By: Francis C. Armstrong, CLU, CFP
An effective retirement portfolio must balance several sometimes conflicting needs.
It must support the planned withdrawal rate, provide for sufficient liquidity to withstand down markets, manage risk at close to an optimum point, and control costs.
The ideal policy will maximize the probability of success, which most clients will define as not running out of money while alive.
The first problem that faces the retiree is that “guaranteed” investment products are unlikely to provide sufficient total return to meet his reasonable needs. Meanwhile, equities are far too volatile to provide a reliable income stream. A compromise must be reached. A combination of stocks and bonds will probably best meet the needs.
Because at least part of the portfolio will be volatile, the question of risk management moves to the forefront. Our first step is to construct a two bucket portfolio.
Bucket One – Adequate liquid reserves
Recognizing that equity investments are too volatile to support even moderate withdrawal rates safely, investors must temper their portfolios with a near riskless asset that will lower the volatility at the portfolio level and be available to fund withdrawals during down market conditions. As a minimum liquidity requirement, I suggest high quality, short-term bonds sufficient to cover seven to ten years of income needs beginning of retirement. While it is tempting to chase higher yields with longer duration or lower quality issues, past experience indicates that the enormous increase in risk swamps the small additional yield benefit.
So, if you expected to draw down 4% of your capital each year for income needs and maintain a ten year buffer, you might want to have 40% in fixed investments. That way if the market takes a dive, as it probably will sometime during your retirement, you will have plenty of time for it to recover. Meanwhile you can draw down the bonds. This protects your growth assets during market declines.
Bucket Two World Equity Market Basket
Our second bucket will contain an approximate weighted world equity market basket. The design philosophy is to construct the equity portfolio with the highest possible return per unit of risk.
This investment policy recognizes the impact of volatility and employs standard portfolio construction concepts to reduce it. These well known Modern Portfolio Theory techniques include utilization of multiple asset classes with low correlations to one another. For this example, I utilize nine distinct global equity asset classes. These classes each have high expected returns at tolerable risk levels and relatively low correlation to each other. We overweight the US for our domestic clients currency preferences, and overweight small and value stocks to increase expected returns while diversifying into dissimilar asset classes. You may also consider further diversification into Real Estate and Commodities Futures.
Withdrawal Strategy Preserve volatile assets in down markets
A rational withdrawal strategy will recognize that equities are volatile and short-term bonds are not. So, we employ a specific strategy designed to protect volatile assets during down market conditions. Otherwise, excessive equity capital will be consumed during market downturns.
Most advisors have been content to treat retirement assets as a single portfolio. For instance, many would advocate a “life style” portfolio comprised of 60% stocks and 40% bonds. However this leads to withdrawals on a pro rata basis from both equity and fixed assets regardless of market experience. It does nothing to protect volatile assets during down markets.
A far superior alternative strategy would treat the equity and bond portfolios separately, then impose a rule for withdrawals that protects equity capital during down markets by liquidating only bonds during “bad” years. During “good” years withdrawals are funded by sales of equity shares and any excess accumulation is used to re-balance the portfolio back to the desired asset allocation. Using spreadsheet models with Monte Carlo simulation we find substantial incremental improvement by imposing this simple rule.
In all cases, implementation is via no-load institutional class index funds. This policy spreads risk as widely as possible in some of the world’s most attractive markets while controlling costs, preventing “style drift”, minimizing taxes, and eliminating “management” risk.
Evaluation of Alternative Strategies
Finance has been silent on the question of where on the efficient portfolio an investor should choose to invest. Monte Carlo Simulation gives us a powerful tool to evaluate alternative strategies. For instance, should an investor needing a 6% withdrawal rate invest in a portfolio with a 10% return and a 12% standard deviation, or one with an 11% return with a 15% standard deviation? Does this answer depend on the time horizon? Does the answer change if the withdrawal rate changes? Here Monte Carlo Simulation can guide us to the best choice depending on the investor’s unique requirements and goals. The correct choice is the one with the highest probability of success.
We can also stress test our assumptions. For instance, what happens if we have volatility right but rate of return falls 2% short of our estimate?
The investor will want to transition from the full accumulation mode to the retirement asset allocation plan sometime in advance of retirement date in order to assure that sufficient liquidity is available when needed.
For instance, with ten years before you retire, you still have a fairly long time horizon. While there is never a guarantee, the odds are greatly in your favor that a heavy exposure to equities will pay off handsomely. Think how you would feel if you had missed out on the last ten years in the market.
But, as you approach retirement, you probably will want to scale back to your preferred retirement asset allocation. Exactly how you manage the transition from stocks to a balanced portfolio is up to you. Too early and you are likely to miss out on a lot of growth, too late and you may be exposed to a market downturn at or near your retirement. Here’s a suggestion that you can modify to meet your needs:
- Determine your optimum asset allocation at retirement.
- About five to seven years before you expect to retire begin shifting equal amounts once a year into short-term bonds so that the year you retire you are at your preferred asset allocation.
Mid Course Corrections and Inflation Adjustments
The discussion’s assumption that a retiree will continue a fixed dollar withdrawal program regardless of investment results is simplistic. (However, without that assumption, no guidelines could be derived.) In fact, a retiree may be in a position to temporarily decrease withdrawals during down markets until his capital recovers. Or, assuming early results in excess of expectations, the retiree may elect to increase her withdrawals as capital increases. In many cases, terminal values were a gratifying multiple of starting capital (Table 4 appendix). So, mid-course adjustments to withdrawal rates are possible and may very well be positive.
A built in inflation adjustment increases risk in the same manner as a higher initial withdrawal rate. The lower the initial rate, the more likely that positive adjustments can be made to hedge inflation.
Alternative Withdrawal Plans
If income requirements are variable or capital permits, an alternative policy of making fixed percentage withdrawals against the annual principal values may be an acceptable solution for many retirees. This policy will provide a variable income stream that is automatically adjusted for investment results.
Retirees that can accept a variable income, and withdraw a constant percent of remaining capital rather than make fixed dollar withdrawals, never face the prospect of zeroing out their accounts–no matter how bad their investment results are in the short term. This option is generally only acceptable to retirees with modest income needs relative to their available capital.
Retirement planning cannot proceed in a vacuum. All aspects of the family situation and objectives must be considered.
Lifetime Distribution Planning
Required distributions at age 70 ½ may cause inconvenient or awkward income streams. Proper selection of distribution elections prior to the Required Beginning Date (RBD) can ensure that funds are delivered in the quantity and at times desired. Full or partial conversion to Roth may help alleviate the problem.
Use of properly designed intervivos trusts and/or a durable power of attorney for non-qualified assets will minimize potential estate tax and probate fees, and provide a management vehicle in the event of incapacity.
Market returns are finite, and costs reduce them. Professional advice, transaction costs, and other expenses are not free. But, the market is competitive, and total costs should be closely controlled.
Be prepared for midcourse corrections
Absent a totally reliable crystal ball, the best mathematical models cannot anticipate all eventualities. By making conservative initial assumptions, we increase the probability that mid course corrections will be positive.