In the first part of this series, we discussed the best distribution retirement strategies and the challenge advisors face today. We noted that advisors today face the most arduous task in generations:
- Large demographic shift
- Very high equity valuations
- Very low fixed income yields
- Lack of pensions
- Longer life expectancy
- High sequence of returns risk
- Low savings rates
The combination of these factors is likely to cause, in our opinion, a retirement crisis in roughly a decade. There was once a report titled, "You can't choose what year you were born." The report concluded that the most important factor for the "success" of retirement was the year in which you were born. That's because of the cycle of markets.
Today, retirement is very different than it was 30 years ago. A lot of retirees had a defined benefit pension along with Social Security to help them generate a significant amount of "base income." That's income that comes in regularly like a paycheck. But the overwhelming majority of retirees today lack that pension and are simply what we call an "investment only" approach to retirement. That means they are living on their Social Security and their portfolios. That's it.
People retiring have been used to a regular paycheck for 30, 40, and maybe 50 years. That cash flow is used to pay for fixed expenses (bills, mortgage, etc). Once a person retires, they get nervous. If you think about it, they are now having to dip into savings or liquidate an investment in order to pay those bills. That would make most people nervous. More on this later...
The chart below shows the secular trends in the stock market over the last 115 years. Why does it matter? If you were to retire in 1982, at the start of one of the greatest bull markets in history your investment only approach would have worked well.
The Retirement Income Challenge
When I started my career in the financial services arena, I considered myself an investment guru. Like Cramer on CNBC, learning about as many companies as I could and becoming an expert in valuing them was my obsession. Discussing financial markets and performance with clients was one of my joys. What I would come to learn is that most clients didn't share that same level of enthusiasm for the markets or individual stocks.
Clients were much more concerned about their plan and if we were on track to meet their goals - primarily affording retirement. When we would discuss how their portfolios "beat the benchmark" they would sit, wide-eyed, staring back at me. The fact is, the client wants to know that their objective is going to be reached and are less concerned with the minutiae of how they get there.
Asset managers today, for a variety of reasons, are much more concerned with the accumulation phase than the distribution phase. Most financial advisors can do the accumulation phase fairly well. They create an asset allocation, pick stocks and fund investments, dollar-cost average in, and ride the roller coaster of the markets for a few decades. It's a very low maintenance approach especially today with all the new technology.
The distribution phase is substantially harder. An analogy would be mountain climbers who hire a Sherpa to ascend Mount Everest. They do so to reach the top AND descend successfully. 80% of deaths occur on the decline, not on the climb.
Without a successful age 60 to 100, the superior management on the accumulation phase would not matter. Advisors tend to not spend much time on this part of the client work simply because it means assets under management going out the door, and thus declining revenue. The incentives are skewed. The advisor gained the client and is collecting his ~1% annual fee, so the motivation to do the much harder work of distribution management is not there.
Diversification Of Income Over Diversification Of Assets
This was the image that we showed in our most recent monthly newsletter. We call it the income plan. It's meant to address that massive retirement income challenge that most baby boomers are facing today.
One of the metamorphosis that we believe we are likely to see is the institutionalization of insurance as an asset class. When we say insurance, we are using it to discuss all aspects of the products in which they offer. From permanent life insurance to income annuities. The industry for decades had been focused on accumulation and optimizing deferral rates, but surprisingly the insurance industry has been at the forefront of focusing on "decumulation" strategies.
Those decumulation strategies include managing sequence of returns and longevity risks. These are going to be the big risks in the future. The investment-only approach basically focuses on the equity and traditional fixed income buckets above. Optimizing the retirement for income based on the expected liabilities is the optimal investing strategy. While the investor may still have a 60/40 portfolio, the better approach would be assess income need and diversify where that is derived.
While this approach entails more "work" for the DIY investor, it will drastically improve the retirement outcome and help overcome the challenge of the current environment. We will be issuing a "How To Guide" that boils down that approach to a manageable set of tasks for members.
The strategy is much more durable than a simplistic 4% withdrawal rate approach. It's also safer given the diversification of the sources of income - most of which outside of the traditional 60/40 holdings are subject to less volatility when markets sour. And we do not believe that dividend growth investing, by itself, is an income producing asset.
