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I am a trusts and estates attorney with the firm Dow Lohnes in Washington, DC. My areas of expertise include domestic and international taxation, finance, alternative investments, fiduciary wealth management and investment strategy.
  • Retro Retirement Planning 0 comments
    Aug 5, 2009 10:09 AM

     

    In another era many years ago, retirement planning for the wealthy involved some fairly simple math.  It went like this: take the yield on a portfolio, and if the dividends and interest  covered a client’s living expenses, the client was set to retire, to live off the portfolio income, and die with an estate comprised of unspent principal (to the delight of the client’s loving heirs).  The same basic rules applied to fiduciary trust administration, where the name of the game is treating current beneficiaries on parity with remainder beneficiaries. The trustee would farm the portfolio income out to the current beneficiaries, and would preserve the trust principal for eventual distribution to anxiously waiting remainder beneficiaries. Simple.
     
    Fast forward to the early 1990s. Asset yields started to vanish. Companies had already began to retain, rather than distribute earnings. For one thing, it made better tax sense to do so – investors would generally prefer stock buybacks, with low-tax capital gains treatment, to dividends, with high-tax ordinary income treatment. And managers were happy enough to retain cash to deploy into empire-building projects, and shareholders were content to oblige. The dividend yield on the S&P 500 approached historic lows. Meanwhile, the yield on ten year US Treasuries started an epic decline. At the high point in early 1995, you could get 8% on these things. By the end of 2008, the yield on this debt had dropped all the way to 2%.
     
    The rules governing money management evolve according to market conditions, much like finches on the Galapagos. Financial planners and fiduciary asset managers took notice of the vanishing yield trend early. For instance, as trust income beneficiaries howled for more distributions, laws were changed to enable trustees to distribute to current beneficiaries a percentage of trust assets (usually between 3 and 5 percent) each year, in lieu of paltry trust accounting income. There were several motivations for this change, but one of the thoughts was that these so-called “unitrust” payments would preserve trust corpus for the remainder beneficiaries while giving the current beneficiaries a fair taste of the trust assets. 
     
    In the retirement arena, planners put aside the old model of just taking a client’s portfolio yield and matching it up to the client’s expenses, in favor of “Monte Carlo” retirement simulations. These were models where you’d calculate a client’s expenses, and then run millions of iterations based on past market data to determine what percentage of assets a client could withdraw each year while preserving some level of confidence that the client wouldn’t outlive his or her money. Charles Schwab penned a famous formula – you could eat 4% of your portfolio each year and retire safely. It worked wondrously, until, inevitably, market conditions continued to change as they always do.
     
    The first change went little noticed. A temporary tax measure was adopted in the United States, under which dividend income was taxed at capital gains rates. From a tax perspective at least, many investors were now indifferent when it came to stock buybacks verses current dividend distributions. In fact, corporations that used stock buybacks often issued stock options to employees – in effect, what used to go out to shareholders as dividends was now going into the pockets of management as deferred compensation. Pressure began mounting for corporations to start kicking out more cash each quarter in dividend form.
     
    The second change was less subtle - the global financial system practically collapsed, and in the process came close to creating a pandemic global depression of nearly epic proportions. Stock prices on global equities indexes were handsomely slashed by 50% or more, which had an interesting impact on many retirement and fiduciary accounts. For one thing, if you were a retiree or trust beneficiary, that 4% draw you thought you could take each year was cut in half, and if your expenses weren’t cut accordingly, you had a problem. And another thing, to eat 4% of a portfolio, you have to sell stuff. But selling into weakness is anathema to asset managers, who quickly groped around for a new management model (including frantic phone calls to beneficiaries asking them to forego distributions temporarily) that wouldn’t require them to sell assets at bargain basement prices as markets swooned.
     
    The biggest impact of the credit crisis, though, may have been the sudden realization that there is a fundamental weakness of a Monte Carlo simulation.  By design, it doesn’t “hedge” for Black Swans. A Monte Carlo simulation weights outcomes within the bell curve of statistical probability, and outlying outcomes are discounted according to their unlikelihood. A good Monte Carlo simulation will virtually ignore the effect that an Earth killing asteroid impact would have on your portfolio. Likewise, pandemic global depressions and collapses of the planetary banking system are given little weight in a Monte Carlo simulation because these events are just way outside of the bell curve. But as many people learned, unlikely, unexpected and rare as they may be, a Black Swan will gobble up 50% of your portfolio within a few short months. It seems foolish to ignore them now.
     
    Conditions have changed, and with these changes, we need a new conceptual framework when it comes to financial management. One of the main conditions of change we see is that now, yields on some assets are, well, huge. According to ETFConnect.com, SPDR Barclays Capital High Yield Bond Fund (JNK) yields over 13% currently. Ishares MSCI Taiwan Index Fund (EWT) is churning out over 10%.  PowerShares Preferred Stock Portfolio (PFF) is yielding close to 8%.  The list goes on.  I’m not suggesting readers invest in these assets, per se, but only that low yield environment pervading the capital markets over the last fifteen years has shifted.  It no longer makes any sense to plan a retirement, or manage a fiduciary account, in a way that doesn’t focus a great deal of attention on yield.  If a client can’t get by eating 3% of the portfolio capital each year, then perhaps leaving capital in place and eating an 8% cash flow will suffice?  
     
    Another condition that has changed is our appreciation of unexpected and dire events, which can snuff out principal values on assets with stunning speed.  While the share price of a stock or bond index can get whacked rapidly, dividend and interest payments tend to change far more slowly – if at all. In that sense, focusing on portfolio yield as a basis for a retirement plan or for managing a fiduciary account offers a great hedge against Black Swans.  Meaning, the value of a portfolio can change, but that doesn’t need to impact a retirement plan or trust account much if the cash pouring out of the portfolio remains relatively constant. 
     
    I remember when bell bottoms made an unwelcome comeback a few years back. When it comes to the rules governing personal finance, I’m thinking we should go back a few decades, too.

    Disclosures:  The author owns positions in JNK, PFF and, soon, EWT.
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