From the May 2009 issue of Research Magazine • Subscribe!

May 1, 2009

Putting It Into Practice: Two Philosophies

Diverse approaches to building retirement portfolios share some common elements.

What's your approach to building retirement income portfolios?

One of the most important and visible issues that advisors address early on with retirees is how to create effective investment management strategies that satisfy the need for current and future income. Yet deciding on the best approach to managing retirement assets can be a challenge. Even the most highly skilled and experienced retirement advisors are not immune to the complexity, customization and time commitment involved with building and sustaining retirement portfolios.

From our interviews with hundreds of advisors who work with retirees, it is apparent that there is no consensus on the most effective way to build retirement portfolios or deliver retirement income. As an advisor we spoke with recently summed up the issue: "If we have learned anything over the past several years, it should be that nobody has the answer. We are all trying to steer the most informed and best course possible. But none of us can be sure we are taking the right course."

While there is no agreement on a single method to use with retirement clients, our research suggests that advisors tend to follow either of two prominent philosophies to meeting ongoing income needs. Slightly more than half of all retirement advisors follow what we characterize as a risk-adjusted total return philosophy, which is similar in approach to how assets are managed for pre-retirement clients. Yet a second group of advisors follows a different philosophy for crafting retirement portfolios, preferring to manage portfolios by adhering to a duration-based pooled or bucket approach.

While there are modest differences in the types of advisors who prefer one approach versus another, the preference for using one method appears to arise more from the advisors' personal experience and belief than it does from channel affiliation, experience or type of client served. Notably, there is wide variation within each segment in how these philosophies are applied by advisors.




-- Risk-Adjusted Total Return Approach: This segment of advisors is total-return-focused, seeking to deliver competitive returns across the investment portfolio consistent with the client's comfort with risk. This approach is similar to how most advisors invest for younger clients that are accumulating assets for retirement or other goals. These advisors do not invest specifically to generate current income, but instead target an annual withdrawal rate from the entire portfolio.

Advisors using the total return approach tend to broadly diversify their client assets, focusing on the risk-adjusted total return of the entire portfolio. The advisors then draw off a portion of the portfolio periodically -- generally on an annual basis -- to meet client needs for income or cash flow. While these advisors may include income-oriented vehicles as part of a diversified portfolio, they do not rely solely on these investments to produce income. Generally, these advisors believe it is more prudent to seek returns across the market spectrum and then cull the returns to meet client needs for current income.

As one advisor who uses the risk-adjusted total return method suggests, "I am comfortable using a more total-return-driven way of serving my retirement clients. I believe that this approach will be best over the course of a full market cycle in ensuring the client has the right mix of current cash flow and longer-term appreciation to stay ahead of the curve. I just feel more comfortable with this way of managing portfolios and find it flexible enough for my clients."

-- Pooled or Bucket Approach. The second segment of advisors is more focused on creating distinct investment pools or buckets, with certain pools oriented to generating current income and other pools targeted for longer-term growth. These advisors invest specific portions of the portfolio to create sufficient income to meet client lifestyle needs and do not focus on a specific drawdown or withdrawal rate across the entire portfolio.

Advisors using the pooled approach create specific time-based pools of assets to generate income for current needs, while investing other pools of assets for longer-term needs. The number of pools will depend on client circumstances, but a typical 65-year-old retiree may have a portfolio allocated among six pools, each with a different horizon and focus across an expected lifespan in retirement of 30 years. Client income targets are satisfied by placing a portion of assets in low-risk investments that produce regular income for a period of time, generally three to five years. This pool of assets may include laddered CDs or Treasury bonds or some form of immediate annuity. The goal is to shield this pool of assets from the vagaries of market volatility. Other assets are invested for ongoing asset appreciation using different investment buckets with progressively longer horizons.

The advisors do not focus on drawing down a particular portion of the overall portfolio each year, but rather meet income needs through the specific pool of assets dedicated to that task. Generally, these advisors believe it is more appropriate to have client income needs resolved regardless of current market conditions and that this approach gives added comfort and sustainability to client retirement plans.

A pooled approach practitioner notes: "I just think that managing portfolios for retirement clients is a different ballgame. Using targeted pools of assets allows me to protect the client in the short term while also looking to the future. And this way of managing assets resonates well with my clients, who feel protected against the ups and downs of the market."

While advisors may differ in the philosophy they follow for retirement clients, there are consistent elements among best-practice advisors that cut across both approaches. These common elements include:

-- Generating an annual income or cash flow target of between 3 percent and 6 percent;

-- Managing portfolios to support spending on essential needs such as housing, healthcare and other daily living expenses while also looking to maintain long-term purchasing power in light of potential inflationary pressures;

-- Seeking to produce competitive returns for the client within agreed-upon risk parameters, but not striving for consistent above-average returns or outperforming market benchmarks;

-- Focusing on broad diversification in asset classes, relying on vehicles they are highly familiar with, such as mutual funds, ETFs, individual securities, separately managed accounts and annuities;

-- Emphasizing the process of constructing portfolios rather than the products or solutions available.

Looking ahead, it is not likely that either method will come to dominate the market. More likely is that additional methodologies that are offshoots of these two main philosophies will emerge and gain prominence. Advisors must select the approach they believe works best for their mix of clients and tailor that philosophy as the retirement-income market evolves.

If you are an advisor who would like to share experiences or practices in delivering retirement income and longevity support, we welcome your perspectives.

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Dennis Gallant is president of GDC Research. Earlier, he was a director of Cerulli Associates and a vice president for Funds Distributor in Boston. Contact him at gallant@gdcresearch.com.

Howard Schneider is the founder of consultancy Practical Perspectives near Boston, worked previously for Scudder Investments and has served as chairman of the Mutual Funds Education Alliance. Reach him at howard.schneider@practicalperspectives.com.

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