Back in 2010 I wrote about the wisdom of combining a 50/50 mix of a bond fund and large-cap value fund to create a simple strategy that could provide adequate retirement income while keeping up with inflation to perpetuity -- if history since 1999 repeats itself.
At the time, I used Vanguard's Wellington and Wellesley funds as the investment options, but this time out, we'll switch to a home team -- San Francisco's Dodge & Cox. It's like switching allegiance from the Yankees to the Oakland A's.
Dodge & Cox has been around since the 1950s and has remained independent all these years. For many, many years, every one of its five fund offerings enjoyed five-star ratings by Morningstar. Then, in 2008, it had what Queen Elizabeth would have described as its "annus horribilis." With Dodge & Cox invested heavily in financial services stocks, the bottom fell out of their portfolio, leaving a 41 percent loss for the year. After earning 40 percent last year, their compound annual returns since 2008 amount to 250 percent, gaining them a nomination to possibly win Morningstar's fund of the year award.
Meanwhile, anyone who had cobbled together and maintained an even split between Dodge &Cox's income and stock funds has experienced a temporary one-year loss of just 22 percent in 2008 and a quick recovery in subsequent years. Total average combined annual returns starting in 1999 and ending last month were 8.79 percent per year -- call it 9 percent per year over a 14-year period that included two market crashes. This calculation also assumes that the two funds were annually rebalanced so that they started each year with whatever allocation changes gave each of them equal amounts of money.
The time period is noteworthy because 1999 was the high-water mark of the dot-com boom. It was followed by the bust and then the subsequent market boom, which ended in 2007. The greatest market decline in 70 years was then followed by one of the longest sustained market increases, which we are experiencing right now. Through thick and really thin, this combination of value stocks and bonds has continued to deliver what for most people would be a sense of security and a possible source of income for retirees.
The nuts and bolts of how a mix of these funds would work as a source of monthly retirement income are as follows: an investor would set them up with the bond fund instructed to direct deposit all interest income each month into the retiree's checking account. The stock fund, by comparison, collects dividends periodically, but unlike interest payments, the dividends are paid semiannually and at different times from different companies. Therefore getting a deposit into a checking account each month requires making an estimate of the annual dividend income from the fund and specifically requesting a monthly deposit of the calculated amount (the annual dividend per share times the number of shares divided by 12 months).
Let's look at what happens if we take out just the income and don't touch the principal. The dividend income alone from the stock fund amounts to about 1.2 percent and the interest income from the bond fund is roughly 3 percent. Combining both income sources means that we have earnings of slightly more than 2 percent as a return on the total account balance. Meanwhile, while the bonds over the long term will not grow in value, the Dodge & Cox stock side can be expected to grow, over time, and exceed inflation by some factor. Historically, broad stock market averages have exceeded inflation by 7 percent per year over long periods.
Remembering the combined annual return of 9 percent over the past, trouble-prone 15 years, it's reassuring that at least 2 percent of the gain was from just interest and dividends. Assuming we want more income than just 2 percent, we can consider withdrawing an additional percentage amount from the stock's principal to bring the total distribution to 4 or 5 percent per year.
Past performance is no guarantee of future results, but if history does repeat itself, we have a strategy that produces a 5 percent income rate per year and leaves a remaining 4 percent on the table to combat the ravages of inflation.
Steve Butler is CEO of Pension Dynamics. Contact him at firstname.lastname@example.org or 925-956-0505, ext. 228.