If there is one thing that most knowledgeable financial advisors agree on it is that building sustainable retirement income portfolios is more challenging than building accumulation portfolios. With accumulation portfolios, time is on your side, and you can compensate for a few years of subpar returns in the future. Once clients retire, however, a few years of bad returns can seriously hurt their ability to withdraw from their diversified portfolios.
Ever since Bill Bengen's seminal article, "Determining Withdrawal Rates Using Historical Data," appeared in the October 1994 issue of the Journal of Financial Planning, advisors have been struggling to come up with retirement income plans that allow clients to live comfortably without the risk of outliving their nest egg. Bengen's initial work focused on determining the dollar amount that clients could safely withdraw annually without outliving their portfolio, as well as the asset allocation of the portfolio. This research was the basis of the widely quoted "4% rule." This "rule" is really just a guideline for determining sustainable withdrawal rates for a given client. Bengen and others have since that time built a lot on the initial research.
To this day, many advisors and their clients approach retirement income planning in one of two ways: They either begin the process with a rule-of-thumb "safe withdrawal rate," still using 4% as the standard. Or they start out with a predetermined "need," such as $80,000 per year adjusted for inflation annually, and then select a portfolio with the expected return sufficient to provide the necessary income (taking into account Social Security and other income sources) at the appropriate level of risk. This risk is commonly defined as the standard deviation of the portfolio.
Manish Malhotra and his fledgling firm Fiducioso Advisors are trying to introduce, through his Income Discovery software, now in beta, a retirement income planning framework that is superior to the methods that have come before. The software itself is relatively easy to master, and the output provides information that clients should readily understand.
Although the Income Discovery venture is new, Malhotra is no novice when it comes to wealth management or financial software. He has spent the last 12 years working for financial firms in various roles ranging from corporate banking to IT architecture. Before creating Income Discovery, he was a senior vice president at Citigroup Global Wealth Management (Smith Barney and Private Bank) leading the IT strategy and architecture function. His team was responsible for building the IT architecture of an integrated desktop for financial advisors and private bankers, a multiyear initiative. He led technology evaluation of major financial planning software while at Citigroup. Before that, he led the IT architecture for enterprise risk systems at Bank of America. He started his career as corporate banker with a leading private financial services firm in India before moving into software at Dresdner Kleinwort's subsidiary in India. He is an engineer-MBA from top schools in India (the Indian Institute of Technology and XLRI).
Income Discovery's calculation engine is powerful, but at its core, what it does is illustrate the interplay between four factors: the level of sustainable income, plan failure rates, the potential life of a portfolio in a "bad case" scenario and the average terminal value of the portfolio. Some comprehensive financial programs can do some, if not all, of what Income Discovery does, but most can't do it as effortlessly, and most can't illustrate on one screen the interplay of the four factors as well as their effect on the income portfolio.
The other interesting aspect of the program is its ability to model the trade-offs inherent in selecting one of three retirement income strategies: a systematic withdrawal plan from a traditional diversified portfolio of stocks, bonds and cash; a joint and survivor annuity (the default choice is one that pays 100% of the benefit when both spouses are alive and then pays 75% of the benefit after the death of the first spouse); and a maturity matched portfolio (MMP).
The concept of a maturity-matched portfolio is similar to that of a bond ladder; however, in a bond ladder, you roll over the principal. With an MMP, you use the interest (if any) and the principal to supply a required cash flow for a stated period of time. For example, if you wanted to provide income for the next five years annually, you could buy zero-coupon bonds with maturities of one, two, three, four and five years. Of course, you could build this MMP in other ways, but this is a simple example. The point is that at the end of the five years, all principal and interest from the portfolio would be depleted.
Matched-maturity portfolios are particularly helpful in mitigating the risks associated with the sequence of returns during retirement. The impact of the sequence of returns can be critical in retirement because if the worst returns come during the first two years of retirement, the damage to an income plan can be severe. In a typical portfolio of stocks, bonds and cash, assuming spending is constant, the client may be forced to liquidate some assets at low prices in order to fund the cash flow needs, resulting in accelerated portfolio depletion.
MMPs help ensure against the risk of a bad sequence of returns by ensuring the required cash flow for the desired period of time. Admittedly, MMPs are not the only method of providing the needed cash flow. You could, for example, hold the money required to fund the cash flow in cash; however, with very short-term rates near zero, MMPs may be preferable for periods of over a year or two.