My research indicates that advisors use a variety of approaches to produce client income. There are advisors who take two years of their clients' income, put it in cash and then make monthly payments to their clients out of this cash account. This can reduce the amount of the client's real income producing assets by a substantial amount in order to keep a fair amount of money in cash.
Other advisors rely on bonds. Because interest rates are so low, a number of advisors have gone to long term bonds to get a higher rate. This is interesting. Some of the same advisors believe interest rates will soon increase, bringing down the value of long term bonds, or bond funds, in which they have invested. A high reliance on bonds can compromise the amount of money available for long term investing. Consider, for example, the client who has income needs of $1,500 a month and wants to derive that income from bonds paying 4 percent. If that client's marginal tax rate is 20 percent it will take $562,000 in bonds paying 4 percent to net the $18,000, after taxes that the client wants (and many think tax rates will go up).
That amount can crowd out the ability to invest in equities for the long term. Other advisors derive income each month by harvesting dividends, interest and capital gains, or sales of equities when there are no capital gains. They rely more on the equity side to produce monthly income. Many advisors think they should do a better job of producing income for their clients. I have a concern these advisors use the same technique for producing income for all of their clients, no matter what the client's risk tolerance. I think more of a focus on how best to produce income for different types of clients will lead to the development of better strategies.
I think that many advisors take an overall approach to asset allocation and retirees, one that makes it harder for them to come up with the best plan for producing regular monthly income for clients. This overall approach usually works best for working clients, because they often have one overriding objective: growth. Working clients often have a bequest motive, but usually use life insurance for that and do not burden their asset plans with bequest needs.
Retired clients have three objectives: first, they often need monthly income. Second, they need growth to be able to keep up with inflation. Third, they need to protect themselves against unforeseen costs over a potentially long retirement and they often have a bequest motive. By the time many people retire they have dropped their life insurance and now want to preserve some of their assets for bequests. The income need and the growth need can be at odds with each other. As indicated above, conservatism in meeting income needs can mean less money for meeting growth needs.
The advisor has to start the portfolio design issue somewhere. It seems to me the place to start is with the question, "how am I going to produce the monthly income my client wants and how much will I have to dedicate for that purpose?" After that it will be easier to decide how to seek growth. Thus, I think there must be more focus on the "income allocation" rather than subsuming this issue within the broader category of an overall asset allocation.
When advisors start off with an overall asset allocation strategy, they often come up with plans that do not produce income in the most efficient way, and do not produce growth in the most efficient way. It's better to focus on the three objectives above, rather than to assume there is only one job and one overall solution.
Mathew Greenwald is president of Washington, D.C.-based Mathew Greenwald and Associates.