Are you worried about an impending recession?
I know! The financial press has been a froth of excitement over the inverted yield curve and Fin-Twit has been awash with doom and gloom traffic.
So I’m not here to tell you it’ll be alright.
There will be a recession. It’s a’coming. It’s the nature of markets to go in cycles and according to the Bureau of Economic Analysis there have been 12 recessions since (and including) the Great Depression.
You’re probably thinking of hunkering down. Am I right?
But what type of hunkering do you need?
Well that depends on where you are in your financial and life journey.
If you’re in the accumulation phase when you are trying to grow your net worth, then a recession is not necessarily all bad. You’re still investing money in the market and lower prices and lower valuations can provide longer term real returns. The key during this phase is not to lose your employment during a downturn. If you can hang onto your job and keep plowing money into the markets then you’ll probably do fine.
If you’re in the final approach to retirement then you’re concerned about a large loss in your assets before you retire. In this case it seems like an ideal position to take some risk off the table. This might involve moving some of your assets from stocks to bonds. The key is to ask yourself whether a 30-40% loss on your equities in the next few years would make you queasy and impact your retirement plans.
If you are in the retirement phase then a poor sequence of returns with a large asset loss early in your drawdown phase can impact your future retirement. However there is a delicate juggling act here. Historically portfolios have required a high equity exposure to sustain a reasonable withdrawal rate of 3-5%. So reducing your equity exposure too much for too long may impact long term sustainability of your withdrawal, but having too high an equity allocation exposes you to sequence of returns risk. I’ve done a lot of work here: Introduction to Sequence of Returns and Buying a Boat in Retirement, Reprise! Sequence of Returns Risk
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So what am I doing?
At this point I’m aggressively invested in stocks. I’m some years from a planned retirement and believe this will provide me with the necessary growth engine to get over the finish line. We can argue about the future level of the equity risk premium but I don’t want to bet against the equity market; historically it’s been amazingly robust.
I’m not all in stocks, I have some real estate and bonds, but in my liquid assets it’s mostly stocks.
So you can see that I’m concerned that there’s a potential rocky road ahead and wondering whether to take some mitigating action.
My wealth is really composed of four key elements:
- My liquid and illiquid investments,
- My home equity,
- My employer pensions, and
- My future earnings.
I have money tied up in my house. At some point we will sell and realize that equity, some of which we might use to buy a smaller place. However, I count it as part of my wealth.
As a couple we are lucky enough to have a few company pension promises in the form of a traditional pension plan. These are monthly pensions, rather than a “pot” of money like a 401k. I’ve put a value on these, and you can do too with the only actuary-sanctioned method in the blogosphere Valuing a pension – actuary style
The last item is perhaps the most contentious.
All the previous three items are wealth that I’ve accrued to-date. It’s money that I’ve earned, and that money is tied up either in investments, primary residence or company deferred compensation in the form of a pension.
However, the fourth item is future earnings. This is money I have yet to earn.
I don’t think of my wealth as my assets at a point in time, I think of what I am worth. Part of that calculus must consider the investment I’ve made in myself in terms of my education, training and development as a professional. That has given me a certain earning potential.
Those future earnings are by no means certain and it would be wrong to build future certainty into a value today.
However it’s an actuary’s job to put a value on future uncertain events and so I’m going to put a price on my future earnings.
Suppose I expect to work another 5 years. It would certainly be wrong to add in five years’ of earnings to my calculation. A lot can happen.
My employer could go bust.
In a future recession I could lose my job.
My bonuses might be limited by a future recession.
All these can be built into a calculation though. I will take five years of future earnings but I’ll discount them. This means that I will reduce the value of earnings the further out they are. I’ll use the following assumptions:
- Assume my 50% savings rate continues and future tax rates are unchanged,
- Give my future compensation a haircut to be conservative.,
- Discount the future payments by an amount that reflects the probability of default by my employer.
- Add additional discounting to reflect the fact that I’m a highly compensated employee and a likely target if we have a recession and my employer is looking for cost-cutting measures.
What's the Right Discount Rate?
Let’s look at those last two items in more detail.
My employer is rated BBB by the bond rating agencies. This is the lowest level of investment grade credit and BBB rates are currently at lows of 3.3%. This rate reflects the risk that borrowers incur in lending to my employer and is a good starting point for a discount rate. I’m now going to add 2% to that to be super-conservative and reflect my last bullet point above. That gets us to a 5.3% discount rate.
I’ll take the next five years of expected earning adjusted for the measures above and then discounted at 5.3% a year.
When I look at the four key elements of my wealth I arrive at the following allocation.
You can see that my wealth is pretty diversified over these four groups.
Roughly we have one part future earnings, pensions and house equity, and two parts assets.
This puts my equity-heavy weighting in context. Yes, it’s a high weighting to equities, but it’s only 42% of my overall wealth.
But is my wealth diversified?
First let’s look at house equity.
House prices undeniably suffer in a recession, and so I wouldn’t expect my house to provide much of a cushion in a downturn. However, I was hoping that the desirable area I live in might be more cushioned than most.
I wasn’t able to get a good house price history for my zip code but I was able to compare real house prices in the Boston area with the USA as a whole. I was also keen to use prices adjusted for inflation (‘real prices’), which is shown below.
I was interested in the potential downside exposure and not the actual dollar amounts so I re-based everything to “100”.
In the chart below you can see that in the late 80’s Boston house prices fell relatively more than the US (bad), but in the financial crisis they fell by less (good).
So the conclusion is a little unsatisfactory. I don’t think I can rely on my house to provide a good diversification through any recession, so I need to think of it as more like stocks allocation.
What about the other two elements – pensions and future earnings?
Pension and Future Earnings
These are basically bonds.
In the case of a pension I loaned my employer my time and expertise and they will then pay me a monthly “coupon” in the form of a pension check. It’s like a bond. It’s secured by the assets in the plan along with the safety measures put in place by the Government. It may not be as safe as a Treasury bond, but it’s pretty damn safe, and so I have no concerns during a recession.
My future earnings is also like a bond. Whereas a pension is deferred earnings, this is immediate earnings. Again I’m paid a monthly “coupon” in exchange for my sweat. (Figurative, not literal sweat. That wouldn’t be a pretty sight, an actuary sitting in a sweaty pool staring at a spreadsheet – right?).
My future earnings is a much more risky bond since there is a possibility of my employer blowing up, or me getting fired. So in the above calculation I reflected that risk by putting a high discount rate on the future payments.
But it’s still like a bond.
What does this all mean?
My investments (mostly stocks) and house equity comprise around 60% of my portfolio, and my “bond” assets (pension and earnings) comprise around 40%.
That’s a classic “60/40” portfolio of stocks and bonds.
It’s a nicely balanced portfolio in aggregate. Not too “growthy” and not too conservative. I’m pretty happy with that balance going into a future recession and so I don’t see the need to re-balance away from stocks in my liquid investments.
What about you? Have you ever thought about counting future earning in your wealth? Do you look at the whole wealth picture like me, or do you think this is actuarial withcraft and prefer a pure look at your investments?
Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my regular day job I advise corporate US on investment and retirement strategies. I’m a qualified actuary, investment adviser and have a PhD in mathematics and reserve the right to have the occasional math post.