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How to find investment income for retired clients

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In case your retired clients haven’t reminded you lately, it’s a tough environment for investors seeking portfolio income. According to the “Wall Street Journal,” in late July, money market funds paid an average 0.40 percent. Five-year certificates of deposit (CDs) averaged 1.39 percent nationally, 10-year Treasuries had yields of around 2.5 percent and the trailing 12-month dividend yield on the S&P 500 was 1.91 percent.

It’s been a while since retirees could count on generous earnings from their portfolios, and given the Federal Reserve’s policies, it could be years before we see significantly higher yields. Here are a few strategies to help advisors and investors cope in this tough environment.

Up the ladder

Bond ladders are a tried-and-true approach to managing clients’ bond portfolios. Russ Francis, CPA, CFP with Portland Fixed Income Specialists, LLC in Beaverton, Ore., continues to build muni bond ladders for higher-net-worth clients who want steady income. He generally keeps the maximum maturity to 12 years or less and sticks with investment grade bonds.

Bond ladders provide several benefits, Francis maintains. They help mitigate interest rate risk from falling and rising rates. If clients don’t need the principal from a maturing bond, then they can reinvest in the ladder. It’s also a low-cost solution, because there are no ongoing investment fees for holding bonds, apart from Francis’s quarterly portfolio management fees.

A modified barbell

A barbell strategy splits the client’s bond investments between very short- and longer-term bonds. Andrew Feldman, CFP, with AJ Feldman Financial in Chicago, Ill., has developed a modified barbell for some of his clients. He divides the clients’ fixed income holdings between “ultra-safe” investments (CDs, money market funds and cash) and more aggressive investments, such as high yield and closed-end funds. That approach allows him to create a fixed income portfolio with less risk than one allocated to all higher yield investments while generating a more competitive yield, he explains.

Safety plus potential

Any time you shift clients’ assets away from short-term or guaranteed accounts, you change their portfolio’s risk and most likely increase the odds of losing principal. Mo Vidwans, CFP, with Vidwans Financial LLC in Saline, Mich., has balanced the safety versus return question for some of his clients with bank-issued structured CDs. These accounts are FDIC-insured and are sold with a low minimum guaranteed return and a higher potential return tied to a basket of traded stocks. Each CD’s structure is different, but in general, if the stocks perform well, the investor earns a higher interest rate than the minimum up to some specified cap. Vidwans has two clients in structured CDs currently and says that this year they have earned 5.75 percent interest on their accounts.

A focused search for dividends

There’s a strong case for including dividend stocks in a retirement portfolio. Dividend stocks can be competitive: Many top U.S. companies have dividend yields of 3 percent and higher. Dividend-paying companies often increase their payouts regularly, providing shareholders with a growing income that can keep pace with inflation. Finally, these stocks have the potential for a higher total return from the combined dividends and share price increases.

Of course, dividends and share prices aren’t guaranteed. When companies cut or suspend their dividends, their share prices often get hammered—just ask bank stock investors who suffered through the 2008-2009 financial crisis. There’s also the question of valuation. Investors have been bidding up dividend stocks for several years, which could mean less potential share price appreciation over the near-term.

These potential drawbacks highlight the need for careful dividend stock selection. Christian G. Koch, CFP, CPWA, with KAM South LLC in Atlanta, Ga., believes regional bank stocks can avoid some of these problems. Dividend yields in the sector are in the range of 3 percent to 4 percent, and stock prices are near book value, he explains. Also, this sector tends to do well as interest rates rise in contrast to some other financial institutions.

Koch cites several examples of the regional banks to which his research has led him. St. Louis, Mo.-based Pulaski Bank (PULB) trades around $11 per share (all stats as of mid-July), slightly above book value, with a dividend yield of about 3.4 percent. Brookline Bank (BRKL) outside Boston is a $9 stock with a book value of $8.80 and a dividend yield of 3.7 percent. Another stock Koch has been buying is Northwest Bancshares (NWBI). It’s a larger institution with about $79 billion of assets; it trades slightly above book value at a $13 per share and has a 3.9 percent dividend yield. “If you can buy maybe 10 to 15 of these in a market basket with the yield-income perspective, it’s been a very attractive portfolio construction asset class for my clients,” he says.

