I met with a university client this past week with an endowment of several million dollars. Like most schools of its size, the college has a diversified portfolio of stocks, bonds, hedge funds, private equity, natural resources and real estate. And like most endowments, the returns in 2008 were horrible. Down about 26%.
Last week, I also met with a friend who is retired. He is 72 and reliant on social security and an IRA to fund his living expenses. His financial advisor invested his IRA in three balanced mutual funds, which average 60% stocks and 40% bonds. The portfolio lost over 28% last year. It is now worth only $75,000.
Endowments annually spend 4% to 5% of their average market value (often calculated on a trailing 3 or 5 year basis). Their time horizon is infinite so in order to maintain the real value of their assets, they need to earn long-term rates of return that at least equal their spending rate plus inflation. Consequently, they structure portfolios with expected rates of return of 8% or greater. They are willing to withstand high volatility, even the rare negative 20%+ return because the money must last for generations. When returns are negative, the annual distribution from the endowment is cut. Reducing spending is an unpleasant task, but it can often be offset by new donations.
My friend’s money doesn’t have to last forever. Only 30 years or so. A year ago, he might have been spending 5% of the IRA market value, but after a 28% loss his spending rate will jump to close to 7%. Unfortunately, his spending is already bare bones. Dramatic cuts are not an option. The IRA will be depleted well before 30 years.
Why would a financial advisor invest my friend’s assets as if he were an endowment? Retirees can’t afford 20%+ losses. Their expenses aren’t as flexible as an endowment. There are no gifts to offset the lean years. Yet again and again, I see financial planners launch their clients into retirement with endowment like portfolios. They put 50% or 60% in stocks and pacify them with Monte Carlo simulations showing only a 10% probability of running out of money.
Guess what. Bear markets reek havoc on probabilities. After a 28% decline, the retirees’ risk of running out of money went from 10% to 30%.
When I speak to institutional investors, I’m often asked how my money is invested. The implication is I should be invested like their portfolios. Eating my own cooking. I tell them I’m not. I’m not an endowment. Nor are retirees. So financial planners should stop investing retiree assets like they are. Unfortunately, for many retirees it’s a little too late to learn that lesson.
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