Picture this: You recommend to a client a retirement portfolio consisting of 90% large-cap U.S. stocks and 10% short-term government bonds. That’s it — just those two ingredients in your client’s nest-egg portfolio.
Is this crazy? Well, perhaps not — at least not according to Warren Buffett. In a 2013 letter to Berkshire Hathaway shareholders, the famed investor said one bequest provides for cash to be delivered to a trustee for his wife’s benefit. Then he gave this recommendation:
“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. … I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”
A retirement portfolio with only two asset classes may not meet a fiduciary standard of care. Nevertheless, let’s analyze this approach to determine how it compares to other retirement portfolio models.
In the chart “Battle of the Retirement Portfolios” we see four retirement portfolio models. The first is a seven-asset model that includes equal portions of large-cap U.S. stock, small-cap U.S. stock, non-U.S. stock, real estate, commodities, U.S. bonds and cash.
The next model is a 60/40 portfolio consisting of 60% large-cap U.S. stock and 40% U.S. aggregate bonds.
The third model is the Buffett-suggested portfolio consisting of 90% large-cap U.S. stock and 10% short-term government bonds. Each of these multi-asset models was rebalanced annually. In addition, a 100-basis point portfolio cost was assumed (thus the annual returns of the indexes used in this analysis were lowered by 100 basis points, or 1 percentage point).
Finally, we have a retirement portfolio consisting of 100% cash (represented by the return of the 90-day Treasury bill).
The source of historical returns used here come from the following indexes: the S&P 500; the Ibbotson Small Companies from 1970 to 1978 and the Russell 2000 from 1979 to 2018; the Morgan Stanley Capital International EAFE (Europe, Australasia, Far East); the Ibbotson Intermediate Term Bond from 1970 to 75 and the Bloomberg Barclays Capital Aggregate Bond from 1976 to 2018; 90-day Treasury Bills; the Dow Jones US Select REIT and the S&P Goldman Sachs Commodities (GSCI).
The Buffett retirement portfolio consisted of 90% S&P 500 from 1970 to 2018 and 10% Bloomberg Barclay’s U.S. Government 1-3 Year index from 1976 to 2018. From 1970 to 1975 90-day Treasury bills were used to represent short-term U.S. bonds.
As this study is focused on the performance of a portfolio during retirement, we needed a methodology to determine how much money will be withdrawn from the portfolio each year.
I decided to use the annual withdrawal percentages stipulated by the required minimum distribution. Thus, this research assumed the retiree was age 70 when the withdrawals began, with a $1 million starting balance in the portfolio. The time frame was the 49-year period from 1970 to 2018. During that window of time, there were 25 rolling 25-year periods.
I examined five variables related to the performance of each retirement portfolio: the success rate (meaning how often the portfolio survived at least 25 years); the average ending portfolio value at the end of each rolling 25-year period; the average annual withdrawal during each rolling 25-year period; the average total amount withdrawn during each 25-year period and the standard deviation of the ending account balance across all 25 rolling 25-year periods.
BATTLE OF THE RETIREMENT PORTFOLIOS
How did Warren Buffett’s suggested asset mix stack up?
A quick review of the results in the table does indeed confirm Buffett’s wisdom, at least to a point. The 90/10 portfolio had the highest average balance, the highest average annual RMD-based withdrawal and the highest average total withdrawal.
However, the 90/10 portfolio also had the largest standard deviation in ending account balance, indicating the outcomes are subject to more variation. A 90% stock/10% bond retirement model is quite aggressive, so it’s not surprising it produced better outcomes historically. The question is whether it represents a sufficiently prudent model for clients.
My gut tells me no, based on the logic of what the Department of Labor has referred to as a qualified default investment alternative. There are three QDIAs: a life-cycle or target-date retirement fund, a balanced fund and a professionally managed account. Target-date funds and balanced funds employ multiple asset classes in their design, as a way of moderating the risk inherent in any single asset class.
