Recommendations: 1
Hi PSU,
Here's where Ray's spreadsheet fails, and you can take it & adjust to fit; It doesn't account for the *RELATIVE* drag on returns of drawdowns (the costs of volatility.)
WHY IT MATTERS; Markets rise & fall... but that's not the only risks. Personal situations rise and fall as well, and they're not well correllated.
When the markets fall (and you are in a naked, unadjusting buy & hold position, as used in Ray's spreadsheet,) and the individual's personal situation hits the fan simultaneously, they face the risk of ruin... if that level is breached, they're destitute; game over.
THUS... if the stated purpose of retirement investing is to achieve the point where safe, passive income supercedes the burn rate on a given cost of lifestyle... and success is determined by the approach that achieves this the fastest with the most certainty with *EQUAL* avoidance of risk of ruin... then 100% of all investible funds must be taken into account from inception.
If 2 people have $100,000 (whether its an immediate lump sum, or a projected accumulation of savings over a future period of time) that they cannot lose, assume one (#A) uses a fixed reset indexing (FRI) strategy, the other (#B) an S&P B&H approach.
The S&P has periodic drawdowns of at least 53% These cannot be waived away as insignificant risks to a naked buy & holder, and they cannot be waived away as insignificant because the drawdowns can be "waited out." Waiting out a drawdown is simply replenishing the principal from work earnings, which are already included in the initial principal calculation no matter how you slice it.
In order to invest $100,000 (all at once, *or* over time) in the S&P B&H approach with a guarantee you’ll never have less than $100,000 liquid cash, you must *also* have a side reserve account of (rounding down from 53%) $50,000 to fill the bucket during the drawdowns. That means you must actually have $150,000 of cash, in order to invest $100,000 safely, in an S&P B&H strategy. The initial volatility cost (VC) is the opportunity costs (lost returns) on the $50,000, which are then subtracted from the long term gains on the $100,000.
BUT IT GOES DEEPER… every dollar of gain that the $100,000 wins, must also be split… with 2/3 going to the ‘at risk’ S&P bucket, and 1/3 going to the “safety refill” bucket earning nothing, and compounding nothing. The 1/3 of every growth dollar that has to be reserved to the refill bucket, earning nothing, effectively reduces the compounding rate 1/3 as well.
IN CONTRAST, that means that, apples to apples… person #A actually has $150,000 to employ (not just $100,000, since #A doesn’t have to keep a fallow bucket to fill in when the market rapes him) and can put the full amount into an FRI strategy, compounding in full from day #1.
NOW we have a race…. Longterm naked S&P returns, including dividends, compounding on only 2/3 of the initial principal, plus 2/3 of the accruing gains… VERSUS 7.5% annual average returns (from an available FRI index blend, see link below) compounding at 100% of initial principal, plus 100% of the accruing gains.
Run that out… the FRI strategy *virtually* always wins. Add the tax advantages of an IUL, and the FRI strategy *100% ALWAYS WINS!*
Volatility Costs are simply defined as the Maximum Market Drawdown.
Volatilityadjusted real returns are defined as; (Naked ‘Buy and Hold’ Rate of Return) times (1 – Drawdown %)
Example; If S&P ‘allin’ average return, with dividends, is 14% S&P max drawdown is 53%
= 14% (1 – 53%) = 14% (47%) = 6.58%
(BY THE WAY, this formula works perfectly well for *ANY* objective investing system that can be backtested to a single or set of markets to determine the historical drawdown ratio.)
Even ignoring taxation, 6.58% volatilityadjusted returns succumb to 7.5% compounding untaxed in an IUL.
To anticipte those who say they do not have to set aside $50,000, because ‘they are young and can stomach the risks of drawdowns and wait it out.’
What they are *REALLY SAYING* is that they are holding their *FUTURE EARNINGS* as their 53% refill bucket. They are saying that if the market shaves their savings in half, they can afford to make zero on their future earnings while they are waiting to accumulate the amount of money that they lost to the market drawdowns.
So, you see… whether you are 80 years old, or 20 years old… either way, you have to pay the volatility piper.
The 20 year old who uses an FRI strategy can afford to put 100% of their accumulation capital to work today, and be assured that 100% of every future savings dollar will be earning and compounding positive gains every step along the way… instead of being used to recapture money lost to the markets in atrisk accounts.
Dave Donhoff Leverage Planner
PPS. To compare Ray's $10,000 lump sum, plus $100/month savings in an S&P B&H strategy requires $5,000 reserves, and sufficient income for an additional $50/month unrisked savings. That gives an FRI investor $15,000 lump sum to start, and $150/month contribution.
Here's a run out of an example for a 25 y.o. female saving $15k lump sum, plus $150/month, over 40 years for a 65th birthday target. Net/net internal rate of return is 7.76%. Untaxed
If, at retirement age 65, a person's lifestyle expenses (i.e. required income) are at a marginal tax rate of 25%, the taxfree 7.76% rate is a taxable equivalent of 10.34% net return rate in a naked S&P strategy.
It can be spent down using taxfree loans at a cost of 5.5%... so every dollar spent at retirement is still earning an average of close to a positive 2% credit, even after its spent.
I know some don't care about the actual bottom line, and want to know the details of how everyone else is getting rich off you... so here's the charge & expense breakout as well.
Enjoy! https://dl.dropboxusercontent.com/u/8644020/20130913%20TMF...



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