Asset allocation can be quite subjective. If one researches the allocation strategies advanced by qualified financial advisors (CFAs and the like) one precept jumps out - they are all based upon, and vary with risk tolerance.
In my case allocation strategy is predicated upon risk tolerance, the yield necessary to sustain a conservative lifestyle, and my knowledge of specific stock sectors. I personally tend to spend at least six hours a day doing online stock research (which is not everyone's cup of tea), and this has afforded me a decent working knowledge of five or six stock sectors. Although from time to time I venture outside of this comfort zone, my focus remains in familiar territory.
For those of you who cannot, or really do not want to do research, there is a wealth of information available about asset allocation using search engines such as Google.
I believe that there are three categories of individuals in the pre-retiree/retiree population cohorts - those that have little, or no savings (it is surprising how large a category this is), those that have one million or one million plus in financial resources, and those whom this series of articles focus upon - the mid-rangers.
The Protected Principal Retirement Strategy (credit goes to SA's editors for suggesting this title) is based upon my desire to withdraw only dividends from both taxable, and tax-deferred accounts (beginning at age 70 1/2), and, hopefully leaving the principal untouched for as long as possible. The annual amount to be withdrawn will be based upon what is necessary to maintain our lifestyles after taking into account savings and social security payments. The majority of my tax deferred accounts are invested with Schwab, and their representative informed me that they will provide checks that can be used for withdrawals.
In order to determine your personal risk level, I suggest that you first review your budget and determine how much income you will need to sustain a comfortable, but not extravagant lifestyle. Next, subtract cash savings, projected part time income and social security income. What remains is the amount that you must fund annually from investments to sustain your desired lifestyle. I provide the following example, which assumes that most of us mid-rangers do not maintain a large savings balance due to exceedingly low current interest rates:
Desired (After Tax) Annual Lifestyle Costs - $55,000 ($65,000 Pre-Tax)
Social Security (Two Persons) - $27,000
Part Time Income & Savings - Varies
Net Needed From Investment Income - $38,000
After deducting estimated annual income from part time employment and what you can allocate out of savings you are left with the amount you will have to generate from investments. Each year, this amount should be adjusted for inflation.
Using the above example of $38,000, let's assume investment portfolio sizes of $300,000, $400,000 and $500,000. It will take a yield of 12.7 percent on a portfolio valued at $300,000 to generate approximately $38,000 in dividends, a yield of 9.5 percent on a portfolio of $400,000, and a yield of 7.6 percent to do the same with an investment portfolio of $500,000. The yield that you need to generate from your investment portfolio therefore becomes your risk tolerance. You can see that your risk tolerance can decrease proportionally as the amount of your investment portfolio increases.
I realize that my calculations are inexact (based upon roughly $65,000 pre-tax income), and do not consider taxes on dividends and distributions (who can guess what these will be by 2013), but this is just an example. Each of you can input your own numbers, tax estimates etc. If, like me you wish to remain productive in "retirement" you can reduce the net needed from investment income by the amount you earn.
Now that you have an idea of how much you need to generate from investments you can begin to allocate your resources. I believe that each of us should stick to the sectors we understand best in developing strategic allocations. In addition, I believe that performing an annual review and re-allocation is not enough when using this type of strategy; re-allocation should be accomplished on a quarterly basis, or more frequently as market conditions dictate.
I will use my current allocation strategy as an example going forward.
I have selected MLPs, Royalty Trusts, REITs, BDCs and Foreign Stocks as my primary income generating vehicles. This decision was solely based upon the fact that I have a decent knowledge of how each of these "work", and that I am comfortable dealing with them on a daily basis, if necessary. I began to put this strategy into effect about seven or eight years ago. If you wish to use a version of this strategy, I encourage you to select asset classes where your comfort level is high.
Having been an ardent follower of energy and energy stocks for the past eight years, and the fact that I do not believe we will become energy sufficient or gain a high dependence on alternative energy in my lifetime, I decided to allocate at least half of my portfolio to MLPs, Royalty Trusts and other dividend paying energy stocks. I decided that I would achieve the most diversification possible by sub-allocations among upstream, midstream and downstream/other MLPs and through a combination of U.S. and Canadian Royalty Trusts deriving royalties from oil, shale, natural gas and natural gas liquids.
Next on my comfort level scale are REITs. I have been invested in REITs for well over a decade - preferring equity REITs to mortgage REITs, but a small portion of the portfolio is dedicated to this speculative sector. I sub-allocate equity REITs among domestic and foreign locations. My total allocation to REITs is presently at the 15 percent level.
BDCs are a step lower on my comfort scale since they are quite sensitive to interest rates, their dividends tend to fluctuate, and their payout ratios often top the 100 percent level. The upside is that yields tend to be higher than those of equity REITs. The present 10 percent allocation to BDCs is divided amongst those that I consider to be the most conservative; typified by increasing earnings, a dividend to earnings per share ratio of less than 100, and a price to net asset value of less than 1.0.
Foreign dividend stocks have a place in the retirement portfolio. Typically, these pay higher dividends than their domestic counterparts; however foreign tax rates on dividends sometimes exceed 15 percent (recoverable in taxable accounts). There is the added benefit of being paid in a foreign currency, which in some cases is stronger than the U.S. dollar. A few years ago, investment pundits suggested a 40 to 50 percent allocation to foreign stocks, but with current global instabilities I think this allocation has been revised downward. I presently have a 15 percent allocation in this sector, 10 percent in equity/income stocks and five percent in emerging markets income stocks.
In previous articles in this series I have mentioned CEFs as an allocation sector. I presently see CEFs as an opportunity to diversify funds among specific sectors such as currencies, commodities, metals, preferred stocks, senior loans, floating rate loans and emerging markets. Being able to purchase stocks for less than their net asset value is certainly appealing, and many CEFs do not use leverage or utilize a return of capital as a means to inflate dividends.
The following depicts the allocation percentages that I presently use (always subject to change) and the amounts to be dedicated to each based upon an investment portfolio of $300,000, $400,000 and $500,000.
One conundrum that we face with this, or any other type of allocation strategy is "how much cash should be maintained for buying opportunities"? Several years ago it was not a problem to keep a cash account that was interest-bearing. Today, if we keep cash on hand we earn close to zero in interest. I personally, grudgingly maintain a cash position between 10 and 15 percent of my portfolio. I would like to have your opinions on this issue, as I believe the sacrifice of income to some of us could be critical.
The next article will focus exclusively on MLPs. I will present my thoughts as to the best ones to include within this allocation, how much each pays, what their distribution policies have been historically, how to best evaluate them and what type of dollar yield can be expected annually. Subsequent articles will address Royalty Trusts, REITs, BDCs, Foreign Stocks, CEFs, and other strategies such as covered call writing as a means to increase the income stream.
Additional disclosure: The strategy and ideas presented in this series are not meant to be recommendations - everyone has different income requirements. I encourage you to do your own research, consult with investment advisers as necessary, and develop an investment portfolio and allocations that best meet your needs.