People who are saving for retirement (savers) face two considerable risks in reaching their objectives. The first is simply investment risk --the danger that investment returns fail to achieve the specific benchmark assumed on the portfolio over its lifetime.
One of the greatest problems with saving for retirement is the use of static return assumptions. Given the massive shift from defined benefit to defined contribution plans in the last 30 years, market risk has become a significant barrier for savers. The use of a flat 6% return assumption when utilizing financial calculators assumes that static number in perpetuity. Advisors like to throw out statistics that discuss compound returns. For example, from 1954 to 2015, the S&P 500 returned approximately 8% annually. Thus, they feel secure when they assume a 6% or even 7% annual return going forward.
The second risk issue is something called the sequence of returns risk. This relatively untalked of risk can make a significant difference between two almost identical savers. The sequence of returns essentially means that the order of returns a portfolio generates matters.
Many advisors know about this risk during the retirement phase -- and much has been written on the subject -- but what is less well-known is the impact during the accumulation phase. A wealth-management marketing piece like the one highlighted below is partially responsible for this misconception.
As the marketing piece notes, "three investors made the same initial hypothetical investment of $1,000,000 at age 40 with no additions or withdrawals." It then notes that they received the same average annual returns over 25 years but with a different sequence of returns. The one-pager states that at age 65, all of the savers had the same portfolio value, although had different valuations along the way.
How realistic is it that the investor starts with $1,000,000 and makes no deposits or withdrawals. The latter is probably the most improbable assumption given that almost all investors dollar-cost-average into their 401(k) plans through payroll deferrals. In this scenario, the sequence of returns matters -- and matters significantly. Let's walk through a hypothetical, one that is much more probable.
If we have two savers who both start saving at the same age, work the same amount of time, have identical wages and wage growth, and the same annualized return on the investment after all fees, they end up with the same amount at retirement, right? WRONG!
The two savers could have substantially different ending balances even though they were identical in every key aspect during the accumulation phase -- except one, the sequence of returns. Now, if the two savers started saving on the same date, then yes, their portfolios would be the same. However, if you shift the start date of the saving, the ending portfolio balance can be substantially different. Thus, even though the annual return of the S&P 500 has been 8% annually, there have been periods of significant outperformance and underperformance. Starting their career in 1979 and working for 30 years will shows a substantially different ending balance than a person starting in 1950, and working for thirty years.
Using those start dates, and a $30,000 starting salary, the difference between the two savers is almost one-third. Advisors need to be cognizant of the start date used in assuming the compounded average return of a saver over their lifetime. The sequence of returns matters significantly during both the retirement and accumulation phases!
Then there's the retirement phase, where the sequence of returns risk becomes even more acute. If a recent retiree realizes significant drawdowns in their assets just as they begin withdrawing from the portfolio, the likelihood of the assets lasting for the rest of the saver's life is low. MFS has a relatively good piece on the subject called, "Ready To Retire?" They show hypothetical negative returns of -11.2%, -18.5%, and -2.9% for the first three years post-retirement (Investor A) and 15.8%, 22.1%, and 12.6% for the first three years for another saver (Investor B). Both investors start with $250K and withdraw $12,500/year, increasing 3% per year.
The difference in the ending balances is quite large with investor B running out of money fairly quickly.
What We Aim To Do
There are two mitigating solutions that advisors and investors should be aware. The first is the ability to tap capital from other sources in lieu of selling assets at inopportune times and permanently impairing their capital. Potential sources include the cash value of life insurance and the use of margin.
The cash value of life insurance can be a useful savings mechanism for investors. The dividend rate at top insurance companies is well-above what can be achieved in the bond market at equivalent credit risk levels. Starting early and building up a sizeable cash value bucket over time that earns the dividend rate can create a large cash cushion for savers. Withdrawing from this bucket when portfolios realize large drawdowns can eliminate the permanent impairment of portfolios.
Margin is another avenue for investors. Margin rates given today's low interest rates are very cheap among brokerages. Most investors could borrow at well below 6% (in most cases around 3%) depending on the institution and portfolio value; (we get 100 bps over prime at TD.) Tapping margin when portfolios drop by more than 7% in a given year and repaying when portfolios rise more than 7% is a good strategy to avoid selling securities after large losses.
The second strategy should be to realize steady yields on portfolios that satisfy clients' spending needs. If a retiree needs $100,000 per year in gross income to meet their lifestyle requirements, a portfolio value of approximately $2,000,000 would be needed. With that level of assets, and guaranteed income of $2,000 per month from Social Security, the client would need $100,000 in withdrawals each year to satisfy their requirement and pay taxes. If the advisor could generate a yield on the portfolio that throws off $100,000 in cash flows each year, then the retiree should never be in a position to have to sell an asset to meet their income needs.
In these cases, we use an asset allocation tilted towards fixed income assets, mostly in the form of closed-end bond funds. While these funds can be more volatile in terms of price risk, they have the ability to generate very consistent and strong yields. In the above hypothetical scenario, if the asset allocation is 20% equities and 80% bonds, $400,000 would be in equities and $1,600,000 in bonds.
If the bond portfolio can generate 6.5% in yield using relatively safe but levered underlying assets (mortgages, investment grade bonds, government debt, senior loans, etc.), the portfolio would create $104,000 in yearly income meeting the investor's needs when combined with Social Security and paying taxes. This investor never has to sell a single bond fund or stock fund to meet their income requirements and thus never has to realize a permanent capital loss.
Imagine an investor retiring in 2007 and taking his first withdrawal at the end of 2008, just as the market falls by 37%. That loss would be catastrophic to their portfolio and the withdrawal amount would not have benefited from the subsequent rebound in 2009 through today. Such events are avoidable using the tactics described above.
Sure, many closed-end bond funds lost significant percentages of their value in 2008. However, the distributions, in almost every case amongst the higher-quality focused underlying strategies, were maintained. In other words, investors in PIMCO Income Opportunity (NYSE:PKO) or PIMCO Corporate and Income Opps (NYSE:PTY) realized the same income stream during the large drawdown in 2008 and 2009 that they received in 2007. At the time, the fund paid out $0.177 per share per month through 2008 and 2009. The saver was never in a position to have to sell shares and realize the loss, impairing the capital, throughout the period.
The ability to identify and build portfolios of high-quality closed-end funds at the right time takes a significant amount of work and knowledge. However, the differentiation that the advisor can then offer the client or that individual investors can produce themselves, is unparalleled from a risk-return vantage point.
The other benefit is that the stock allocation (20%) can also be maintained and the principal never has to be touched; (in some cases we use the dividend yield of the allocation to help meet income needs.) The ability of the advisor to 'sell the story' of generating enough income so that the portfolio can ride out storms is very compelling for their business. The portfolio becomes similar to an endowment in these cases as the time horizon is extended far into the future.
Our marketplace service attempts to generate yields for retirees that are large enough today to adequately meet spending requirements while mitigating the potential large capital loss of the equity markets.
Marketplace Service For Those Hunting For Yield
We launched our new marketplace service, Yield Hunting: Alternative Income Investing, a few months ago -- dedicated to yield investors who wish to avoid the froth associated with the equity, REIT and other more volatile areas of the market. We encourage investors to utilize the free two-week trial in order to benefit from our yield opportunities within closed-end funds, business development companies and other niche areas. We attempt to construct a "low-maintenance portfolio" with a yield in excess of 7% on a tax-equivalent basis with capital gain optionality.
Disclosure: I am/we are long PKO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications or other transactions costs, which may significantly affect the economic consequences of a given strategy. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.