Retirement Investing: Reach for Income or Play It Safe?

by: Mick Weinstein

Many retirees have been doubly hit by both declines in their stock portfolios and loss of yield income at the worst possible time, due to this extended period of low interest rates. If you are a retiree or are approaching retirement, how should you position your portfolio now?

On Wed. March 17, Seeking Alpha hosted an expert panel that discussed the particular challenge of producing yield now, addressing the following topics among others:

- Bonds, including inflation protected bonds, high-yield bonds, foreign bonds, munis and bond ETFs
- Dividend paying stocks, including utilities and dividend ETFs
- Protecting yourself from inflation

Our panelists were three experts with broad, hands-on experience in fixed income investing and advising retirement investors:

John Lounsbury - Financial planner and investment advisor

David Merkel - Fixed income expert; Chief Economist and Director of Research of Finacorp Securities

Roger Nusbaum - Financial advisor and portfolio manager at Your Source Financial

The panel was sponsored by Merrill Lynch.

~ Mick Weinstein, Seeking Alpha Editor in Chief

Below is an edited transcript of the livechat:


Mick Weinstein, SA Editor: Hi everyone, thanks for joining. Here's the agenda:

(1) We'll start by asking our three panelists to each explain how they're addressing the yield challenge facing retirement investors - their own clients or other investors/profiles.

(2) An open discussion about the different approaches, opportunities and pitfalls to avoid.

(3) I'll start bringing in questions from our readers.


David Merkel: I always start by analyzing yield relationships. They are less subject to bias than some other measures. Here's what I wrote last night:

  • Equities - Slightly undervalued at present, particularly high quality stocks (U.S. and foreign).
  • Credit - Investment grade credit and high yield are fairly valued at present.
  • Real Estate - The future stream of mortgage payments that need to be made is high relative to the present value of properties. There will be more defaults, both in commercial and residential.
  • Yield Curve - Steep. It is reasonable to lend long, so long as inflation does not take off.
  • Inflation - Low, but future inflation is probably underestimated.
  • Foreign currency - One of my rules of thumb is that when there is not much compensation offered for risk in the U.S., it is time to look abroad, particularly at foreign fixed income.
  • Commodities - The global economy is not running that hot now. There will be pressures on resources in the future, but that seems to be a way off.
  • Volatility is underpriced - Most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

All that said, for retail investors, I am not crazy about the options at present. I would leave more in money market funds than most would as a part of capital preservation. I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates. This is a time to preserve capital, for the most part, and be careful about where you get yield. When I don't like much, I look at foreign debt, but the dollar is better than the pound, euro, yen and Swiss franc in my opinion, leaving little else - maybe and Canadian and Australian dollars.

Roger Nusbaum: Generally I am not a believer in taking on a lot volatility and risk in the fixed income portion of a client’s portfolio. Quite simply if we, generically, are in a 5% world and you buy something yielding 10% you are taking risk. You either understand the risk or you don’t - but you are taking it. Obviously there is not always a negative consequence for taking risk, but that does not mean you are not taking it.

Unfortunately, we are now in a 0% or 1% world, which is a source of frustration for people of course, but if you are getting 5% in a 0% world you are taking risk.

The way we are positioned for most clients, fixed income wise, is three domestic, high quality corporate issues maturing in 2-3 years, short term sovereign debt from Norway, Australia and Denmark, Vanguard Ginnie Mae (VFIIX), one or two bank preferreds, MFS Intermediate Trust (NYSE:MIN) - this is a closed end fund and varying level of TIPS exposure depending on the income need and age of the client.

I believe this allows us to avoid being overly exposed to normal risks and if things look like they are headed to yet another 100 year flood, we could cut back quite quickly.

Owning dividend paying stocks makes sense, but too much of anything becomes a bad idea. If all you own are big dividend payers then you will not have a diversified portfolio. A diversified equity portfolio means owning stocks with varying characteristics.

John Lounsbury: Many of my clients are 65-85 and concerned more about return of capital than return on capital. I have to push some of them to diversify into some riskier investments. Younger clients (late 30s to mid 60s) have to be pushed in the opposite direction to diversify to offset higher risk.

I use the same elements in portfolios for both groups and individually adjust the elements to suit each client. Every portfolio should have some of the following: Bonds, gold, commodity related holdings, cash (or very short term bonds, notes and bills) and stocks.

  • Bonds - Right now nothing over five years maturity; mostly two years to under a year. Exception is inflation-linked, which can be longer duration.
  • Stocks - Emphasize dividends with good free cash flow stable/growing earnings and a history of dividend increases.

Proper management of retirement plans, IRAs and Roths is very important.


