Will international investments make your retirement nest egg last longer?

The answer to that question comes from the same three Trinity University professors---Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz--- who did one of the original studies of withdrawal rates and portfolio survival. Writing in the May issue of the AAII Journal, the monthly publication of the American Association of Individual Investors, the researchers compare survival rates for portfolios with, and without, international investments. They compare, for example, survival rates of a portfolio that is 50 percent U.S. stocks and 50 percent bonds with a portfolio that is 25 percent U.S. stocks, 25 percent international stocks, and 50 percent bonds. They do this for equity allocations ranging from 100 percent down to 25 percent.

Their conclusion?

International diversification probably isn't worth the trouble.

While there was a minor advantage for relatively short periods of time, investors considering 25 to 30 year periods were unlikely to benefit from international diversification. Since the life expectancy of a typical retiree is about 17 years and the joint expectancy of a couple is about 25 years, prudent planning dictates most investors should be thinking about 25 to 30 years.

Specifically, they found that a 75 percent U.S. stocks portfolio versus one that was 50 percent U.S. and 25 percent international both had an 87 percent survival chance, assuming an initial withdrawal rate of 5 percent over a 25 year period. Over 30 years, the international portfolio did slightly better--- a 79 percent survival rate versus a 78 percent survival rate for the pure domestic portfolio.

The researchers are quick to point out that diversification is still a good idea but "you should not expect dramatic results by adding international stocks to your retirement portfolio."

Since the research was done with unmanaged (and expense free) indices, it's quite possible that any slender advantage for international investing could be lost to additional fees. Vanguard Total Market VIPER shares, the exchange traded fund version of their U.S. Total Market index fund (ETF), have an annualized expense ratio of 0.15 percent. The Barclays Global iShares EAFE index ETF shares, however, have an annualized expense ratio of 0.35 percent.

What the paper doesn't address is the importance of current income for retirement portfolios. The main reason retirement portfolios don't survive is that they are endangered when payouts exceed dividend and interest income. When that happens, shares or bonds must be sold. Do that in a down market, and the portfolio is damaged. That's why Peter Lynch's 1995 advice--- that investors could safely withdraw 7 percent a year from a 100 percent stock portfolio--- was dead wrong.

So how do we increase portfolio survival?

Other research has shown two options. Ibbotson Associates has put its seal of approval on REITs as a portfolio diversification tool. (Think about it: REITs generally have more current income than stocks.) Other research has shown that adding a life annuity to your retirement portfolio can enhance the odds that your overall portfolio will survive. (Again, life annuities provide current cash income and reduce the need to make withdrawals from the remainder of your portfolio.)

If current income is the key to survival, we may have to add a caveat. In virtually all of the time periods used in this and other portfolio survival studies, dividend yields on stocks have been much, much higher. So have yields on bonds. According to the Ibbotson database, for instance, the average dividend yield on large stocks from 1926 through 2003 was 5.2 percent. The average interest yield on intermediate government securities was 4.3 percent. So a 50/50 portfolio produced income at a 4.75 percent rate.

Now try the same trick today. Large stocks yield 1.46 percent. Intermediate bonds yield 3.85 percent. So a 50/50 portfolio yields 2.73 percent.

That's a full 2 percentage points lower than the long-term average. More important, it means every dime over the 2.73 percent yield is taken from principal--- reducing the chance of portfolio survival.

Bottom line?

Diversify, yes. But watch the spending more. Try to match spending to current income.

On the web:

Sunday, October 1, 1995: Dangerous Advice from Peter Lynch

The Portfolio Survival Reader

The Original Trinity study portfolio survival rates, with withdrawals adjusted for inflation