Retirement Income Strategies
I was recently challenged by an investor couple attempting to determine the amount of annual spending they can make based on their portfolio. How, they asked, can we make a rational decision when we do not know the future return in investment markets, the future rate of inflation or their life expectancy?
My general rule of thumb has been to take no more than 4 to 5 % of the portfolio per year. For many of my clients this translates to having an investment portfolio around $2 million in addition to social security in order to maintain the life style they are comfortable with. A five percent withdrawal rate would be the maximum unless the time horizon is under 20 years. For purposes of determining life expectancy, I generally use age 95 unless the client suggests otherwise. This assumes a portfolio with a 50/50 split between stocks and bonds.
Sometimes clients prefer to use a set monthly dollar amount for a withdrawal, such as $7500 per month, and annually adjust this amount as needed to pay expenses. This disadvantage of this approach is if financial markets decline significantly, we need reduce the monthly amount.
I have recently read an excellent article by Jaconetti and Kinniry that serves as a useful reminder of the factors to consider and how best to balance competing retirement goals.
It is important to annually review your spending strategy and your investment portfolio with your investment advisor.
More on Portfolio Inflation Strategies
A May 2011 lengthy article by Gahagan and Martin, suggests a modest, permanent allocation to inflation-hedging -assets , such as TIPS, commodity futures, and REITs.
The interesting part of the article is a discussion of how different inflation-hedging assets perform across the inflation cycle. For example, TIPS perform best in an inflationary period of less than 5% inflation while Commodity Futures perform best when inflation is more than 5%.
The bottom line of the analysis is that a mix of inflation-hedging assets provides a better risk-adjusted outcome across an inflation cycle.
Hedging Inflation: Comparing Commodity Futures and TIPs
I have generally recommended the use of Treasury Inflation Protected Securities (TIPs) as a hedge against inflation. Are Commodity Futures an attractive inflation hedge similar to TIPs?
In a March 2011 article, author Geetesh Bhardwaj, addresses the use of various investments as a hedge against unexpected inflation. (Let me know if you would like a copy of the paper). The author differentiates between expected inflation, that is already incorporated into stock and bond prices, and unexpected inflation, that is not reflected in prices of most assets. Both TIPs and Commodity Futures have a positive correlation to unexpected inflation and are unrelated to expected inflation. Interestingly, REITs show little or no relationship to unexpected inflation.
One negative of commodity futures is that they can be volatile in price, unlike TIPs, whose value should be more stable.
As an investor wanting to hedge against inflation, a portfolio consisting of stocks, bonds, TIPS certainly makes sense. Commodity Futures, while intriguing, probably carry more risk than reward.
Investing for Retirement Income – Part 2
One of today’s biggest challenges facing investors in retirement or in semi-retirement is obtaining enough income and growth from their portfolio to match annual expenses. Is it possible to create a mix of steady income, upside potential and longevity protection by a blend of 80 percent bonds and 20 percent stocks?
My definition of income investing is to construct a portfolio with a heavier emphasis on income producing assets. Ideally, the investor does not need to access principal to meet daily living expenses. In a low rate environment, this becomes difficult without relying on high yield bonds for a significant part of the portfolio mix. Another common approach with investors is to hold high paying dividend stocks.
An alternative investment approach is to maintain a more balanced portfolio allocation, understanding that principal will need to be accessed to meet annual expenses. This allows for a higher equity allocation with the possibility for overall portfolio gains with stock appreciation.
The income dilemma highlights how investing is about tradeoffs between different risks. Perhaps more analysis of risk factors and which risks to mitigate would result in portfolio allocation decisions that investors can be more comfortable with.
Some risk factors can be easily addressed—e.g. diversification and keeping fees low. But few investors see these as important if they believe they are missing the next new investment opportunity. I have a neighbor that claims to have recently made a lot of money investing in oil futures. I suggested that while his gamble paid off, that this was not investing. But he cannot see the risks inherent in this strategy, in part, because the gamble paid off. But is this any worse investment behavior then the investor who is so concerned about the next financial catastrophe that he can only purchase insured CDs?
So to meet cash needs, perhaps the investor needs to first address the risks associated with different investment strategies and understand their tolerance for various risks.
For some investors, a comfortable risk tradeoff may well be an 80/20 split between bonds and stocks.
Combating Investor Overconfidence
In my discussions with clients and prospects, one of the recurring themes is how, as their investment advisor, I can best provide advice contrary to their bias, intuition, or reaction to current business/economic events.
An example is the current investor bias toward equities since the stock market has performed so well recently and bonds are feared because of the threat of increased inflation.
It is probably natural to hear that the asset allocation decision made just a short time ago is being questioned based on market psychology and the resulting impact on investment decision-making.
My role, as an investment advisor and fiduciary, is to challenge these tendencies and serve as a source of independent insight.
One client is a couple in their early 50s who have put two of three children through college. They have a substantial joint income, no debt, but few investment assets. We have established that they will require $2 million in investable assets to afford a comfortable retirement and they have less than one-third of that amount presently. We have used an Aggressive Model for their investments with 70 percent invested in equities. Investment panic has set in with the realization that full retirement in their early 60s is unlikely. Their reaction is to move 100 percent into equities and is buoyed in that opinion by the recent stock market results.
As their investment advisor, I want to avoid simply confirming my clients’ bias in order to accommodate them. They are overconfident in the stock market by extrapolating recent gains into overly rosy forecasts. I find this behavior pattern is especially prevalent with people who have been successful in the business world. It is similar to the thought that “I can beat the market” since I have made other correct decisions in my professional career.
Research has shown that individuals who report that they are “100% sure” of a particular fact are wrong 20% of the time. I experience the phenomena with my barber, who never met a fact he could not mangle. Overconfidence is the best known bias in making investment decisions.
Clients working with Rockbridge have two advantages. First, we provide investment models that are not subject to current whims of the investment media. Second, we provide independent advice and we see our role as providing an unbiased viewpoint.
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