Marketwatch, April 5, 2014.
ROBERT POWELL
When building retirement-income portfolio, advisers tend to fall into one of two camps. There’s the save-the-principal-and-live-off-the-income camp. And there’s the income-is-income camp. Which should you choose? And how can you avoid making mistakes with your retirement-income portfolio?
Well, to be fair, that depends on many factors: How much you have set aside in your nest egg? What sort of income your pensions, including Social Security, will provide? And what sort of income might you might earn from employment while in your 60s and 70s. It also depends on your lifestyle, and how much income you need to support the retirement you desire.
But assuming you’ve worked through your budget, here’s what experts say you should think about when constructing a retirement-income portfolio.
Live off the fruit of the tree
Steve O’Hara, a certified financial planner and the founder of CLA Financial Advisors, said all investment questions are in the frame of financial planning. He suggested, for instance, asking the following questions: What are the goals for retirement income? What is a realistic time frame? How important is maintaining financial independence, or am I OK with relying on my children, or inheritance yet to come? Am I OK with “front-loading things,” that is, putting more expenses up front when I/we are healthy, and will be able to travel extensively, or is that putting us too much at risk?
In his practice, he assumes that clients will live to age 100. “So almost regardless of starting point/age, they need to live off the ‘fruit’ and not the ‘tree,’” he said. “In other words, they need to plan to spend income/appreciation, while leaving the principal base intact.”
If a person has investment assets and a home, planning on spending at about the 5% level, earning a little more, leaves them with a portfolio that can maintain starting purchasing power, he said.
“But this also means they need to be in equities for a measurable part of their portfolio,” said O’Hara.
For example: A 65-year-old couple has a second death life expectancy of 92 — on average one of them will live until that age. And a 3% inflation rate will double cost of living in 24 years for a couple who needs to fund 27 years. “So they need to accomplish 30 years of living off the fruit,” he said.
Don’t think only in terms of income
Meanwhile, David Mendels, a certified financial planner and director of planning for Creative Financial Concepts, suggests that retirees not think about income at all. “The biggest mistake retirees make is to think in terms of ‘income,’” he said. “The pursuit of ‘income’ does more damage to retirees than just about anything else.”
According to Mendels, “Income” is not even an economic concept. Rather, it’s a legal term deriving from trust law and now defined by state law. The concept, he said, goes back to feudal times and old English common law. “In those days wealth consisted of land and income — what the land produced — consisted of crops,” said Mendels. “There was no inflation. There was no capital appreciation. The land was the land and the crops were the crops.”
Yet the financial world is very, very different today. “While the essential intuition remains that by ‘preserving the principal and living off the income’ one is being a prudent steward of wealth, the pursuit of ‘income’ leads to increasingly concentrated portfolios of increasingly risky assets — and that is anything but prudent,” he said. “And this is especially so in today’s environment with interest rates as low as they are.”
Retirees don’t need “income,” said Mendels. “What they need is money to spend in reasonably predictable amounts at reasonably predictable times,” he said. “That is what they should be thinking of when constructing a portfolio.”
And of course they need to be concerned about inflation, about the effect of rising interest rates and about outliving their money. Plus, they need to be concerned about things that they can’t even anticipate, all in addition to being concerned about market volatility.
“The point, here, is not that market volatility doesn’t matter, but rather that too narrow a focus on market volatility while neglecting the other risks a retiree needs to be concerned about is not prudent, but reckless,” said Mendels.
Seek inflation-adjusted income
Rob Luna, the CEO of Surevest Wealth Management as well as a certified investment management analyst, said the primary purpose of a retirement portfolio should be able to distribute enough inflation-adjusted income to maintain the investor’s lifestyle throughout their lifetime.
“The obvious risk in this scenario becomes running out of money before they die,” said Luna, who is also co-author of “A Good Financial Advisor Will Tell You…: Everything You Need To Know About Retirement, Generating Lifetime Income And Planning Your Legacy.”
So, to balance these objectives, Luna said investors need to focus on consistency of returns or absolute returns instead of relative returns. “Many pre-retirees focus on how their portfolio performs relative to the S&P 500 SPX -0.12% ,” Luna said. “But when investors enter retirement, the focus needs to shift toward achieving the rate of return which is the absolute minimum to meet their income goals.”
