Retirement income management requires advisers and clients to adopt a different investment strategy, because the strategies that helped investors accumulate wealth may be a recipe for disaster once they need to live off the wealth.
History can help us understand the difference.
Traditional portfolio management relies primarily on capital gains for total return. Income and cash flow are secondary considerations. That makes sense as long as investors have a sufficiently long time horizon to wait out the volatility in the equity markets and wages serve as the source of investors’ annual income.
But once retired, investors need constant portfolio distributions to fund their living expenses. Sticking with the traditional method of portfolio management and relying on capital gains to fund these distributions may lead to major problems with funding distributions.
If you analyze historical stock market returns, it appears that advisers should be able to count on capital gains as the primary source for funding distributions. The long-term rate of return for equities is about 10%, and the stock market goes up about 70% of the time. If retirees generally take distributions of 4% to 5% a year, what’s the problem?
The problem is that stock market returns are random and unpredictable. While the market goes up about 70% of the time, it doesn’t follow a pattern of going up for two years and then down for one. During some cycles, the market can go up for 15 to 20 years and then down for five to 10. Over the last 110 years, we have had a number of these long-term cycles with extreme positive and negative returns.
We are currently experiencing one of these cycles. Consider that from 1982 to 1999, the stock market basically went up. And from the peak in 2000 to the low point in 2008, it went down. The Standard & Poor’s 500 stock index is not back to the high it reached in March of 2000. An eight-year cycle with no equity appreciation can be a big problem if an investor is relying on capital gains as the primary source of distributions.
WILD CARD
In any given year, there are three sources of funds available to meet distribution needs: interest, dividends and capital gains. Interest and dividends can be calculated with a reasonable degree of certainty. Capital gains are the wild card.
Because retired clients need income, advisers should reverse the priority of returns by focusing on income first and capital gains second. By creating a high-yield portfolio, the income from dividends and interest can be use to fund the majority of the 4% to 5% distribution. Capital gains, if available, can then serve as the bonus to enhance distributions and keep up with the effects of inflation.
With some planning, even in today’s lower-yielding environment, advisers can structure retirement income accounts with yields between 3.5% and 4%. This type of an account generally requires a larger allocation to fixed-income assets and higher-dividend-paying stocks.
Once the cash flow is secured, the account has tremendous staying power. During declining or stagnating equity markets, the cash flow can be distributed to fund the majority of the client’s income needs. If the adviser also holds a small cash reserve of 5%, the cash can be used to fill the gap between the yield and the annual distribution. Assuming that the gap is somewhere between 0.5% and 1%, the distribution needs could be funded for five to 10 years without ever selling any equities.
Having a source of cash flow to fund distributions gets time back on the retiree’s side. Once the retiree has time, he or she can invest in equities for their long-term appreciation. But without the cash flow, the retiree may be forced to liquidate his or her equities at the worst time.
Selling capital to fund distributions during bear market cycles poses the biggest threat to the sustainability of a retirement income account. Based on what we know about the history of the markets, retirees are likely to face at least one major bear market cycle during their anticipated 30-year retirement.
As clients move into their retirement years, it is important for advisers to educate them about the difference between investing to accumulate wealth and investing to live off their wealth. Initially, clients may be apprehensive about changing their investment strategy, particularly because the old one may have worked just fine. The key to the education process is to let history illustrate the difference.