Time Weighted Allocation Investing
We then break down the asset allocation into pieces (or buckets) that show the need for each period. This is a fatalistic way to get a sense of your risk tolerance and how to get granular in the portfolio strategy. Let's run through an example below, which we will detail more in our upcoming "How To Guide To YH." The concept is a bit complex but we hope to lay the foundation for the construction of a proper portfolio during retirement.
Let's start with Mr. and Mrs. Green. They have $3.3 million in investment savings, are 64-years-old, and retiring at the end of the year. They need approximately $150,000 per year to sustain their lifestyle, net of taxes. That amounts to roughly 4.5% of the portfolio per year. However, Mr. Green will begin social security benefits of approximately $32K per year and Mrs. Green $18K starting next year. Thus, total portfolio need is approximately $100,000 or a much more manageable 3%. (If you portfolio need is more than 3%, then you may need to reassess your spending).
He is how we would approach the retirement income plan that's based on income diversification, not asset diversification. As we showed in the graphic above, having those five income buckets is the key to a healthy retirement and not outliving your assets.
The question becomes, how much do you allocate to. each? Here's a bit of a busy diagram showing how to approach the situation. Mr. and Mrs. Green take their $3.3M and allocate as follows:
- $285,0000 would into an immediate income annuity to produce an income stream of approximately $20K per year (reducing the $100,000 portfolio need by 20%).
- We place three years worth of portfolio spending into the safe bucket strategy.
- The next four years' worth of spending (years 3-7) would be placed into a 20% equity/80% bond split. The 80% bond portion of this bucket combined 25% core income with 55% traditional fixed income.
- The next eight years' of spending (years 8-15) is then placed into a 40% equity/ 60% bond core allocation. The 60% bond part of this bucket combines 40% core income with 20% traditional fixed income.
- The 15-plus years bucket is then invested more aggressively with a 60/40 core allocation.
Overall, the non-annuity allocation is approximately 45/65 which we think is adequate for a moderate-to-slightly aggressive investor at this point in the cycle. Remember that core portfolio positions are more risky than traditional fixed income so the allocation is actually riskier - but a lot less than all equities.
The portfolio has 34% in the core, 13% in other fixed income (preferred stocks and baby bonds, and/or fixed income mutual funds), 43% in equities, and 10% in our safe bucket (which can also be considered bond). Lastly, the annuity also should be considered fixed income but is very safe. For those who do not purchase an income annuity, we would advocate shifting the allocation by 10% toward fixed income. But we definitely implore members to consider an income annuity to offset about 20-25% of your portfolio need per year.
For those more risk averse, we would recommend the following changes to the portfolio:
- Reduce the Core to 25%
- Reduce equities to 25%
- Increase safe bucket to 15% or four years of portfolio income spending, whichever is greater.
- And/or keep safe bucket at 10% but add a corporate bond ETF ladder for the next 3-5 years.
- Increase traditional fixed income to 35%
The decumulation phase of your portfolio is much harder than the accumulation. In Part I we discussed why you should avoid the "investment only" approach and a better way to structure your retirement portfolio to provide better longevity risk mitigation and sequence of returns risk. In Part II, we wanted to dive down further into actually constructing the underlying pieces of the portfolio using the core portfolio, income annuities, safe bucket, and equities.
We hope this report helps out our members in constructing your own retirement income plan and mitigating the risks/pitfalls that effect many investors. And we would be happy to help out any of members who have questions regarding annuities or any other aspect of this report. Please comment below.
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Yield Hunting is a marketplace concept that focuses on finding that best risk-return area of the market for income investors, especially those nearing or in retirement. We focus on a Core Portfolio that aims to provide enough income to support your lifestyle without taking on excessive risks. We provide members with model portfolios, a vibrant and educational chat room, and access to professionals who can help guide you in building a proper portfolio for your risk tolerance. We issue a monthly letter and weekly commentaries used by financial advisors for their clients. For a sample of a past newsletter, please message us on SA.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.