The primary portfolio objective, he said, is no longer to beat the S&P. Rather, it’s figuring out what mix of investments gives them the highest possibility of consistently hitting their target with the least amount of risk. “Investors who take large hits early in their retirement are at the greatest risk of going broke,” said Luna. “I always tell clients if I was able to get you a 6% rate of return in T-bills that would make up the lion’s share of your portfolio today.”
The fact, said Luna, is risk and reward are both dynamic “so the balance of a retirees asset mix needs to constantly change along with the investment landscape.”
The most common mistakes
So what are some of the more common mistakes investors make when building/managing a retirement income portfolio? Well, according to experts, retirees can’t seem to strike a balance with their retirement-income portfolios. They tend to be either overly conservative or overly risky.
“Many people say that once they enter retirement that they will just ‘live off the income,’” said Luna.
But if you took that approach, you might find yourself living below your desired standard of living. Consider Luna’s example: In 1990 if you retired with $1 million dollars and put that money into seemingly safe 10-year Treasuries you would have started out collecting annual income of $82,100. By 2000, your income would have been cut to $66,600, and today, in 2014, you are sitting just marginally above the poverty line at $27,000 a year.
“Being conservative doesn’t mean blindly pouring more money into bonds,” said Luna. “The 30-year bull market in bonds, from 1982 to 2012, has caused many people to blindly believe in a traditional mix of say 60% bonds and 40% stocks. In today’s market that is a misguided and dangerous assumption.”
Other experts agree that being too conservative is a big mistake that retirees make with their portfolios.
“If they have a ‘pretty big pile’ of investment or retirement capital, they tend to think they need to be overly protective, and conservative,” said O’Hara. “Putting too much in bonds today, or cash in this volatile environment, is a most common mistake.”
Mendels agreed, saying: “Too great a focus on ‘income’ and market volatility while neglecting the other critical risks that they face.”
At the other extreme, Luna said retirees choose to pick stocks based off of highest yields. “The problem is sometimes a high yield is not sustainable by a company and could actually be a sign of deteriorating fundamentals,” he said. “If a company’s cash flow doesn’t support those dividends, the dividend is likely to be reduced or eliminated. In general building a portfolio simply on yield is a dangerous strategy.”
There is also a very real risk to being too conservative, Luna said. “I hear retirees say that they can’t invest in foreign markets or growth stocks because they are ‘retired,’” he said. “With people living longer, retirement can last upward of 30 years in some cases today. This means that you need money today, but also 15 years from now.”
To keep pace with inflation, Luna said investors should segment their portfolio in a way that addresses both short-term income needs but also balances future inflation.
In fact, Luna favors what some refer to as the bucket approach and others refer to as asset-liability matching. “Investors should have multiple time frames within the same portfolio,” he said. “The money for the next five years should be invested completely different than money for 10 years down the line and 20 years down the line. This is liabilities-based portfolio management.”
Another mistake to avoid is to take your eye off the ball. “Having a checking account with your brokerage allows you to supplement your spending in a way that you may not feel the amount dropping real rapidly,” said O’Hara. “Plan to do a budget-check frequently in the first three years.”
In fact, he recommends that you develop a budget and check how you are doing with it every 90 days. “If you have a total yearlong budget, even taking your total expenses, as seen in your checkbook, each quarter and comparing it to the plan will tell you quickly if you are creating future problems for yourself,” said O’Hara
What else to consider
What else should retirees and those saving for retirement consider when building a retirement-income plan? Are there things they often overlook or fail to consider fully?
Mendels said retirees cannot afford to focus only on retirement risk they might face. Instead, they must “strive” to mitigate all the risks they might face inflation, longevity, interest rate risk, market volatility and the like. “We don’t live in a risk-free world and we don’t do away with risks by simply choosing to focus our attention elsewhere,” said Mendels.
For his part, Luna said investors must never forget that “there is no set-it-and-forget-it solution” for retirement investing.
“They need to be forward looking and have the flexibility to adjust,” he said. “What worked over the past 20 years is unlikely to work over the next 20,” said Luna.
What’s more, he said retirees ought to beware of back-testing as it gives a false sense of security directing you to a portfolio that probably will fail. “We are in uncharted waters and investors need to think more dynamically,” said Luna. “This doesn’t mean to become a day trader; it just means that investors need to incorporate a much wider set of tools to address the potential risk scenarios. A good mechanic doesn’t only have a hammer in his tool belt. As you build your retirement portfolio in this environment you need to be more flexible than ever.”