolio of investments each year, with annual increases by amounts based on actual inflation rates. Bengen assumed a portfolio of 50% to 75% stocks and back-tested the rule using overlapping 30-year time periods.

Since 1994, Bengen and other planners have produced variations on the 4% theme. They suggested that retirees could raise the initial withdrawal percentage if they agree not to increase withdrawals in years following future stock market declines. Such variations have been tested using both historic returns and Monte Carlo simulations.

The Sharpe paper

Financial economists often object that the 4% rule may produce consumption patterns that do not maximize lifetime utility. Sharpe uses this argument, and makes two other criticisms.

First, he calls the rule wasteful because it typically leaves excess funds at the end of life (he assumes a client with zero bequest motive). Using Monte Carlo simulations and assuming a 30-year retirement, his modeling predicts surpluses ranging from 10% to 20% of initial portfolio value.      

The underlying math is straightforward. With a market-mimicking portfolio of stocks and bonds, and initial withdrawal rates low enough to hold the chance of failure to 0% to 5%, one would expect the average scenario to produce a surplus. To prevent a surplus would require spending more –and raising the probability of failure to a prohibitive 50%—or investing in low-return, risk-free assets. Sharpe’s example produces a 4.46% initial withdrawal rate. He doesn’t, however, advocate that planners recommend only risk-free assets. I’ll have more to say about his overall conclusions later.

Sharpe also accuses the 4% rule of wasting 2% to 4% of initial assets that could be saved by using options strategies to eliminate sequence-of-returns risk. He makes the subtle point that financial markets don’t compensate investors for sequence-of-returns risk, thus creating opportunities to use options as cost-free risk reduction. He uses a straight options strategy (buying and selling calls with different strike prices), as opposed to a life contingent strategy, which might include purchasing a variable annuity with a guaranteed lifetime withdrawal benefit or one of the newer standalone living benefit products that insure taxable separately managed accounts. 

Using an efficient frontier graph with Cost on the horizontal axis and Expected Utility on the vertical axis, Sharpe demonstrates that the 4% rule produces an outcome falling well below the efficient frontier. He then shows how one might narrow the gap by spending the surplus and using options to eliminate unnecessary costs. These strategies do not move us all the way to the efficient frontier. To completely close the gap, he suggests shifting consumption between periods in ways that increase utility.   

Sharpe also tests “glide-path” investment strategies, which systematically reduce portfolio volatility as a retiree ages. He generally concludes that such strategies are no less wasteful than constant mix strategies.     

The question remains: What would Sharpe recommend to replace the 4% rule? Disappointingly, he doesn’t provide details. Instead, he offers generalities such as, “There appears to be no doubt that a better approach can be found than that offered by combinations of desired constant real spending and risky investment,” and “It is time to replace the 4% rule with approaches better grounded in fundamental economic analysis.” We will need to wait for future papers for more specifics.

The Milevsky paper

Milevsky uses a different modeling approach in criticizing the 4% rule. His model uses stochastic mortality instead of a 30-year time horizon, and simplifies investments by assuming only risk-free assets. He provides calculations of utility-maximizing withdrawal rates using what economists refer to as “constant-relative-risk aversion” (CRRA) utility functions.

Milevsky’s modeling generates optimal withdrawal percentages, and his initial rates are in line with the 4% rule. The optimal withdrawals do not remain level, but instead decrease over the retiree’s lifetime. In one example, a 4.6% initial withdrawal rate at age 65 decreases slightly to 4.4% by age 75, but drops to 3.6% at age 90 and 2.2% at age 100. (Note, these percentages and all that follow refer to withdrawals as a percentage of the initial portfolio, and all withdrawals include adjustments for inflation.)

This pattern makes intuitive sense. Most 65-year-olds would think it reasonable to plan to spend roughly the same amount from ages 65 to 75, but they would be less likely to sacrifice income in the early years to ensure a similar annual income from ages 90 to 100—unless they are extremely averse to longevity risk.    

That’s Milevsky’s point. He shows the initial withdrawal rates and the slope of planned withdrawals by age to be a function of the degree of longevity risk aversion. The risk-averse retiree is one who wants to make provision for a longer-than-expected life, so as risk aversion increases, initial withdrawal rates go down and the slope by age gets flatter. For example, the optimal initial withdrawal rate for a 65-year-old retiree might range from 4.1% to 6.3%, varying inversely with the degree of risk aversion.