Going hybrid

Bonds and stocks are not the only income-generating assets that your retired clients, especially those with higher net worth, might consider. Devin B. Pope, CFP, with Albion Financial Group in Salt Lake City, Utah, says that his firm has expanded its roster of income investments to include hybrids that have characteristics of both bonds and stocks. Examples include master limited partnerships (MLPs) that own oil and gas pipelines, preferred stocks, and floating rate bank loans. Other assets the firm considers include publicly traded real estate investment trusts (REITs) and business development companies (BDCs). In addition to providing higher yields, these holdings can increase portfolio diversification. The investments’ return can be volatile in the short term, but clients willing to hold them for the long term are more likely to earn the expected returns.

Albion Financial Group also uses these hybrids for its wealthier clients through a private equity fund of funds. Albion started offering these funds to accredited clients around 2005, Pope explains. The firm serves as a limited partner, collecting money from its participating clients and then investing in roughly half a dozen different private equity funds. The Albion Income Fund, the firm’s third fund of funds, invests with private equity managers that focus on yield-producing investments. Yields are higher on the private equity side, he says, and the fund has a goal of paying 8 percent to investors from its positions in MLPs, revenue loan companies and BDCs.

Lending to strangers

Here’s a novel investment strategy: making uncollateralized loans to strangers over the Internet. It may sound far-fetched, but that’s the basic idea behind peer-to-peer (P2P) lending companies such as Lending Club and Prosper. Investors willing to act as lenders provide funds; borrowers apply for loans that are priced based on the loan’s term and an assessment of the borrower’s creditworthiness. The lenders claim that their technologies allow them to offer credit at lower costs than traditional banks, and they share the returns with investing lenders.

When Jeffery Nauta, CFA, CFP, with Henrickson Nauta Wealth Advisors in Belmont, Mich., first learned of P2P lending from a client, his response was “lukewarm at best,” he says. After examining the lenders’ businesses and the technology platforms, however, his interest in P2P loans as a possible investment for clients grew. His firm now works with a hedge fund for qualified investors that invests in loans originated on Lending Club and Prosper. The yields are approximately 10 percent annually with very little deviation, he says.

Expanding the horizons

Many U.S.-based investors limit their income search to U.S. corporate or government securities. That domestic bias is understandable, both from the perspective of sticking to what’s familiar and a desire to avoid the additional risks of fluctuating currencies and unstable foreign politics. But it’s a shortsighted approach. Although the U.S. financial markets are very large, investing in foreign securities can provide attractive risk-adjusted yields and add portfolio diversification.

That’s the idea behind the Schroder Global Multi-Asset Income Fund (SGMNX), which launched June 23, 2014. According to Iain Cunningham, CFA, the fund’s manager, the fund’s goal is to deliver a real annual distribution rate of about 5 percent to investors and a total return of about 7 percent, with the distribution growing over time.

The fund plans to invest across multiple asset classes and national markets to accomplish that goal. The emphasis is on flexibility—the fund isn’t tied to an asset class, a benchmark or a national market. “We’ll invest anywhere in the world that we can find opportunities, we’ll invest directly and we’ll invest across all asset classes,” Cunningham explains. “We’ll invest across some 20 asset classes such as equities, all the fixed income asset classes you can think of from municipal bonds, emerging market debt, high-yield debt, convertibles, preferred shares and we’re doing that on a global basis.”

That approach exposes investors to an expanded range of both returns and risks, but Cunningham believes the fund’s strategy can help offset the potential risks. “By diversifying across lots of different asset classes, by diversifying across a lot of different securities, we’re hoping or seeking to diversify all the specific risks associated with those different things,” he says. “And, as we do that, we’re to lower the amount of risk that those investors are exposed to whilst maintaining the same level of yield that they can get from higher risk.”