From the September 2009 issue of Investment Advisor • Subscribe!

September 1, 2009

The Affluentialist: Building Retirement Portfolios Now

A study describes new retirement income best practices

In my June column we examined how retirement planning specialists with a significant list of near- and post-retirement clients deliver their services. These advisors, for example, responded to clients' feelings of uncertainty about ending their work life and beginning their retirement years by adding more lifestyle services.

In a follow-up survey of 500 advisors, the same collaborating researchers--Dennis Gallant of GDC Research and Howard Schneider of Practical Perspectives--found that advisors view building retirement income portfolios as much an art as a science. "The emphasis of advisors is on integration of investment tools, rather than on just products," the two observe in Examining Best Practices in Constructing Retirement Income Portfolios: How Advisors Support Retirement Clients. "Few advisors use a cookie cutter approach to retirement income support, believing that solutions must be tailored to meet the particular needs of individual retirement clients."

As one advisor characterized the steps, "Creating retirement income portfolios is all about the assembly of tools, not the tools themselves. Numbers are the easy part most of the time. It is the process that is complicated."

Solving the Income Puzzle

"Advisors now are focusing much more on solving the income needs puzzle for clients," notes Schneider. "When we talked to them for the previous survey, they discussed solving for cash flow for clients, merging together income needs and income wants." Income needs include mortgage payments, living expenses, and healthcare. Vacations, hobbies, and other lifestyle expenses were typically lumped in with income needs. Today, more advisors are stripping out the difference between the minimum clients need to maintain their lifestyles and separating other expenses--such as expensive travel and substantial gifts--as discretionary expenses.

According to one advisor interviewed for the study, "The key to retirement portfolios is managing the retiree. To do that you need to educate, educate, educate. I explain that retirement income needs to be considered in a minimum of three categories. Number one is the core expenses that have to be paid. Number two is the quality of life things we want to do. Number three is the frills that we do because we can, and that includes what is spent on children and grandchildren."

Most advisors have typically relied upon U.S. equities and fixed income investments when building retirement income portfolios--with less going to international equities and cash. Not surprisingly, the tumultuous economic environment pushed advisors to change asset allocations. Many advisors chose to reduce exposure to U.S. and international equities, while increasing allocations to cash and U.S. fixed-income investments. Non-traditional strategies such as real estate, commodities or hedging strategies, or other types of alternative investments saw only a modest change.

Practice Differences

The study found a couple of insightful distinctions in the practices of these retirement specialists. First, there were significant differences across the channels. RIAs, for example, are more likely to handle managing investments internally, including asset allocation, research, and investment selection. They are also more likely to take a total return approach. Wirehouse/regional brokers and bank/insurance advisors are much more likely to seek additional investment guidance. Independent broker advisors are more evenly divided in using their own allocation and relying on third parties.

There are also differences among advisors based on the amount of their practice devoted to retirement income planning. At one end are the "committed" advisors who have 60% of their list identified as retirement income clients. At the other end are the "fledgling" advisors with 20% or less of their clientele devoted to retirement planning. As might be expected, the number of years of experience relates to the degree to which advisors devote their practices to retirement income planning. The committed group tends to have the most experience and more older clients--52% had more than 20 years of experience while 24% had 10 years or fewer. In the fledgling group, only 29% had more than 20 years of experience and 41% had 10 years or fewer. The remainder of the survey group fell into the middle.

Seeking Guarantees

Given that advisors have expressed less confidence in their ability to manage retirement income portfolios, it's not surprising that they've voiced greater interest in retirement products with guarantees, which were at the top of their wish list, says Schneider. Many of them said they're going to look to variable annuities. Advisors who particularly focus on retirement income security are more likely to use annuities, where the product represents a part of an integrated portfolio and not the single solution offered. More of these "committed" advisors view annuities as among the most effective retirement solutions and view annuity providers more favorably.

Most advisors look to their same providers for constructing retirement income portfolios as they use for their other clients, even if the asset classes and allocations skew toward the more conservative for the retired group. Annuities are the exception. "The challenge, of course," says Schneider, "is that many of the annuity providers have pulled back. The products that advisors were looking at in the past [with] many attractive features and riders have now been pulled away because they weren't sustainable. So while many more advisors are looking for guaranteed solutions, their options may be more limited right now."

The study also demonstrated how the theme of guarantees helps define advisor satisfaction with their investment approach. For those who followed the total return approach, more questioned whether they should consider using guarantees on part of the portfolios. The pooled or bucket practitioners felt more comfortable coming through the market storm, since they had a floor or guarantees in place and the clients' incomes streams were sustainable. Those who followed the total return approach were more likely to have that uncomfortable conversation with the clients about adjusting expenses to meet a shrunken income stream. It's this experience that the researchers believe is driving more total return advisors to transition to the hybrid approach (see sidebar) which puts a floor beneath some of the income needs while still managing the rest of the portfolio to optimize it.

One advisor noted the challenge that the market downturn has caused, mentioning that "Retirees regardless of income and net worth are in no mood for making a lot of money or finding a market bottom to 'buy low.' They want safety first and then a reasonable rate of return, even if it is just a return of the money."

What's Important

Although business models and methods of creating and managing portfolios demonstrated a broad range among advisors, some important themes remained consistent:

o Advisors' views differ on the construction of retirement income portfolios.

As mentioned, most advisors use risk-adjusted total return or the pooled (bucket) method. The researchers found that the preference for one over the other derives more from personal experience and beliefs than from the type of practice or client served.

o Advisors take a complex and customized approach to portfolio construction.

Regardless of the approach, advisors describe a highly detailed, customized solution involving a deep understanding of clients' needs and goals.

o Advisors emphasize process, not products.

Advisors see their process of portfolio construction as the real value they provide clients, not the retirement income products they might use. The retirement income process is dynamic, requiring regular monitoring.

o Advisors follow a formal process with a focus on ongoing monitoring.

While there is a wide range of processes for building and maintaining a retirement portfolio and providing ongoing oversight from practice to practice, advisors tend to take the same general path with each client. The steps typically include: Client Discovery, Investment Planning, Implementation, Monitoring and Adjustment.

o Advisors target an annual withdrawal rate of between 3% and 6%.

Regardless of the portfolio construction or drawdown method used, the vast majority of advisors use this goal for generating cash flow from the investments.

Challenging Clients

Some of the biggest challenges to building effective retirement income plans arise during the discovery phase. Clients may need even the most basic education in investments, which can also come with unrealistic expectations about retirement income and flexibility to absorb discretionary expenses. Advisors try to screen for these problems while maintaining a lifestyle spending level without exceeding it.

One advisor described his biggest challenge this way: "The number one obstacle is the client themselves. They need to let me do my job as a professional. Too often, clients can't comprehend issues related to retirement or variables that will change things down the road. Many can't comprehend longevity or the impact that inflation, the coming Social Security crisis, or medical cost increases can have on a portfolio. There are so many intangibles that will diminish income people receive, yet they don't understand most of it."

Another advisor expressed his responsibility to his clients similarly: "My role is simple...to help client's avoid daydreams and set realistic expectations for the future."

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