Evaluating Investment Options for
Retirement
Risks that are most relevant to investors drawing down their portfolios are market risk, longevity risk and inflation risk. We want to explore the various types of portfolios available to the retired investor, each portfolio’s strengths and weaknesses and how effectively each addresses the various risks facing retirees.
On the menu are investment and insurance strategies (such as laddered bonds and annuities) that are traditionally used for retirement income generation, as well as asset allocation portfolios (usually used by investors in the asset accumulation phase) and new ‘hybrid’ retirement solutions. Investor interest in all of these options has been growing in recent years as more of the approximately 76 million baby boomers enter retirement every day.
Laddered Bonds
Laddered bonds are perhaps the simplest means of using assets to generate a recurring income stream since they are built to mature at regular intervals, typically annually, to meet an investor’s cash flow needs. Assets are evenly distributed across the maturity spectrum (e.g. 1/5th of assets would mature each year in a 5 year ladder, 1/10th in a 10 year ladder, etc). As the bonds at the beginning of the ladder mature, the freed-up principal is used to purchase additional securities at the end of the ladder. Because of their simplicity, laddered bonds have long been a favorite of investors who simply want to protect principal, primarily in today’s dollars, and create a relatively stable income stream.
The laddered bond approach is not without its shortcomings when used as the sole means of generating retirement income and may be too simple to address all the risks clients face in retirement. For one, the approach is not a fully diversified investment approach – it is 100% fixed income. The portfolio can be diversified across different maturities, credit qualities and issuers but pales in comparison to the diversification that can be achieved by blending multiple asset classes.
A second challenge with laddered bonds is that much of a client’s purchasing power may be lost over time. Laddered bonds, assuming coupon payments are spent and not reinvested do not provide protection against inflation. A laddered bond portfolio will generate the market interest rate return, which is not indexed for long-term inflation; the principal amount also does not address this concern as it remains fairly stable unless additional investments are made. As baby boomers are living longer in retirement, increases in the cost of living are magnified and pose a problem for a laddered bond portfolio to keep up.
The implication with laddered bonds is that a “coupon clipping” approach to retirement income is optimal. This approach does not take into account that interest rates change and could rise or fall significantly in the future, causing income to potentially fall short of expenses. In such a shortfall scenario, or with any unexpected need for cash, principal may be liquidated, sometimes at values below par. The problem is compounded over time; as principal decreases, the income it can generate also declines, causing a further need to draw on principal.
Despite its challenges as a sole retirement strategy, there are many benefits to a laddered bond portfolio. Provided that the investor spends only the interest payments and leaves the principal intact, a laddered bond can last into perpetuity (although, as discussed, purchasing power will, most likely, decrease over time due to inflation). Laddered bonds are also typically very low cost, and an effective means of protecting principal.
Annuities
Annuities, historically considered an insurance product, can provide a regular stream of guaranteed income during retirement, a feature very appealing to retirees and unlike the other options mentioned. Depending on the type of annuity chosen, this guaranteed level of income could last a lifetime or longer, even passing on to a spouse in some cases. In general, annuities can be customized in a number of ways. Annuities can be:
- variable or fixed, meaning the payment is either static or changes depending on underlying interest rates;
- valid for a pre-determined term, such as 10 or 20 years, or can be open-ended, expiring only with the holder’s (or spouse’s) death;
- customized with a myriad of other options offered by the insurer.
A high level of customization does not come free. Oftentimes, the major drawback of annuities is their high costs, in part due to things like surrender charges. Furthermore, once annuity options are selected, the annuity becomes difficult to change should circumstances call for adjustment i.e. many are illiquid - you’re locked into a solution that addresses your present needs and isn’t very flexible if your circumstances change due to a health issue or other emergency.
