Baby boomers continue to impact our nation. The generation that fought for free speech and civil rights is now forcing financial services to re-evaluate investing and retirement planning. They are the first group to transition from traditional pensions to the 401(k). Boomers will increasingly have to look to their own accounts to support them in retirement. Essentially, they have to treat their 401(k) and IRA accounts as their personal pension.
Clients approaching or in retirement can build a personal pension using a hybrid approach that combines the best of pension-like predictable cash flows and higher long-term returns of a total return approach. A personal pension needs to be engineered specifically to each client’s financial goals that are uncovered through the financial planning process. By linking to the financial plan, clients can balance the sometimes competing goals of predictable cash flows and portfolio longevity.
To generate both predictable income and long-term returns, we advocate splitting a portfolio into two sub-portfolios—income and growth. Each sub-portfolio uses asset classes that best suit its purpose. Individual bonds are used to generate the predictable pension-like cash flows in the income portfolio, while stocks and other long-term-growth-oriented assets make up the growth portfolio.
The income portfolio delivers predictable cash flows in the near term, usually eight to 10 years, regardless of what is happening in the stock or bond markets. It also provides a time buffer for the growth portfolio to ride through down markets. The growth portfolio is tasked with driving long-term total return to replenish the income portfolio as it is spent down.
From Accumulation to Decumulation
Up to now, most of the research and industry focus has been on investing in the accumulation phase. The main objective has been to grow clients’ portfolios so that they would have enough to retire—hitting their “number.” As clients transition to retirement, they shift their focus to generating predictable income out of portfolios and making sure they don’t run out of money.
With more boomers retiring every day, we are starting to see weaknesses in using accumulation strategies like pure total return for clients who now have to look to their portfolios to replace their paychecks. Traditional income approaches, like dividends, also face challenges when equity markets break down.
Spending needs, however, are not driven by market returns. Mortgage payments don’t change if the markets are up or down. Neither do car payments or utilities and grocery bills. Income from pure total return and dividend strategies, however, is impacted by market functions, causing retirees to either take pay cuts or sell assets in declining markets.
The effectiveness of an income strategy isn’t revealed in calm or rising markets. Strong market returns can hide a multitude of sins. The true test of a strategy comes when markets are melting down like we experienced in the crisis of 2008. We will see that building a personal pension to fund a client’s retirement will help them fare better than accumulation-centric total return approaches or traditional income strategies like dividends and annuities.
An Institutional Strategy for Individuals
Liability-driven investing (LDI) is an institutional investment strategy that has been used for decades by pension funds looking to match a stream of payments to retirees. For a pension fund, the liabilities are the benefit payouts owed to the pool of retirees. In the age of the 401(k), retirees are challenged with the same liability, but rather than being part of a pool of beneficiaries, individuals have to look to their own portfolio to replace their paychecks.
Income-matching, based on dedicated portfolio theory, is the most appropriate form of LDI for individuals. An income-matching portfolio can be characterized as a “smart bond ladder” where the portfolio matches a target income stream through a combination of coupon interest and bond redemptions. This approach integrates well with the financial planning process because the target spending needs flow directly from the capital needs analysis in the client’s plan.
To build an income-matching portfolio, individual bonds are laced together to match the target spending needs. Using a mathematical programming technique to minimize the cost, a series of certificates of deposit and government agency bonds deliver cash flows in the most efficient manner.
Downside Protection for Cash Flows
Unlike bond funds that face low or negative returns in periods of rising interest rates, an income-matching portfolio will deliver the target income stream, regardless of changes in value of the underlying portfolio. The bonds in the portfolio are intended to be held to maturity, and the combination of the coupon payments and bond redemptions make up the cash flows that fund the client’s spending needs. The cash flows are perfectly predictable (barring default on CDs and agency bonds) and are not affected by rising interest rates. In fact, the worst-case returns for a bond held to maturity are known the day it is purchased: its yield to maturity.