Mick Weinstein, SA Editor: What about munis here? A lot of folks are pursuing yield there, often tax-free.

Roger Nusbaum: I just wrote a negative post about munis. I mostly want to avoid the space, including BAB bonds. I took a little flack in the comments of that post as some munis could be attractive, but if dominoes fall, then I think it could distort the entire market.

John Lounsbury: I can't find muni yields that make sense, especially in light of the default risk that could occur if this recession doesn't end as expected. My clients often find the best yields, even after tax at Credit Unions. Several have 1-year CDs well over 1%, one is even over 1.5%.

David Merkel: Be careful where you go for it with munis - a lot depends on the finances of the municipality with general obligation bonds. So many states and municipalities queered their finances with their pension and retiree benefit underfunding. Revenue bonds, if carefully chosen, can be safer.

"Reduce Overhead"

Mick Weinstein, SA Editor: Roger, you've encouraged retirees to rethink entirely what retirement means as well: "Reduce overhead. Find some sort of work that is fun and that can relieve some of the burden on the portfolio, and get religion about living within one's means."

Roger Nusbaum: To fund retirement, we may not be able to rely on capital markets as much as we used to. Instead of 4%, we may need to ratchet down to a 3% withdrawal rate.

Mick Weinstein, SA Editor: So credit risk is priced too high now, historically, to fund the sort of income investing that Americans have traditionally assumed would accompany their retirement?

David Merkel: Interest rates are a statement about the overall productivity of the economy. When they are low, it is a statement that GDP can be expected to grow more slowly in the future. Thus looking to the future for cash flows in retirement is difficult when rates are low. Credit spreads are higher than average historically, but so are the risks of default.


John Lounsbury: Reply to John Hussman - I have not used preferreds at all in the past couple of years. I have basically let them slip off my radar screen. That may be a mistake. I'll put that back on my screening lists.

Roger Nusbaum: I have two preferreds in my ownership universe - one from JPMorgan (NYSE:JPM) and one from Wells Fargo (NYSE:WFC) - small weightings in the portfolio.

David Merkel: Preferred stocks hate volatility; they are like subordinated debt. Sub debt only does well after a crisis ends. I can see having some corporates in the portfolio at present, but as Jeremy Grantham of GMO says, the one cheap asset class on a relative basis is high quality stocks, many of which pay dividends.


Mick Weinstein, SA Editor: What about inflation-protected securities?

John Lounsbury: I use them, and they are the only bonds that I consider past five years maturity. I am mostly 5-10%, some lower than 5% of portfolios for TIPS.

Roger Nusbaum: We have some exposure of varying weight, depending on the age and income need of the client - no more than 10% in most cases. I will be shocked if the deflationary threat lasts longer than 3-4 years.

David Merkel: I hope you are right, Roger. TIPS can be useful. I think everyone should have some. The trouble is, we don't know whether government policy will be price inflationary or not. If the government does what it did in the Great Depression, long treasury zeroes will do the best. Many expected price inflation in the Depression, and did not get it.

Sovereign Debt

Mick Weinstein, SA Editor: For sovereign debt, can you explain what you are looking for?

Roger Nusbaum: Countries on firmer economic footing, smaller debt loads, reasonable prospects for a relatively healthy currency.

Mick Weinstein, SA Editor: David, you've said you like Canadian and Australian debt, and Roger you've mentioned Norway, Australia and Denmark.

David Merkel: The euro is still an experiment, which is now undergoing significant stress. Japan may have internally funded its debt, but demographics will lead to a liquidation of some of those debts. In general, the commodity currencies have good economies due to demand for their exports, and for the most part they have had better economic policies. Switzerland has a lot of banking exposure. UK as well, and their housing markets are still sagging.

John Lounsbury: I have used currency-linked CDs from Everbank. Right now I am using the debt free currency package linked CD. These have FDIC-insured principal. I am looking now at Canadian and Aussie linked CDs. Three and four years ago I did great with the New Zealand linked CDs. Left that two years ago.

Roger Nusbaum: Yes, Australia never had actual subprime and the economic event for Australia was more cyclical than secular. Ditto Norway about cyclical and Denmark has a very good balance sheet. Unfortunately, individual issues are difficult to access for retail investors. I buy in blocks and allocate over many client accounts.

Build America Bonds

Comment From Ilan: I am interested to know the panel's opinion on Build America Bonds. They seem to have yields that are generally higher than investment grade corporates but have risks closer to municipal bonds. Seems too good to be true.

Roger Nusbaum: BABs... The long maturities are dicey. I like the concept but would want to wait until there is a little less risk of rates skyrocketing. No matter what else is going on, rates are VERY low - so buying long term paper is buying high if you plan to hold on. PowerShares has an ETF and Pimco has one in the works for BABs.

