Many of us at Thornburg are baby boomers, and we are amazed by the disparity in the retirement income discussion within the financial advisor community. The discussion ranges from a simplistic comparison of product features to one that is academic and grounded in a holistic financial planning process. For those advisors who take a process approach to retirement income, there is a broad body of academic research regarding spending policies, tax planning techniques and evolving asset allocation strategies. The goal of this research is to enhance the client’s annual spending in retirement and the sustainability of the retirement portfolio for 30, 40 or possibly 50 years.

In our opinion, only a few of the retirement products now available have a place on the market. So many are overpriced or too complicated, and most require loss of control over assets. We know the so-called retirement-income product industry is bracing for a wave of capital from baby boomers, but we do not believe it will materialize because the products cost too much and investors are loath to lose control of their hard-earned assets. This reluctance will create an opportunity for knowledgeable financial advisors to assist baby boomer clients. During this pivotal stage of life, boomers’ accounts will need to be consolidated under one advisor to accommodate implementation and monitoring of a retirement-income process. To participate in this opportunity, advisors need to know about all the tools available to structure retirement portfolios and be committed to staying abreast of all the academic research that is being done in this area.

Building Sustainable Retirement ­Income Portfolios
In 1994, William P. Bengen, CFP, pioneered research into sustainable retirement income portfolios and establishing appropriate withdrawal rates when he  published “Determining Withdrawal Rates Using Historical Data.” Using historical returns data, Bengen tested 50 different 30-year retirements that ran from 1926–1955, 1927–1956, 1928–1957, and so on up to 1975–2004. The analysis covered many business cycles and included four major bear markets. A major bear market was defined as one that lasted more than one year and consumed 50 percent of the retiree’s purchasing power after factoring in effects of both the S&P 500 Index decline and inflation. Needless to say, major bear markets have a devastating effect on any portfolio, but they especially impact those also undergoing withdrawal.

As a result of this research, Bengen is credited with establishing the 4 percent withdrawal rule (or “SAFEMAX,” to use Bengen’s vernacular), which states that for a retirement portfolio with a beginning value of $1 million, a retiree can spend $40,000, or 4 percent per year, and increase the annual spending amount by an annual cost-of-living adjustment. Bengen concluded that at this spending level, there was a 100 percent probability that the portfolio would last at least 30 years. Since then, Bengen has developed asset allocation models and withdrawal methods to find ways to increase the withdrawal rate without affecting the portfolio’s sustainability.

In 2006, Bengen wrote "Conserving Client Portfolios During Retirement" as a review of his research. The book also provides an eight-step process for developing a withdrawal rate and retirement-income portfolio tailored to a client’s needs. Bengen studied how various asset-allocation strategies affect both the withdrawal rate and sustainability of a retirement portfolio in distribution. For instance, he concluded that the optimal equity allocation was 60 percent, with the remaining 40 percent allocated to intermediate-term government bonds. He studied how the addition of small-cap stocks to a retirement portfolio could offer diversification benefits while allowing a retiree to increase the withdrawal rate or have greater confidence in the portfolio’s sustainability.

Many academic studies have sought to determine the benefits of allocating a portion of equity to various asset classes including small-cap, real estate investment trusts and international stocks. We found limited information, however, on how a high and growing dividend total-return strategy might benefit a retirement portfolio that is under the duress of withdrawal. While several academics have studied high and growing dividend strategies — most notably Jeremy Siegel at Wharton in his book Future For Investors — all these earlier studies proceeded from an accumulation perspective.

To advance this research, we analyzed a hypothetical retirement portfolio with an allocation to high-dividend paying stocks. We found that this focus on dividends had a significantly positive impact on both the portfolio’s withdrawal rate and its sustainability. While it would be optimal to spend merely the dividend income that a retirement portfolio provides and preserve the corpus for a legacy, this option is only practical for the wealthy minority. Most retirees will need to spend dividend cash flow and principal to sustain a retirement of 30 years or more. Regardless, we found that using a strategy focused on companies with high and growing dividends alleviates the stress of regular withdrawals and enhances the amount available for a legacy.



 

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