If your middle-income clients will be depending upon their investments to fund a meaningful portion of their retirement standard of living, the traditional way of looking at saving and investing will not serve them well.
Until recently, a high percentage of middle-income people reaching retirement could look forward to maintaining their lifestyles through a combination of Social Security, a company pension and small amounts of savings. Now, and increasingly in the future, middle-income people reaching retirement will be depend upon receiving lifetime income from their savings and/or a lump-sum distribution from a company pension plan.
This creates a dilemma, as most people have never managed a significant amount of money without guidance through a pension or 401(k) plan. Even if you have successfully worked with these clients during the asset accumulation period, their needs will now be for income growth, not asset growth. Their primary need will be not to outlive their money rather than grow the assets to leave for their kids. A child's best legacy is financial freedom from parents during their retirement years. A parent's best reward is freedom and independence.
Here are some issues with which most people have little experience:
What are the types and severity of risk with which I must contend?
What kind of expectations should I have for investment returns?
How will taxes impact my decisions?
Can I meet my objective without buying stocks?
How do annuities work and can they be useful?
Do I still need life insurance?
For stock market investing, is indexing or active management better?
Should real estate be part of my portfolio?
How can I distinguish a good mutual fund or exchange-traded fund from a poor one?
Should I hire an investment advisor or do it all on my own?
If I am going to work with an advisor, how do I pick a good one?
Beyond basic medical insurance, do I need to provide for long-term care? If so, how?
How do I invest for income rather than capital appreciation?
What does my budget need to be when I retire?
One factor that makes it difficult for the financial services industry to refocus toward income is that investment advisors and financial firms are usually compensated from fees based upon assets under management. If an advisor or firm seeks to maximize income and guarantee it will last a lifetime by using annuities to systematically invade principal, the asset base for the advisor's or firm's compensation from this client is being reduced over time. In addition, only a life insurance company can provide lifetime annuity income-meaning that investment-only firms or advisors are less likely to recommend this solution. Too often, the advisor is more inclined to encourage his client to take more risk to enhance income, rather than recommending the safer route of systematically liquidating assets.
Another factor is that the advisors' clients may need financial services for which the advisor will receive no compensation. Such products might include long-term-care insurance; a reverse mortgage on a primary residence; and charitable annuities to provide income, tax savings and the desire to leave something to a favored institution.
Financial firms and advisors must develop the skills and capabilities to serve this growing market of income investors. They need to recognize that this new market, though needing new approaches, provides them a great opportunity because the number of clients needing their services will grow exponentially: It will be a challenge for the average middle-income earner to modify how he or she approaches saving and investing to provide for a secure retirement.
A New Look At Stocks
With ten-year government bonds paying less than 4% and the prospect of inflation, a plan that relies on fixed-income investments for future income results in the highest risk of outliving one's assets. The Bengen Study (1994) concluded that portfolios with 25% or less allocated to stocks were more likely to run out of money than portfolios with 50% or more allocated to stocks. Yet tax-free municipal bonds, Treasury bills and bonds, corporate bonds and bank CDs are the largest allocations for the typical retired person who is investing for income.
The period from 1982-2007 gave us one of the longest and largest bull markets in stocks. That quarter century of positive results has led an entire generation to look at making money in the stock market by trading stocks. Investors who were in the market from 1968-1981 didn't think that way in 1981-just as the giant bull market was set to begin-because the market had been flat for 13 years. Certainly, those in the market from 1928-1945 didn't see trading in the market as a potentially profitable activity-as the war ended and the great post-war prosperity was set to start-because the market had been flat for 16 years. The advent of widely practiced "day-trading" is a phenomenon produced by our recent and long bull market.
Unfortunately, the amateur day trader appears to do no better than the professional stock picker in beating the benchmark indexes.
Even those investors who are not active day-traders are caught in a habit I call "market-price myopia." Myopia is a fancy word for nearsightedness, meaning that you can only see things up close and therefore never see the whole picture. If you can only see a stock, fund or ETF from the standpoint of its market price and price movements in the near term, you miss much of the essence of the value of a company, fund or ETF. All you see and care about is the market price today and what you think it may be tomorrow.
This myopia leads to "hot stocks," "hot funds," "momentum investing," "a herd instinct," "asset class bubbles" and "buy high-sell low"! Myopia focuses the investor on playing for achieving his/her investment gains solely on market price appreciation rather than earnings or dividends of stocks. It generally leads the investor toward a bias of increasing his stock holdings in a bull market, and reducing his stock holdings in a bear market.
Our retired, or soon to be retired, investor is no dummy. He or she has been around long enough to have seen the trauma seniors suffer when the prices of their stocks drop substantially. He or she knows that in retirement years there isn't the time to earn it back. He or she, therefore, logically concludes stocks are not the answer.
Benefits Other Than Market Appreciation
I own my primary residence. It provides me with a place to live that I enjoy and in which I take pride. In 2006 and 2007, I was told its market value was nearly 2.5 times what I had invested in it. Now, in the fall of 2009, I am told that if I sold it I might be able to realize 1.5 times what I have invested. That is a significant drop in my equity in just two years!
However, at neither the market price in 2006-2007 nor the market price in 2009 is there a reason to sell my home. I had purchased it for the greater value of a home to enjoy and a wonderful place to live. Had I sold it at the top of the market, I would have had to replace it with another home that had the same intrinsic value plus a price low enough to absorb the sell/buy/move expenses. If I sold in this 2008-2009 depressed real estate market, I would still be faced with the same issue. Can I sell at the market price, absorb the costs, and buy something else with the same or greater enjoyment value? Market price on any given date has little to do with my decision to sell and buy a new home because what I am looking for is not connected to price, but enjoyment value.
As an income investor who needs to protect against running out of retirement funds to support their lifestyle, your client needs to have the same attitude about all his investments as I do about my home. Namely, the price at which you can sell an asset at a point in time is not the issue. Can the assets you own provide what you need (income) both now and in the future at a level that maintains your current lifestyle?
To achieve what your client needs requires owning assets that provide dependable and increasing income so that he/she is not dependent upon selling assets to provide that income. There are only three categories of publicly traded investments that can do that: dividend-paying stocks, real estate Investment trusts (REITs) and master limited partnerships.
Your retirement income investors may well be heavily invested in fixed-income products, which could lead them to the disaster of running out of money before they run out of life. Helping them move toward a significant commitment to dividend stocks, REITs and MLPs could be their salvation. How much commitment will depend upon your clients willingness to move away from the falsely perceived safety of bonds and CDs to the less risky income provided by equities.
Curtis R. Bryant, CLU, ChFC and CSA, writes in more detail about helping retirement-income clients achieve their goals in his new book, Investing for Income: The Retirement Dilemma. He has more than a half-century of experience in the financial services industry, and has worked as a life insurance agent, securities registered representative and as both a field and home office manager. In 1986, he and his wife, Pat, founded their own pension consulting firm in Southern California. He retired on December 31, 2008.