David Merkel: One interesting thing about BABs is that foreigners are buying a lot of them, unlike most munis. Wonder what that does to the market in the long run?

Closed-End Funds

Comment From Matt Augspurger: What about closed end funds? The return is often 8-11%, but what is the risk of loss of principal? Is this more or less effective over time than seeking actual dividend producing ETFs?

Roger Nusbaum: Look at the volatility of any fixed income CEF that existed in June and July 2003. That along with 2008 is about as bad as it gets with CEFs. That is what you are buying. Not all are that volatile of course, but buyer beware.

John Lounsbury: I have always tried to play the discount/premium game with closed end funds. Doesn't always work, but better than ignoring that variable.

David Merkel: I was looking at a CEF, ticker EFT the other day - high yield bank loans, 6.3% yield, but 8% premium to assets. Levered too. Avoid these sorts of CEFs. With others, look under the hood - what are they investing in?

Target Date Products

Comment From Mike: Thanks for this event. So many factors to weigh. Are there any individual funds, target date or otherwise, that you respect for their ability to provide retirement income while giving due consideration to principal protection and real returns?

Roger Nusbaum: I hate target date products.

Mick Weinstein, SA Editor: Why do you hate target date products, Roger?

Roger Nusbaum: They all have different ideas about when to change weightings. Additionally, no matter your age, there are times to overweight equities versus your target or underweight - and target date funds do not do that. So many conservative ones blew up in 2008 - bad news.

John Lounsbury: Ditto on dislike for target date funds. When they work, they are OK. When they don't work a mattress is better. My dislike is the rigid formula for allocation. Even simple dynamic allocation is less risky. In early 2008 I cut my equity allocations in half. That was my most drastic move ever and proved prescient. Even though I didn't move all the way back in 2009, I still was way ahead of what any rigid target date allocation performed.

David Merkel: There is no magic - if you seek returns much above the average out of fixed income and other income products, you will get burned. Also, target dates force an artificial deadline that can hamper value maximization.


Comment From Andrew: What's your collective opinions on using an annuity with an income rider for a portion of a client's money while investing the rest in more growth-oriented securities? This way a portion of their assets is protected while another portion can still grow?

David Merkel: Look at Vanguard's fixed income funds - very basic management with low fees.

Roger Nusbaum: I'm not a fan of annuities - very expensive. Products that rely on something like this are dangerous. I got a couple of truly panicked calls from friends (non-clients) when they thought their annuities were going to flush; there would have been nothing they could have done.

John Lounsbury: The safety issue with annuities can vary from state to state. States like New York with the strongest insurance departments have a lower risk to loss of principal when a carrier goes under than do some other states.

David Merkel: Fixed immediate annuities guarantee a cash flow stream, subject to the solvency of the insurer and the state guaranty funds. They make sense for a portion of one's money, but remember inflation is a risk to these.


Comment from Annualgain: Do any of the panelists like MLPs as a way to find yield, or are they too correlated with BBB and junk bonds?

David Merkel: Maybe 10-20% divided up among a few insurers - they are a bond substitute and a longevity hedge. Keep it under the guaranty fund limits. They are correlated in the short run with BBBs and junk. The trick is to analyze the underlying business. Does it have defensible boundaries? What is a fair valuation? etc. You are investing in a business with a MLP, and all businesses go through bad patches. Safety first. Also try to determine how much of the dividend is true income and sustainable over time.

Roger Nusbaum: Generally I have a bias against locking into anything. I have seen them blow up too many times. Partnerships are OK, just go easy - the downdraft caused in Q3 2006 when Canada announced a change to the tax structure was brutal. This is a 1% world, things like partnerships that yield 8% have risk that you need to understand.

John Lounsbury: MLPs also have some onerous tax filing issues at times.

Writing Covered Calls

Comment From Gary: Writing covered calls as an income strategy? What do you guys think?

John Lounsbury: Covered calls are great in the right environment. It is possible that 2010 could be right. 2009 was a disastrous year. Prices moved too rapidly.

Roger Nusbaum: I do not do this in my practice; I'm not in love with it. I would suggest covering only a portion of the position, and thinking about the premium as enhancing the yield of the portfolio - the 3% per month is complete garbage.

David Merkel: Writing covered calls is the same as buying a put option. My experience has been that you have to be right about timing. You want to write when volatility is high, but then hope that volatility declines so the call loses value.

High-Quality, Dividend Paying Stocks

Mick Weinstein, SA Editor: David, you said: "I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates." Can you specify what stocks?

