The once standard 60% stock/40% bond retirement allocation has become another casualty of the new investment environment. The amount of income a retiree can expect from the 40% bond/fixed-income allocation can no longer be taken for granted. Investors (and their advisors) are going to need to work hard to create a predictable retirement-income stream.
The Rules Have Changed
As this low-interest-rate world shows no sign of changing, let’s look at some basic numbers. When a government bond yields 4%, a $1 million investment delivers $40,000 in annual interest. Today the tables have turned. In a market paying 2%, an investor needs $2 million in capital to annually receive $40,000. How do we react when many clients need 70%-80% of their pre-retirement income to maintain their retirement lifestyles? Where can one find the additional capital or higher yield to produce the same $40,000?
RISK, A ‘Four-Letter’ Word
An advisor's (and investor's) first priority is to protect and preserve capital. This makes risk generally something investors and their advisors try to avoid or at least minimize. While this is often true for many retirees and pre-retirees who cannot afford to lose principal, it is also important for others, such as the entrepreneur who has sold a business and is now depending on predictable interest payments to fund a lifestyle. Risk however, comes in several forms and even the so-called safest of investments carry some degree of it.
There is risk in every action and there is risk in taking no or very little action. This is opportunity risk. To build long-term wealth an investor must generally accept a certain risk level. Many would argue that investing in so-called risk-free investments such as high-yield savings accounts may be one of the greatest risks of all. While the investor takes what he believes to be virtually risk free, he may be practically guaranteeing that his capital will erode as its long-term purchasing power is weakened due to inflation plus tax on the small amount of earned interest. This becomes apparent when resources cannot provide the cash flow necessary to maintain one’s lifestyle.
Where Do We Turn?
If the 60/40 portfolio is dead, with what do we replace it? On the other side of the table, investors can frequently be heard asking: “Is that all?” In other words, for better or worse, the low-rate environment is whetting the appetites of many yield-hungry clients for riskier investments. Advisors need to keep clients’ needs in mind in light of this new environment as we decide whether such investments are appropriate.
In a low-interest rate backdrop some investors will undoubtedly consider leaving bonds in search of yield elsewhere. This strategy can have merit and may lead to a deviation from the traditional 60% (equities) / 40% (bonds) composition. It is true that alternative investments are no longer restricted to wealthy investors, pension funds and endowments. Many investors can now utilize non-correlated assets to potentially satisfy their yearn for yield.
One goal then is to identify low-beta (low-risk) quality equities able to pay (and possibly increase) dividend yields through all market conditions and/or work with low-volatility equity managers via mutual funds, exchange-traded funds (ETFs) or separately managed accounts (SMAs). It is imperative that each will have such attributes as a favorable balance sheet (including a strong cash position), seasoned and stable management, desirable, innovative products and/or services and a means to deliver them.
Where Do We Go From Here?
While Congress, the administration and the Federal Reserve Bank (the Fed) have provided significant stimulus to lessen the financial impact of this unprecedented economic slowdown, rates remain historically low. While this may help some parts of the economy, it is making it increasingly challenging to uncover investments paying competitive rates without excessive risk.
Markets, like economies, while arguably efficient, tend not to move in straight lines. They are erratic, making it nearly impossible to know when we have hit a bottom or reached a peak. But no matter which point in the market or general economy we are at, advisors must operate from the position that risk is always present.
Act now. Evaluate client plans to protect retirement purchasing power. Start by reevaluating overall allocations then dig into the fixed income/bond components. What is the income your plans now produce and at what risk? What‘s left after expenses and taxes? What happens to an income stream when a bond matures and the principal is reinvested at a lower yield while the cost of prescriptions just increased? The 40% bond/fixed income portion used to be the easiest to manage. The tides have now changed and may stay this way for some time.
Robert Wermuth is senior partner at Legacy Planning, an independent, wealth-advisory group in West Chester, Pa.