The seven-asset model here is analogous to a target-date fund, and the 60/40 portfolio is representative of the typical balanced fund. The Buffett model is simply not diversified enough, and will rise and fall based largely on the success of U.S. large-cap stock. For the majority of retirees, it is simply not prudent to place that much emphasis on one asset class, particularly a potentially volatile one such as equities.
A 100% cash retirement portfolio, on the other hand, doesn’t contain enough risk. This portfolio materially underperformed the other three, and illustrates why an all-cash retirement portfolio subject to the RMD is a suboptimal choice for nearly everyone.
Take note also that the RMD guarantees a portfolio cannot be liquidated within 45 years. Thus, being too conservative ignores the natural protection inherent in the RMD methodology. This reality is evidenced by the fact that each of the portfolios had a 100% success rate, meaning they all survived intact in every rolling 25-year period. This would be the case regardless of the asset allocation model.
RISING INTEREST RATES
One major factor to consider in this analysis is that of interest rates, and how a rising rate environment will impact bond returns over the next 10 to 15 years. The analysis presented here covers the period from 1970 through 2018. The Federal Discount Rate began its decline in 1982, thus 75% of this 49-year period was during a declining rate environment — which provided a tailwind for U.S. bond returns.
In fact, the average annualized return of U.S. aggregate bonds from 1982 to 2018 was 7.64%. This compares to an annualized return of 3.83% for U.S. bonds from 1948 to 1981—a period of rising interest rates in the U.S.
What if the performance of U.S. bonds over the next 10 to 15 years reverts to a return somewhere in the range of 3% to 4%? If this occurs, a 60/40 portfolio will be impacted more dramatically.
To test this possibility, I subtracted 400 basis points from the U.S. aggregate bond returns in this analysis, as a way of projecting a future with lower bond returns.
Here’s what happened: The average ending portfolio balance in the seven-asset retirement portfolio went from $2,305,786 to $2,007,411 — a decline of 12.94%. By contrast, the 60/40 ending portfolio balance fell from $2,406,112 to $1,628,463 — a decline of 32.3%.
The Buffett 90/10 portfolio utilizes short-term U.S. government bonds, so I subtracted 200 basis points from the historical bond returns. The outcome: The average ending portfolio balance fell from $3,002,765 to $2,861,488 — a 4.7% decline. This is indeed the best performance of all the portfolios, which makes some sense, given the low allocation to bonds.
DECLINING EQUITIES
So how about equities? What if the performance of the U.S. stock market is less robust over the next 10 to 15 years?
To test this possibility, I subtracted 400 basis points from the annual returns of the S&P 500, and 400 basis points from the annual returns of the Russell 2000. The bond returns were also held in their reduced state (200 bps lower for the 90/10 portfolio, and 400 bps lower for the seven-asset portfolio and the 60/40 model).
This is where we see a steep decline in the Buffett portfolio, and the chief reason behind my not being able to recommend it as a strategy for most clients: The 90/10 average ending balance fell from $2,861,488 to $1,182,255 — a decline of over 58%. Ouch.
The 60/40 portfolio average ending balance fell from $1,628,463 to $896,127 — a 45% drop.
While the diversified portfolio certainly took a hit, it wasn’t nearly as much as the other two — the seven-asset portfolio average ending balance declined from $2,007,411 to $1,517,958, a drop of just 24.4%.
If we project a bleaker future in terms of U.S. equity and bond returns, the seven-asset portfolio demonstrates materially better historical performance as a retirement portfolio design. (Of course, it should be noted that the other asset classes in the seven-asset portfolio could also experience diminished returns in the future.)
In summary, a more diversified retirement portfolio likely stands a better chance of thriving in a rising rate environment and a climate in which equity returns are lower. It may not end up with the highest return in the end, which is one risk, but the broader overall risk is mitigated.
Broad diversification just makes better sense — even if Buffett’s strategy could potentially give clients better returns.
