It's no secret to the advisor community that the baby boomers are entering the traditional age for retirement this year. En masse, their (and our) primary financial mindset must shift from a lifetime of building wealth to a relatively ill-defined but likely lengthy period of spending as much of it as is prudent ... while sustaining some level of wealth in the process.
Going Institutional
How to achieve this delicate balance? A recent article in The Wall Street Journal, citing a Vanguard Group analysis, points to the intriguing observation that there are actually two distinct groups of investors facing the same critical need to meld spending and capital preservation needs:
1. Retirees
2. Endowment funds/institutions
Like retirees, endowment funds have ongoing, annual spending requirements where the goal is to reasonably determine appropriate withdrawal rates over time, amidst evolving funding needs and market volatility. And yet, surprisingly, we find few examples of institutional funding models applied to retirees' planning needs. By mining ideas from the most successful institutions (such as David Swensen's Yale Endowment Fund model) and amalgamating them with the smartest individual investment solutions (low-cost, index-style investing), advisors can best position retirees to enjoy their golden years.
Flexibility Is the Key Ingredient
Traditionally, retirement spending rates have been calculated by applying William Bengen's 4 percent to 5 percent "safe withdrawal rate." We agree with the sound logic of this widely accepted strategy. But, as reflected within the Vanguard analysis, the overall planning process also requires ongoing flexibility to address evolving personal circumstances as well as the ever-volatile forces within the markets and the economy. As the Wall Street Journal observes, if retirees rely exclusively on the safe withdrawal rate, they "may be overlooking some basic variables -- such as current interest rates and stock valuations -- that will have a direct impact on how long their money lasts."
In other words, the safe withdrawal rate is a good first step, but without ongoing flexibility, a gap emerges, into which a retiree's portfolio can stumble and fall. An institutional model can help bridge this gap.
Strategy Applied To Reality
At our firm, we have turned to David Swensen's Yale Endowment Spending Policy as an appropriate model to layer on top of the initial safe withdrawal rate, to help determine ongoing spending rates. To this, we add a component of account management, in which retirees' riskier, wealth-building investments (equities) are separated from their predetermined number of years' worth of annual "retirement salary" (fixed income). The results look something like this, in process and structure:
1. Effective spending rates based on the Yale Endowment Fund strategy - Enhancing the traditional Bengen-inspired "safe withdrawal rate" to reflect the more nuanced realities of how markets and the economy impact retirees spending rates.
2. Portfolio construction based on passive investment vehicles - Investing with low-cost, index-style solutions, according to the academic evidence on how markets efficiently deliver premium returns over time.
3. Capital preservation through appropriate market/risk exposure - A separate, all-equity account using low-cost, index-style solutions provides market exposure in accordance with individual capital needs.
4. Withdrawal/spending through a twist on traditional asset allocation techniques - A separate income reserve account holds 5-10 years of "retirement salary" invested in short-term fixed income and cash equivalents. This is the equivalent of addressing individual risk tolerance via traditional fixed income allocation.
5. Managing evolving needs and circumstances - Using the withdrawal strategy of the Yale Endowment Fund model, we apply a back-weighted withdrawal formula to smooth out cash flow, with a performance logarithm based on recent returns to adjust retirement salary spending rates.
This structure offers a number of distinct advantages over the more traditional approaches of simply layering the Bengen-based safe withdrawal strategy on top of an existing wealth accumulation plan or loading up on costly variable annuity products.
Smoother, More Realistic Decision-Making
By running quarterly performance logarithms we determine how much, if any, of the equity investment account should be sold to fund the income reserve account. This allows the income reserve account to float below its targeted number of years when equity returns are down, and then refill as equity returns outperform historic averages. It supports a "buy low, sell high" approach, as well as a realistic way to assess when it is alright for clients to spend a little more freely, and when it may be time to recommend modest belt-tightening.
An Enhancement on the Theme of Asset Allocation
Among the greatest challenges advisors face is helping their clients choose -- and remain invested in -- the "right" asset allocation for them. Using separate accounts for the equity/fixed income allocations affords a different perspective on risk, placing it in a context that investors can more readily understand.
A client's initial retirement salary will be set at 4 percent to 6 percent of the overall portfolio value, based on the 4 percent safe withdrawal strategy and modified as needed for individual circumstances. Next, we ask clients to imagine how many years of safely stored retirement salary they need to alleviate their fears of market volatility. For some, six years of "safety net" is plenty. Others may prefer eight or 10 years of income reserve to confidently ride out stormy markets.
To the advisor, this can handily translate to an asset allocation of roughly 70/30 equity/fixed for a 5 percent, six-year reserve; or 50/50 equity/fixed for a 5 percent, 10-year reserve. But investors can more comfortably contemplate the same question in terms of years. When the talking heads on TV are crying that the sky is falling (again) he or she can clearly see that the next 6 years to 10 years of retirement income is protected in an account where the bottom line isn't getting smaller.
Assessing The Model
To confirm our assumptions, we conducted a behavioral survey of more than 40 highly affluent investors throughout 2009. Even with identical end returns, would participants respond differently to an aggregated, traditional 60/40 equity/fixed income account statement, versus a separated account strategy? We presented each model (in a variety of market conditions), and asked participants about their perceptions and preferences.
Most (88 percent) recognized performance to be the same or better within the separate account model.
Interestingly, even though underlying performance was the same, just over half perceived the separated account portfolios to have performed better.
Almost two-thirds indicated they felt better about their money with the separated accounts.
In other words, the data supported our intuition that retirees appreciate the clear view that the separate account structure affords them of a prudently modeled investment portfolio.
In our mind, perhaps the greatest dangers investors face in retirement is the inability to remain true to a carefully planned strategy that reflects their goals and their vision of what retirement means to them. At our firm, we devised our "Strategic Allocation for Income and Longevity," or SAIL program to address this concern. By seeking to deliver an overall financial experience that focuses on employing smart strategies in an understandable way, we believe retirees stand the best chance to keep their eyes on the horizon and avoid the motion sickness that near-view market volatility can otherwise so readily cause.
Grant Blindbury, CFP® is a partner at FMB Wealth Management, an independent RIA, in Westlake Village, Calif. His practice is focused on coordinating the advanced planning and longevity planning for early retirees. You can reach him at [email protected].