From the August 2009 issue of Boomer Market Advisor • Subscribe!

Thinking through the fixed side

Research suggests that many advisors and investors do not have a clear strategy for allocating and managing the fixed income side of the portfolio.

My firm conducted a survey of advisors in 2007. Sixty-three percent asserted they always or often recommended clients shift to more conservative investments when they retire. That share has risen to 72 percent. We also asked advisors if retirees should reduce their exposure to equities as they enter their late 70s and 80s. In 2007, 59 percent said yes; Now it's 78 percent.

However, there is a fundamental problem. In a focus group I conducted, an advisor mentioned she didn't have a well-thought out asset allocation for the fixed side of her clients' portfolios. She had detailed ideas about the equity side, including the proportions that should be in international stocks, in large-cap US, mid-cap, etc. But on the fixed side, beyond the basic concept of bond laddering, she had no firm ideas. Other advisors in that group had the same situation. If an increasing amount of money is going into fixed investments these days, we need to do better than that.

We all know boomers will have very expensive retirements. This raises questions about how asset allocations that start conservative and get increasingly conservative will be able to cover large retirement expenses. Generally, conservative portfolios do not produce the returns like those taking on more risk.

Review the objectives of fixed investments. Advisors often mention liquidity, income and risk moderation as the main objectives. It's interesting, as an aside, that many advisors use bond mutual funds as a fixed investment, when their value can shift significantly. Bond mutual funds are not perfect producers of risk reduction. Company bonds are also not exactly without risk, just ask GM.

The problem with liquidity is that it has a cost. Too much liquidity can cost a lot in terms of sacrificed returns. Financial institutions reward investors for assurances that they can hold onto the assets for awhile. Few retired boomers have the luxury of passing up this added return. Many retirees make the mistake of defining retirement security as having access to as much money as possible. In reality this isn't necessary, since most of the cost of retirement comes from ongoing expenses that can be parsed out a little at a time. Many buy more liquidity than they need and do not recognize the cost of their liquidity.

So how much liquidity is actually needed? To fund essential expenses (food, housing, insurance and transportation) there's no need for liquidity. The basic cost of these is fairly predictable. Liquefying too many assets to fund these expenses means those supportive assets will not be there the next month.

Some fixed investments are doing poorly to provide income, CDs and money market funds, in particular. Longer term fixed investments pay more, but with inflation, there is often a reluctance to go too long term.

Real fixed investments do help to reduce overall risk, but they can subject people to a loss of purchasing power if their returns are too low. Uncorrelated investments, if they can be found, may be a better way of moderating the risk of equity investments. Guarantees of various sorts can also be used to reduce overall risk of loss in the overall portfolio.

I'm not arguing against fixed investments. However, considering the recent downturn, many advisors have simply concluded that more fixed investments offer more protection to clients, who now appear to have had less risk tolerance. But putting more money on the fixed side requires a thoughtful approach about the purpose of those investments and the best way of achieving these results. We need a well-thought out asset allocation strategy for the fixed side of the portfolio that encompasses all of the different types of fixed investments. Otherwise, we'll end up with portfolios for retirees that won't go down much, but also won't provide the needed income.

Mathew Greenwald is president of Washington, D.C.-based Mathew Greenwald and Associates.

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