James Dew’s business is booming these days. He’s seeing a rush of new business from pre-retirees and retirees who are disillusioned with their current advisor now that their portfolios are, in many cases, badly depleted. Like other advisors and retirement income planning experts, Dew, president of Dew Wealth Management in Scottsdale, Arizona, knows precisely why these clients lost a sizeable portion of their wealth: many advisors used retirement income strategies that failed to adequately assess client risk and thus couldn’t weather the market maelstrom.
Indeed, in the quest to generate retirement income for their clients, many advisors relied on their investing-for-accumulation roots, and therefore were not focused on retirement income planning. “True retirement planning first begins with an assessment of the ultimate risk a retiree faces, which goes beyond pure capital risks,” says David Macchia, president and CEO of Wealth2K. “When advisors fail to recognize or manage these risks properly, clients’ retirement security can be extremely harmed. This is what happened in many cases.” Retirement income investing begins first and foremost, Macchia says, “with creating a retirement income floor–a guaranteed income floor–to handle that client’s essential expenses. When you’re using a systematic-withdrawal-type methodology to produce returns, that’s not accounted for.”
Advisors latched on to the systematic withdrawal method back in the go-go stock market days of the 1980s and 1990s, when it was typical for people to “retire at 65 and be dead at 72,” Dew says. In those days, advisors started creating portfolios of stocks and bonds for retiree clients and then, in order to generate income, the advisor would just set up a certain amount to be automatically withdrawn each month (typically 4% to 6% per annum of a portfolio’s value) and deposited into the client’s checking account, notes Dew. So the client’s portfolio, says Dew, was concentrated in “conservative investments that generated income.” Anything left over was placed in growth stocks. That approach works well when the overall markets are doing well. “But when the markets don’t cooperate,” says Dew, “instead of using interest or capital gains for income, you may be spending principal.” When that happens, Dew drolly points out, “it dramatically impacts a portfolio.” Plus, nowadays people are retiring at age 50, 55, or 60 and living to 80 or 90.
What’s more, the tired mantra “the markets always come back,” which advisors use to reassure worried retiree clients that they’ll recover their lost money, doesn’t hold water when money is being withdrawn from their account–and when the market continues to perform badly. “If you’re taking no money out of a portfolio, yes, you can sit and wait for the market to come back and you’ll be fine,” Dew says. “But if you’re withdrawing from a portfolio, you’re doing reverse dollar-cost-averaging and selling a large number of shares at lower dollar values, and that’s just a spiral downward. That’s where people get afraid of running out of money.”
Dew says clients of other advisors who’ve used the automatic withdrawal method–who’ve lost anywhere from one third to half of their portfolio’s value–are now coming to him looking for a solution, which he says he has. Right after the market crash of 2001 and 2002, Dew set up a retirement planning strategy in which he sets at least a 10-year time frame on equities–meaning a client won’t need to touch the money in equities for at least 10 years. Then for the first 10 years of a client’s retirement plan, it’s essential to have “reliable, dependable income from safe, conservative sources,” Dew says, “even if that means having three to five years of cash.” While the rate of return on that cash isn’t going to be good, he argues that “you have to have somewhere to get the income in a reliable, predictable fashion” without relying on the markets cooperating. That means turning to money market funds, laddered Treasuries, laddered high-credit-quality corporate bonds or laddered munis, and CDs, he says.
A Closer Look at Risk
Dennis Gallant, president of GDC Research in Sherborn, Massachusetts, says that advisors who have used a “more deliberative” approach to managing money for retirees, and not one based on their accumulation strategy, more closely scrutinize the retiree’s risk. These advisors “look at retirees and say, ‘We’ve got to deal with longevity issues and inflation, but we also have to mitigate risk,’” Gallant says. “I think that approach has fared well in this marketplace compared to those [advisors] who had taken a slightly modified, less risky approach to managing a portfolio” for their retiree clients.
Macchia agrees. “Advisors have to have a greater sensitivity to the multiple risks retirees face. They have to manage those risks more efficiently than they have, and that includes more than products–it includes assessment of the client’s human capital opportunities, social capital opportunities, and investing capital by only exposing the appropriate portion of that to upside potential, but first establishing an income floor. That’s much different than the way many advisors have been approaching [retirement income planning] traditionally.”
Before totally throwing a wrench into the automatic withdrawal approach, however, there are retirement experts who say that the universe of advisors performing retirement income planning are actually pretty evenly split in their opinions about whether retirement income planning strategies can successfully mirror accumulation strategies.
Howard Schneider, president and founder of Practical Perspectives, a consulting firm to the asset management industry in Boxford, Massachusetts, says that research his firm has conducted found two schools of thought among advisors when it comes to retirement income planning.
One group looks at delivering retirement income using the same approach they use for clients in the accumulation phase: “building a risk-adjusted total return portfolio, and following the classic rule of thumb within the financial planning industry to take down between 4% and 6% of the portfolio each year which becomes the income stream. If you do that for the client, the portfolio should last for an extended period of time,” he says. The second school of advisors–almost equal in size to the first–believe that a strategy that works for accumulation doesn’t work for retirement income. “These advisors gravitate to what we, and others, call the ‘pooled’ or ‘bucket’ approach,” says Schneider, “where they are trying to bulletproof the income, at least over the short term, by allocating specific assets to income-generating securities or vehicles and then progressively investing the other assets in riskier securities or buckets that go out over time.”
Advisors who use the “bucketed” approach for their clients say “they’re able to keep their clients invested in the equity market over time because the clients stay calm during periods of volatility,” Schneider says. Macchia of Wealth2K concurs that it’s much easier to keep clients invested in volatile markets when advisors mix guaranteed and non-guaranteed products.
Macchia presents the scenario this way: “Let’s say an advisor and a client were using a diversified investment portfolio and taking systematic withdrawals to produce income. When the client starts to see that the values in the portfolio are dropping, and dropping precipitously, in some cases the client will say, ‘I want to sell out and take that equity money off the table.’ Once that loss is booked, that money is gone, and the income-generating capacity is diminished.
“So if you had a different kind of strategy–let’s say you’re using a little more complex strategy, maybe a combination of products like income annuities–the security that the client has knowing that the income paycheck is going to be coming each month is very important. It probably will help that client keep the equity positions through even a volatile market.”
Schneider says the jury is still out on which strategy is better–the consensus is that it really depends on the type of client–and “it will probably play out over time and we’ll learn more.” But there are some advisors who are thinking of combining the two approaches and “creating a layer of guaranteed income in the portfolio by using annuities or laddered munis or laddered Treasuries and then putting the rest of the portfolio in a diversified allocation approach for the future.” Schneider notes that it’s interesting that many advisors began moving away from “the total return approach, at least in the years preceding this market, and have decided to take another approach to the marketplace in terms of retirement income.”
Target Date Funds Exposed