New benchmarks for retirement income management

With retirement income management becoming the primary objective of many investors, it's time for new investment benchmarks which reflect that. For decades, investors have been using the S&P 500 or the Dow Jones Industrial Average as defaults for investment performance. But constructing portfolios that track those benchmarks is of little value for investors who must live off the returns on their portfolios. As anyone who has worked with retired investors knows, matching or beating a broad market index during retirement has no bearing on the investor's ability to meet his or her income needs for a 25- or 30-year anticipated retirement. For instance, in the recent cycle, if a portfolio was down only 54% when the S&P 500 was down 55%, the manager could take pride in beating the index, but it wouldn't have been much help to his retired client. That type of hit to the client's portfolio, coupled with a distribution, would substantially increase the odds of portfolio depletion during retirement. Thus, simply tracking a broad market equity index increases the risk that a retired investor will deplete his or her portfolio. Once an investor decides to live off the returns on his portfolio, the investor's holdings should be compared with an index or benchmark that is designed to help the individual meet his or her unique objectives. In my experience, retired investors generally have four primary portfolio objectives: current income, growing income, principal protection and capital gains. The objectives are listed in order of importance. Thus, a retired investor would place greater value on a portfolio that provided current income versus one that provided no current income but an opportunity for capital gains (or losses). At this point in the investor's financial life cycle, current income is more important than the potential for capital gains. Because capital gains cannot be predicted, and we can have long stretches of no gains (1999 to 2009 for example), the retired investor's portfolio should favor income over gains. That's not to say retired investors don't want capital gains, but in terms of priorities, the potential for gains is generally less important than current income and a reasonable degree of principal stability. To create an index that meets the unique objectives of retired investors, it must consist of securities that provide current income, opportunities for growing income, principal protection and opportunities for capital gains. That generally means an index that is comprised of both high-quality fixed-income securities, which provide the current income and principal stability, and equity holdings that provide opportunities for growing income and potential capital gains. While advisers will differ on how to select the securities, in general, one would need to consider a benchmark that incorporated those attributes. And the securities that made up the index must provide investors with a high degree of certainty that the specific securities will meet the index objectives. For instance, if you were going to use fixed-income holdings for principal stability, one would need to select bonds that are of the highest quality, so that in a financial crisis, the bond values wouldn't decline as a result of concerns about credit risk. And the bond holdings would need to be well-diversified to protect against the default of any individual issuer. If one were going to use dividends as a source of growing income, the index would need to be comprised of companies that have a high probability of paying their current dividend and also increasing that dividend over time. Not all companies in an index like the S&P 500 or the Dow meet those criteria. Moreover, it may not make sense to have a market-capitalization-weighted index for retirement-income portfolios. In a market-cap index, the largest companies obviously have the largest portfolio weightings. But if the investor's objective is income, by holding concentrated positions, a dividend cut by a large company would have a disproportionate impact on the retired investor's opportunity not just for current income, but also growing income. An equally weighted approach may make more sense if the objective is stocks that can pay and increase dividends, as opposed to stocks that can help a manager match a broad market index. Thus if you have a cut by one company, the effect is minimal on the total income potential for the index. The main point is that the industry needs to begin to educate investors about the unique investment objectives of retirement income management. Simply benchmarking off a broad-based stock or bond market index is not sufficient to meet the objectives of those investors who must live off the returns in their portfolios. Broad-based indices may be appropriate for investors with long-term total return objectives, but not for investors with immediate income and principal protection needs that must also be balanced against longer-term opportunities for growing income and capital gains. We have elected to address this issue by creating the Farrell-Northstar Retirement Income Index (FNRI Index), which is an index that tracks securities that provide opportunities for meaningful current income, growing income, principal stability and long term capital gains. If you are interested in learning more about the FNRI Index and its components, you can visit www.northstarinvest.com While this is an index that we believe works for retired investors, other advisers will, of course, elect different approaches. But again, the point is to encourage your client's to think differently about the portfolio objectives that they value once retired, and to benchmark their portfolios against an index that incorporates those objectives. Don't be a slave to broad-based market indices because they probably don't meet your retired clients' investment needs. Charles J. Farrell, J.D., LL.M., is a principal with Northstar Investment Advisors in Denver, and author of Your Money Ratios: 8 Simple Tools for Financial Security.