Retirement Income Strategies For Today's World

You can be young without money, but you can’t be old without it.

-Tennessee Williams

The current environment for retirement income distribution is one of the worst ever. Not only are investors facing low future return realizations from an ultra-low interest rate environment and high equity valuations, but longevity risks are increasing. Financial advisors are facing a perfect storm of variables that are making their objective (making sure their clients' assets last their lifetimes) exceedingly difficult.

Outliving your assets is increasingly likely unless your portfolio and financial plan are setup in a way where you do not draw down assets. For most of us, this isn't a possibility given portfolio size.

The perfect storm is approaching. The World Economic Forum recently notedthat by 2050, the world economies will be facing a nearly half a quadrillion dollar shortfall in retirement savings. A quadrillion is 1,000 trillion! The U.S. is the country with the largest deficit at $137 trillion.

John Mauldin recently cited the longevity problem, with people born in 2007 on average projected to live to 103. If they retire at 65, it means that more than half will have had roughly the same amount of retirement years as working years.

The shortfall is driven by chronic underfunding of entitlement plans, pension plans, and healthcare costs on a macro level while consumers fail to adequately save early and enough money for their golden years.

So how should investors solve this problem?

The preferred method of retirement distributions is like saying who makes the best pizza; it's going to be very retiree-dependent. The key variables that the retiree needs to consider are the amount of risk they are willing to take and their ultimate goals.

Those goals could include leaving a specific legacy to their children or favorite causes, or simply spending every last dime they have. For most of our clients, we plan to get them to become a permanent investor that can weather the vagaries of the market without worry.

Sequence of returns risk is likely the highest it has ever been. This is the risk that your portfolio takes a large drawdown just as your retire and start withdrawing from it. In those scenarios, the assets that have been withdrawn to meet your lifestyle need are no longer in the portfolio to experience the rebound. Asset manager Blackrock has an investor education piece that details the current dilemma.

Why is the sequence of returns risk the highest it has been? Namely we have never seen equity and fixed income valuations so high at the same time, just as so many are retiring or set to retire.

One of the other major problems facing retirees is the lack of what we call "base income." Social security is the primary base income source today - though it has been diminished by low cost of living adjustments and age increases. Previously, retirees could rely on defined benefit plans (pensions) to supplement their social security creating a significant amount of base income to meet their lifestyle needs. Most retirees today no longer have such plans.

As an aside, we almost always recommend taking the lump sum to remove the "credit risk" of the pension. We have written previously on defined benefit pensions being largely unsustainable, leaving retirees at risk of significant cuts in their payment streams. (We have a new piece coming out soon on it as well.)

The Permanent Investor Approach relies on early planning to make sure that goals align with savings. In other words, spending "wants" need to be congruent with reality, and assuming a "reality-based" rate of return. The strategy is not as popular as dynamic withdrawal formulas or the 4% withdrawal rule. These strategies sell and take out a specific amount of the portfolio each year to meet their spending. As we noted above, the problem is the sequence of returns risk investors face today.

We have seen other approaches that leave as much as two years worth of distributions in cash as a buffer for a large decline in the markets. This way, the investor is not withdrawing during those drawdowns. However, two years worth of cash earning nothing can be an expensive way to mitigate the sequence of returns risk.

There are two ways to become a permanent investor ensure you will not outlive your assets:

  1. Have a large enough portfolio that even ultra-safe assets like treasuries produce enough income to meet your needs.

  2. Take some additional risk in order to become an income-only with drawer from your portfolio.

We focus primarily on No. 2 as the first can be difficult to achieve.

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The permanent investor approach is difficult in today's market given the lower interest rate regime. The strategy relies on generating enough "safe" income from the portfolio to meet your spending needs when added to Social Security and any other base income the retiree receives.

As we noted, in today's environment that can be exceedingly difficult. Certificate of Deposit investors have seen their "pay checks" get cut by over 90% thanks to the Federal Reserve's financial repression. Moving up the risk curve is essential in order to meet those goals.

Of course, moving up the risk curve will likely make the volatility of the portfolio increase. However, remember that we are never selling securities when we do not want to. That gives us significantly more flexibility in managing the assets. Sure, the value of the portfolio will jump around more, but the paycheck covers your living expenses, the most important factor during retirement.

We still focus on preserving capital, so investing in ultra-risky securities is not in our approach. In fact, we take less risk than the S&P 500 (SPY) on an aggregate basis. If we can do the following, we will deem the plan a success:

  • Prevent a permanent capital loss of the portfolio

  • Maintain or build on the income stream over time to combat inflation

  • Leave some cash on the sidelines to take advantage of opportunities to improve yield on cost.

The focus on yield provides greater safety in meeting goals. Yield is recurring and predictive, whereas relying on capital gains is far more uncertain. Capital gains are hard to pin down. Investors assume a flat rate of return (say 6% per year), but returns never come in that steady or predictable. The variance of returns means that a 4% rule withdraw investor can never know when his 6% will come in to cover the sales.

The approach is not for every investor. In fact, proper education early and often is a must for success. There is no perfect solution for the predicament we face. Drawdowns in higher risk assets are typically significantly greater than treasuries or bond ladders, but the consistency of cash flows is our primary objective. As such, we look for solid income securities and diversify across sectors. Our goal is to maintain the income generation power of the portfolio in any given year to meet the needs of the retiree while preserving the capital.