The first rule of retirement income planning is: never run out of money. The second rule is: Never forget the first rule. It seems pretty straightforward. Where it gets complicated is negotiating between two equally valid but conflicting concerns
: the need for safety and capital preservation, and the need for growth to hedge inflation over the retiree’s life. Few people want to take high-flying risks with their retirement funds.
However, a zero-risk investment portfolio – invested only in safe income vehicles such as US Treasury bonds – will continue to reduce the value of the nest egg, even with very modest withdrawals.
As counterintuitive as it may seem, it is all but guaranteed that a zero-risk portfolio will not meet any reasonable economic goals. Equity-only portfolios, on the other hand, have higher expected returns but come with volatility that risks ruin if withdrawals continue during a down market. The right strategy balances these two conflicting needs.
A balanced portfolio
The goal will be to design a portfolio that balances liberal income requirements with enough liquidity to survive the markets. We can start by dividing the portfolio into two parts with specific goals for each:
- The highest possible diversification reduces the volatility of the equity portion to its lowest practical limit while providing the long-term growth needed to hedge inflation and meet the total return required to fund withdrawals.
- The role of fixed income is to provide a store of value to the distribution of funds and reduce the volatility of the total portfolio. A fixed income portfolio is designed to approximate money market volatility rather than trying to pull for yield by increasing duration or reducing credit quality. Income generation is not the primary goal.
Both parts of the portfolio contribute to the goal of generating generous sustainable returns over the long term. Note that we do not invest specifically for income; Instead, we invest for total return.
Total return vs. income
Your grandparents invested for income and crammed their portfolios full of dividend stocks, preferred shares, convertible bonds and more common bonds. The mantra was live off the income and never touch the principal. They chose individual securities based on their big fat juicy yields. That sounds like a reasonable strategy, but what they got was a portfolio with lower returns and more risk than needed.
At the time, no one knew any better, so we can forgive them. They did the best they could under the prevailing wisdom. In addition, dividends and interest were much higher in your grandparents’ time than they are today—and life expectancy after retirement was shorter. So, while not perfect, the strategy worked after a fashion.
Today, there is a better way to think about investing. The whole thrust of modern financial theory is to shift the focus from the selection of individual securities to asset allocation and portfolio construction, and to focus on total return rather than income. If the portfolio needs to be distributed for any reason, such as to support your lifestyle in retirement, it’s possible to pick and choose from asset classes to shave shares as appropriate.
Total return investment approach
Total return avoids artificial definitions of investment income and capital, leading to numerous accounting and investment dilemmas. It produces portfolio solutions that are superior to the old income-generation protocols. Distributions from any portion of the portfolio are opportunistically funded without regard to accounting income, dividends, or interest, or losses; We can refer to distributions as synthetic dividends.
The total return investment approach is universally accepted by the academic literature and institutional best practices. It is required by the Uniform Prudent Investment Act (UPIA), the Employee Retirement Income Security Act (ERISA), common law and regulations. Various laws and regulations have changed over time to incorporate modern financial theory, including the idea that investing for income is an inappropriate investment strategy.
However, there are always those who do not get the word. Too many individual investors, especially retirees or those who need regular distributions to support their lifestyle, are still stuck with grandfathered investment strategies.
Given the choice between an investment with a 4% dividend and 2% expected growth or an 8% expected return but no dividend, many people will choose the dividend investment, and they can argue against all available evidence that their portfolio is “safe.” ” Apparently not.
Total return on investment in action
So, how can an investor generate a withdrawal stream from a total return portfolio to support their lifestyle needs?
- Start by choosing a sustainable withdrawal rate. Most observers believe that an annual rate of 4% is sustainable and allows the portfolio to grow over time.
- Have a top-tier asset allocation of 40% to short-term, high-quality bonds and 60% (balance) to a diversified global equity portfolio of perhaps 10 to 12 asset classes.
- Generate cash for disbursement dynamically as the situation requires.
In a down market, a 40% allocation to bonds can support distributions for 10 years before any volatile (equity) assets need to be liquidated. In good times, when equity assets appreciate, distributions can be made by shaving shares and then using any surplus to rebalance to a 40/60 bond/equity model.
Rebalancing the portfolio
Rebalancing across equity classes will enhance performance over the long term by enforcing the discipline of selling high and buying low as performance varies between classes.
Some risk-averse investors may choose not to rebalance between stocks and bonds during down equity markets if they prefer to keep their safe assets intact. While this protects future distributions in the event of a prolonged equity market downturn, it comes at the price of opportunity cost.
However, we know that getting a good night’s sleep is a legitimate concern. Investors have to determine their preferences for rebalancing between safe and risky assets as part of their investment strategy.
The bottom line
In a low-interest-rate world, it’s easy for investors to stick with yield. However, even for a retirement-oriented portfolio, a total return investment strategy will yield higher returns with less risk than an income investment approach. This translates into higher distribution potential and increased terminal values while reducing the likelihood of portfolio funds running out.