Milevsky then shows the optimal withdrawal rates of a retiree who receives Social Security and/or other pension income.  Other things being equal, more pension income will raise the optimal initial withdrawal percentage and increase the year-by-year tilt. For example, a 65-year-old retiree with $1,000,000 in assets, a $50,000 inflation-indexed pension, and low risk aversion might optimally consume 8% of the investment portfolio compared to 6.3% for the individual with no pension. For higher levels of risk aversion, similar proportional relationships apply, although the overall optimal withdrawal rates are lower and flatter by age.

Providing specific withdrawal percentages is not Milevsky’s goal, however. He’s out to prove that optimal planned withdrawal patterns decline by age, and may vary quite considerably as a function of risk aversion and pension income. In other words, 4% level withdrawals may be far off the mark in terms of utility maximization.

Though it’s not his central thrust, Milevsky also shows that investors can achieve higher withdrawal percentages by annuitizing some of their assets for life. A retiree with medium risk aversion and no annuitized assets, for example, would optimally plan to withdraw 4.6% at age 65, declining to 4.0% by age 80. At the opposite extreme, a client who annuitized 100% of assets could lock in a consumption rate of 6.3% for life. 

Responding to the criticisms

Did Bill Bengen come up with a flawed idea in 1994, and have financial planners been doling out misinformation ever since? Should we tell clients to ignore the 4% rule and consult an economist? Or should we consider modifying the advice we dispense?

Before answering those questions, we should first ask, “How prevalent is the use of the 4% rule in actual financial planning practice?”

Stories in the Journal of Financial Planning or Financial Planning Magazine suggest that use of the 4% rule is pervasive. Hardly a month goes by without an article about the 4% rule or some variant of it. But I wonder how often the 4% rule is actually used in day-to-day financial planning practice.

Most clients have a myriad of cash flows with different timing. A client may have income streams that automatically adjust for inflation, like Social Security benefits, and others that do not, like corporate pensions. The client may have temporary expenses, such as a nearly paid mortgage, and one-time windfalls, perhaps from downsizing their housing. The complexity of the cash flows makes it nearly impossible for a planner to apply a simple rule of thumb like the 4% strategy, even if he or she wanted to.

This innate complexity forces most planners to customize their approaches to individual client cases. Ironically, the application of such customization may bring planning closer to the theoretical ideals of the financial economists mentioned here. For example, if a risk-averse client needs funding for basic recurring living expenses, the use an immediate annuity would help overcome some of the objections to the 4% rule voiced by both Sharpe and Milevsky.

Different clients may have adequate income for basic living expenses, and prefer to allocate their savings for vacation spending. They may also want to spend their vacation dollars early in retirement rather than spread them over an uncertain future. This approach, which could be implemented without any knowledge of utility theory, would satisfy Milevsky’s utility-maximizing approach.  

What can we learn from financial economics?

Indeed, planners can learn a lot from financial economists. For example, Sharpe illuminates the difficulties of trying to “finance a constant, non-volatile spending plan using a volatile investment strategy.” He also alerts us to the use of options strategies to mitigate sequence-of-returns risk. Although he doesn’t dwell on it in his paper, Sharpe also cautions against “free lunch” thinking. While it is feasible to reduce uncertainty on volatile investments, he says, it is not feasible to eliminate all risk and still earn a premium over the risk-free rate.

Milevsky establishes that the front-loading of spending may make sense for utility-maximizing spending plans that recognize longevity risk. His work also demonstrates how different degrees of risk aversion may affect optimal spending patterns and provides the numerical analysis to demonstrate the orders of magnitude of the differences. In addition, he shows how pension income may influence optimal spending and how the purchase of income annuities can increase funds available for retirement.

Unlike investment returns, utility cannot be measured precisely. Nonetheless, both of the papers discussed here argue convincingly that retirement planning should focus on the maximization of utility. To do that, we as planners will have to stretch our thinking beyond the application of mechanical rules.

Interestingly, both Sharpe and Milevsky assert that planners can use annuities to reduce their clients’ investment risk and longevity risk. Our profession has focused on techniques aimed at making assets last a lifetime without adequately considering all the product alternatives. We need to listen to the criticisms of those outside our profession, and be more open to new ways of helping our clients plan for retirement. 

 ©2010 RIJ Publishing LLC. All rights reserved.