Comment From Mike D: What about quality dividend stocks like Kimberly Clark (NYSE:KMB), Johnson & Johnson (NYSE:JNJ) and Genuine Parts (NYSE:GPC), all give between 3-4%.

David Merkel: Do your own due diligence, but my portfolio is listed here. I own some GPC, very steady-eddie company. JNJ looks interesting, as does KMB.

John Lounsbury: One interesting strategy is selling deep in the money calls to capture dividends with no downside risk. Of course you lose the stock in the end, and risk not getting all the dividends if there is early exercise.

Roger Nusbaum: A diversified equity portfolio should include stocks with high yields, but also stocks that do not pay dividends too. Selling deeps is often subject to early assignment the day before the ex-dividend date.

John Lounsbury: Yes. You risk early exercise with loss of dividend. But if you want to sell anyway, it's a way to do it with the possibility of dividend capture. The premium must be priced right on the call. Occasionally you can get a mispricing and make a little on the call writing as well.


Comment From Tom: Do convertible bonds (or convertible bond funds) have a role to play in an income-oriented portfolio?

Roger Nusbaum: I used to own a convertible CEF that did badly in the blow up. You need to be willing to sell out occasionally. SPDR has an ETF in the convert space.

David Merkel: Remember that most convertibles are low investment grade or junk grade, so they do best when the stock market is running, and the credit markets are sound. That's why they were so troublesome in 2008, and great in 2009. Few were willing to buy junk in the midst of the panic, but the yields were compelling. At the bottom, you could have had unprecedented defaults, and still made money over two years. With convertibles watch the credit cycle.

Preferred Bank Stocks

Comment from Mike D: Preferred bank stocks that are now paying 6-8% dividends - what should one look for in the bank?

Mick Weinstein, SA Editor: Roger, you said you owned a couple of these - what do you look for there?

Roger Nusbaum: I named names of what we have up above. Relatively firm footing - nothing unique here just a reasonable expectation that the bank will not default, for common stocks we only own foreign banks. A lack of front page news maybe.

David Merkel: Consider what the banks assets are - a bank's assets are its liabilities, as an old boss of mine said. If they have high exposure to commercial mortgage loans or home equity loans, stay away. Those aspects of the crisis are not over, as well as Alt-A loans.

John Lounsbury: I am worried that a new Pecora commission may wreak havoc with banks.

Roth Conversions

John Lounsbury: I have been doing some work with Roth conversions - any interest in discussing that?

David Merkel: What value do they have?

John Lounsbury: Starting this year the income limits on conversions of regular IRAs to Roths have been removed. Direct contributions to Roths are still restricted but conversions are not.

Mick Weinstein, SA Editor: So what investor profile does that affect, John?

John Lounsbury: If someone has a traditional IRA, it can be converted to Roth and taxes paid on the conversion. If rates are to go up in the future (I think that is a certainty) this is a way to shelter money against higher future taxes.

David Merkel: Assuming that the government doesn't retroactively change the rules somehow, or move from income-based taxation to a VAT.

John Lounsbury: This can be done at any income level now, but before this year conversions could only be done in years where AGI was under $100,000. Yes - abolishing the income tax would make this a bad move. I expect that both VAT and income taxes will be used in the future. There is a way to do this conversion that essentially replaces the prohibited process of direct Roth contributions. This is done by making a non-deductible traditional contribution each year, and immediately converting to a Roth. Only $5,000 or $6,000 per year - but it can add up.

Final Advice For Retirees

Mick Weinstein, SA Editor: We're nearing the end of our time. To close, if you have just one thing to say to a recent retiree or someone nearing retirement about how to address the yield shortfall that they're now experiencing, what would that be?

Roger Nusbaum: Figure a way to draw an income doing something you enjoy. I have blogged in the past about figuring out how to monetize a hobby. I have a neighbor who is 78, owns a backhoe and has more work than he wants doing backhoe. Put another way he makes $60/hour to play on a life-size Tonka Toy. Figure out your own equivalent.

David Merkel: Be careful of fraud. There are inducements to bad decisions through greed or fear. Some investments, say a structured note from Wall Street, have an above average yield. Read the fine print. Have a smart friend read it too. There are many out to cheat people in their old age. The structured notes always have a way of making the high yield disappear, in circumstances unfavorable to the investor, and favorable to the bank.

John Lounsbury: Roger gave an answer close to mine. Keep doing something you like. I retired early from the corporate world 18 years ago and have followed my personal interests that now produce an income equivalent to the corporate income I left, adjusted for inflation.

Mick Weinstein, SA Editor: Thank you very much to our panelists and readers who left questions!

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