Because cash flows for spending needs come explicitly from the income portfolio, changes in the value of any equity holdings do not have any impact on the client’s retirement paycheck. Especially in times of market turmoil, this break from the market can provide skittish investors with more fortitude to stay the course knowing that several years of income have been set aside and are protected.
Sensible Withdrawal Rates
A personal pension strategy needs to deliver predictable, stable near-term cash flows to fund living expenses. It also needs to keep longevity in mind so that retirees don’t run out of money. Given the current interest rate environment, most clients are looking for a withdrawal rate that is above the yield curve. Conventional wisdom and a fair amount of research on sustainable withdrawal rates suggest retirees draw somewhere between 4% and 5% with some adjustment for inflation. As of Sept. 8, the 30-year CD/agency bond yield curve was yielding about 3.4%, so an all-bond portfolio clearly does not provide enough return to reach a 4% or 5% withdrawal rate.
Retirees looking to draw above the yield curve will have to take on some equity exposure to have a chance of reaching their goals. They also have to bear in mind that there is some uncertainty associated with taking on equity risk. An all-income portfolio would deliver many years of predictable income, but it also would not last 30 years. With a reasonable withdrawal rate, a balanced exposure to equities will provide a good chance that the portfolio will last the client’s lifetime.
Balancing Predictability and Longevity
A partial LDI approach allows retirees to balance the trade-offs between predictability and longevity. Retirees can capitalize on the predictable nature of their income portfolio in the near-term and higher long-term total return of equities in their growth portfolio.
From a behavioral perspective, splitting the portfolio into the income and growth sub-portfolios helps clients break out the goals of the income and growth portfolios distinctly. The purpose of the bonds in their income portfolio is to deliver predictable cash flows: a retirement paycheck. The equities in the growth portfolio deliver higher expected long-term total return. The income portfolio acts as a time buffer to help clients ride the periods of poor stock market performance.
Shortcomings of Traditional Income Strategies
When evaluating traditional approaches to retirement income like pure total return, dividends and REITs, it is important to consider how the approaches hold up in poor markets. Clients don’t invest in safe assets like bonds to ride through smooth markets. Pension strategies are meant to hold up when markets are melting down. Thus, we need to analyze common retirement income strategies through tumultuous markets to see if the approaches will provide predictability and peace of mind.
In retirement, a pure total return approach simply seeks to grow assets faster than spending needs. Total return is really a long-term growth strategy that is suited for the accumulation phase or to be parsed out to the growth portfolio. In decumulation, it exposes clients to sequence risk, particularly in a rising interest rate environment.
Withdrawals made either as a part of rebalancing or opportunistically, work fine when stocks or bonds have positive returns. It is years like 1969 that expose the soft underbelly of pure total return approach. Rising interest rates caused bond fund returns (as represented by the 10-year Treasury index) to drop by 5% while simultaneously the S&P 500 was down 9%. Where would a retiree look for income? They would likely have to sell assets into a declining market and dig an even deeper hole.
Dividends from stocks and REITs are a very important part of long-term total return, but they are a lousy source of predictable retirement income in periods of market turmoil. According to Standard & Poor’s, dividend payments from companies in the S&P 500 dropped by 23.5% from January 2008 to January 2009. Publicly traded REITs fared slightly worse than the S&P 500 according to Cohen & Steer’s, cutting dividends by 26%. Clients who relied on dividends for their paycheck suffered a 25% pay cut and may have been forced to sell equities into a declining market to make up the balance of their spending needs, which did not decrease.
By building a personal pension with an income-matching portfolio on the front end and a growth portfolio on the back end, retirees can balance their need for income and growth. Their assets serve the purpose for which they are best suited. Bonds provide predictable near-term income, protected from interest rate risk. Equities deliver the opportunity for higher long-term growth needed to replenish the income portfolio over time.
Stephen J. Huxley, Ph.D., is chief investment strategist and Brent Burns, MBA, is president of Asset Dedication LLC, in Mill Valley, Calif. They are both founding partners of the firm and can be reached via www.assetdedication.com or 866-535-0897.