In a few weeks the calendar will turn to 2018, marking almost eight years since the 10-year Treasury bond last provided a 4 percent yield. The subsequent period of low rates has created a near impossibility for most retirees to “maintain principal” and the associated challenge for advisors to reorient client thinking. The dangers of “stretching for yield” have been well documented and the old axiom “if it’s too good to be true, it probably isn’t” has been regularly repeated. Despite these and other warnings, retirees’ demand for income is as robust as ever, along with the expectations they often place on their financial advisors, whether reasonable or not.
One potential solution advisors might consider leverages the great insights of recent Nobel Prize-winning economist Richard Thaler. Perhaps best known for his work on nudge theory, Thaler is also credited with illuminating the behavioral tendency of “mental accounting.” Thaler explains that people treat money differently, depending upon origin and intended use. While advisors are in the business of constructing efficient portfolios that maximize return per unit of risk, most individuals view their wealth in buckets or pots. In other words, while our industry creates holistic plans using the fungible asset of money, clients are often thinking in terms of “my retirement funds,” “my rainy day reserve” and “my vacation stash.” Success from the client perspective is often determined by whether there are sufficient funds available in a bucket to satisfy its intended use.
Having a better understanding of how people think, matching client objectives to various sources of income can help shift the discussion away from yield and toward cash flow. In our framework there are three tiers of income: anchor, cushion and yield. For most people, anchor income will include Social Security benefits and employer pensions. Depending upon the client, other sources may include royalties, rental income and annuity payments. Ensuring that anchor income will sufficiently cover essential expenses such as housing, utilities, food and insurance premiums can provide clients peace of mind that their most pressing needs are accounted for. If projected anchor income is short, converting a portion of the client’s portfolio to a guaranteed income stream may be an appropriate course of action.
The next step is to account for the client’s discretionary expenses. Examples include travel, making charitable or family gifts or other expenses that can best be thought of as “wants” or “wishes” rather than “needs.” A cash cushion equal to two years of discretionary expenses should be set aside to meet these expenses as they arise. Typically, cushion income is invested conservatively, generating some return, but with a primary objective of preserving principal. The reason why we believe it is important to set aside two years of cushion income is because it may help curb some clients’ tendencies to sell some investments, such as stocks, immediately after they have gone down in value.