At the beginning of 1980, a 10-year Treasury note yielded 11.13%. In 1990, 8.43%. In 2000, 6.68%, and in 2010, 3.63%. Now it stands at 1.36%. That’s a dramatic change for people heading into retirement or already there, who are focused on the level of income they can generate from their portfolios.

While the rule of thumb of a 4% withdrawal rate, which many advisors use and many clients expect, looks pretty reasonable when there’s an 11.13% yield on the 10-year treasury, at 1.36%, 10-year Treasurys are a non-starter.

So where should advisors be looking for income in such a low-income environment?

That was the question posed to three industry professionals at a Morningstar Investment Conference 2021 panel last week in Chicago. The panel included Jonathan Guyton, a CFP and principal of Cornerstone Wealth Advisors, a Minneapolis-based planning and advisory firm; Michael Finke, professor of wealth management at The American College of Financial Services with an interest in retirement spending, life satisfaction and cognitive aging; and Hong Cheng, a portfolio manager at Morningstar Investment Management, where she manages income strategies in both the asset accumulation phase and the decumulation phase.

Of the three, only Cheng was ready to talk investment details. Her portfolios have targeted payout ratios—for example, that 4% over a 20-year timeframe. Her concern, she said, is making sure the portfolios can deliver. 

“We really rely on our internal expected return forecast, what we call our capital market expectation, where we look at the fundamental drivers of the underlying asset classes and to try to predict what the return is going to look like,” she said, adding that she’ll use a good, old-fashioned Monte Carlo simulation to make sure the client will have at least a 90% success rate.

“You need to build in more flexibility in your retirement planning so that you can have more sources of income, especially in the earlier years,” Cheng said. “If the market takes a big hit, you need to be able to source your income from other [places] while looking for better return opportunities within [your portfolio].”

Cheng said she manages two types of income products. The first is built to preserve principal over a full market cycle while delivering a certain income goal, like cash plus 2% or 3%. “We call this an endowment-like model, where we are trying to preserve that principal over time, versus a decumulation model,” she said. The second is a more traditional drawdown model. “We have a target payout ratio for these portfolios, where people will draw down the asset while supporting a stable stream of income. Even with the current low interest rate environment, these portfolios could deliver something like a 4% withdrawal rate,” she said.

To achieve that, advisors have to look beyond traditional investment asset classes. Cheng looks on the equities side at what she called midstream energy companies. “These are in a niche market between exploration and the downstream companies, but they have lower price risk compared to upstream companies,” she said. “They’re less sensitive to energy prices, and they have great yield.”

Done right, investing for income through these kinds of equities could deliver what clients expect, and more, she said. “Not only could they support a stable income stream without touching principal while a client is in retirement, but there is also a good ending value at the end of the client’s time horizon, compared to a total return approach.”

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