Another point to consider is that the more favorable the options selected are to the annuity holder, the lower the payout. For example, a fixed-term annuity will most likely have a higher periodic payment than one expected to last until death. And, an annuity that expires at the owner’s death will most likely generate a higher periodic payment than one that lasts until the death of both spouses. Clearly, the options chosen can significantly impact both overall cost and the amount of the annuity payout.
Finally, most annuities are not indexed to inflation and, as such, the guaranteed income, while stable, falls in value on an inflation-adjusted basis as the cost of living rises.
While annuities can be a great option in terms of providing peace of mind, they typically include a healthy profit margin for the firm issuing the annuity. In comparison, many investors may have the wherewithal to generate similar, if not better, monthly cash flows, at a much lower cost, but at its own price: the loss of a guarantee.
Asset Allocation Portfolios
One way to implement a total return approach, using both income and principal to meet expenses, is through asset allocation portfolios. While, many of the methods for constructing these portfolios work well for accumulating assets during a client’s working years but fall short in mitigating the complex risks faced in retirement.
These portfolios provide several benefits. One, they are typically well diversified, which can help a retiree ride out market turbulence. Two, they allow distributions to be taken from any asset class, not forced liquidation of an asset class potentially in a down market (such as laddered bonds). Three, they utilize the total return approach, which is the most flexible approach for retirees and easily allows for allocation changes if necessary.
Cases where retiree objectives for fixed income may not match the ability of a strictly asset allocation portfolio open the door for hybrid retirement strategies like those described in the next section.
Hybrid Retirement Strategies
Unlike annuities, hybrid retirement strategies are not guaranteed. Some are designed to last a pre-determined length of time and others to provide a steady stream of income as long as possible - but they are not guaranteed. There are a number of these types of solutions already on the market, with many others currently in development. However, there is currently little standardization in this area and each investment firm takes a different approach to addressing this problem. For this reason, it is important to compare carefully, side by side, any hybrid solutions an investor intends to use.
Because of the high degree of variability among these types of products, we will focus our attention solely on SEI’s proposed solution. The concept behind DFS is similar to that of an annuity, in that an investor receives a steady cash flow, minus the guarantee annuities provide.
The primary benefit of these packages is the ability to customize to a client’s needs today given the various options an investor can choose as well as its ability to adapt to a client’s circumstances over time. Most competitive offerings in this space are of the one-size-fits-all variety, packaged as fund of funds.
Some factors to consider when choosing this type of product would include:
- Flexibility. Can you make withdrawals in excess of the distribution rate should your circumstances change?
- Customization. Can the portfolio be designed with different risk levels ranging from less to more aggressive, different distribution rates, and does it have the option of distributions adjusted for inflation?
- Can the plan be implemented in either taxable or tax-deferred accounts?
- Finally, does the portfolio provide, like many hybrid investment products, professional investment oversight and rebalancing so that the portfolio’s risk characteristics are managed over time, at moderate costs?
Summary
Individually, each of the strategies discussed above have their own strengths and weaknesses. Different investors will reach different conclusions regarding which approach is most appropriate. Additionally, one solution is not necessarily always the best answer. Many of these strategies work well in conjunction with one another, better managing the various retirement risks in tandem than they do independently.
Regardless of which implementation or combination of implementations is chosen, a retiree needs a solution that not only addresses risks but is also flexible enough to allow for changes as financial or health situations change over time.
This emphasis on flexibility, along with risk management, is an important consideration. For most investors, consuming dividends and income alone is not a viable long-term solution. Insurance products are often too rigid and complicated while traditional strategies are not aligned with the goals of the typical retiree.
While new retirement portfolios aim to manage the majority of risks faced by retirees, an investor may choose to blend such a strategy with an annuity and/or a laddered bond portfolio. Having a number of different investment solutions working together will not only increase diversification, but can, in aggregate, provide both upside potential, principal protection and a guarantee all in one.
Contact Joe to get a checkup of your financial health, or to answer to any specific investment questions.
Joe can be reached by phone at (949) 900-0099 x 507,
by email at JLC@josephlcannava.com
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