Retirement Portfolio Design for a Changing Economy

Going beyond conventional wisdom to create a better retirement outcome

In 1964, Bob Dylan released an anthem called The Times They Are A-Changin’ and while Dylan’s message was about his views on social injustices, the message of change is really relevant to our economy today and to the 78 million baby boomers who are preparing for, or already in retirement.

Our economy has experienced many changes over the last decade, and we’re currently seeing more changes with interest rates and volatility on the rise. Our boomer population faces changes and risks unprecedented in history. In response, boomers must embrace a new investment approach if they hope to secure and protect an income that will last a lifetime. Investments and portfolio design strategies prior to retirement are very different than post retirement. Prior to retirement, the focus is on maximizing portfolio returns with a conventional approach. Meanwhile, endeavoring to solve the income for life equation while in retirement requires a completely unconventional approach.

Why the 60/40 Portfolio Doesn’t Work in Retirement

Using the “conventional” 60/40 portfolio (60% stock for growth/40% bonds for safe money) reduces the probability for success for today’s retiree. The new “unconventional” portfolio design combines the allocation of “safe money” from bonds plus a new asset class of insurance, coupled with “growth” from investments such as stocks. A recent research study commissioned by Nationwide Financial and completed by financial advisory firm Morningstar Investment Management LLC, compared a traditional 60/40 stock and bond portfolio to a portfolio consisting of stocks, bonds and insurance (fixed indexed annuities). The study concluded that repositioning a traditional retirement portfolio consisting of 60% equities and 40% bonds to a portfolio consisting of 36% equities, 24% bonds and 40% fixed indexed annuities (FIAs) would offer virtually the same return, but with a 40% reduction in potential portfolio risk and volatility. Both of which are the number one objectives for your portfolio as you head into retirement. The study utilized Nationwide’s New Heights fixed indexed annuity in combination with stock and bond indexes to compile the results.¹

This new unconventional portfolio addresses the challenges of the economy and the myriad of risk retirees will face as they enter a new phase of life. This combination approach of turbo charging a smaller portion of the portfolio through stocks, while providing for safe money through bonds and insurance, strikes the proper balance between risk and return to provide a reliable income stream for life.

 Major Retirement Risks

A recent survey by The American College of Financial Services identified 18 distinct risks that retiree’s face – any one of which, if not addressed with careful planning and portfolio design, could irreparably damage a retirement nest egg.  We explain three of the MAJOR risks below that if identified and controlled in advance of retirement, will reduce or eliminate many other risks, including longevity risk and inflation risk, and give a retiree a much higher probability of success.

Volatility Risk

When in retirement and withdrawing income from a portfolio, it’s absolutely imperative to reduce risk and volatility. Recent studies have proven that when withdrawing income from a portfolio, the portfolio with lower volatility will experience a longer lifespan than one with higher volatility. A recent study completed by Sure Dividend, Why You Must Care About Volatility In Retirement concluded, “Simply put, the greater the volatility of your portfolio, the greater chance you have of outliving your money all other things being equal. By its nature, higher volatility means greater swings in the value of your portfolio.”²

The Sure Dividend study assumed the following:

– Retirement Portfolio Value: $1,000,000

– Withdrawal amount: $3,333 per month (4% withdrawal rate)

– Rate of Return: 9%

– Retirement Duration Goal: 30 years (age 65 – 95)

 The study results:

Standard Deviation is a measurement of risk or volatility in the portfolio; the higher the standard deviation the higher level of volatility in a portfolio.

– At a 45% Standard Deviation: 69% chance of financial ruin (running out of money before 30 years)

– At a 30% Standard Deviation: 40% chance of financial ruin (running out of money before 30 years)

– At a 20% Standard Deviation: 12% chance of financial ruin (running out of money before 30 years)

– At a 15% Standard Deviation: 3% chance of financial ruin (running out of money before 30 years)

– At a 10% Standard Deviation: 0% chance of financial ruin (running out of money before 30 years)

The results of the study concluded that the higher the standard deviation or volatility in a portfolio, the greater chance of portfolio failure or “financial ruin”. As standard deviation or volatility was lowered, portfolio failure rate was decreased and a higher degree of success (portfolio survival) was realized.

Sequence of Return Risk

Sequence of return risk is a major risk that must be mitigated by a retiree when beginning to take withdrawals from their retirement portfolio. Sequence of return risk is defined by Investopedia as, “The risk of receiving lower or negative returns early in a period when withdrawals are made from an individual’s underlying investments”. Dramatic portfolio losses early in retirement will reduce the lifespan of the portfolio. While sequence of return risk cannot be controlled any more than market volatility can be controlled, its effect can be mitigated. Having a “safe money” bucket of funds to draw income from in the event of a dramatic downturn in the stock market can be an effective strategy to reduce the portfolio from negative sequence of return risk. Research studies have concluded that having a “buffer” to draw from when market losses occur can have a positive effect on the long-term survivability of the overall portfolio. Your safe money funds will provide this critical buffer.

As an example, during the 2007-2008 stock market downturn, having a safe money buffer or reserve account to withdraw income from, until the stock portion of portfolio rebounded, would have been a positive step to protect from negative sequence risk. As a reference, in an article completed in February, 2015 by Wealthfront’s Andy Rachleff and Duncan Gilchrist, PhD; the 2007-2009 market loss was 56.39% and took the market 1,485 days or 4.06 years to recover. Since 1911, the average recovery time after a stock market downturn has been 684 days or 1.87 years!³ Due to this fact, a buffer should be in place 3-5 years before retirement begins and should have approximately 4-5 years of retirement income needs covered. A proper buffer can consist of life insurance cash values, a reverse mortgage reserve account, cash or CDs, a guaranteed annuity, or any other account that will have limited effect on a stock market downturn.

In conclusion, portfolio losses just prior to retirement or early in retirement can have a dramatic effect on  portfolio survival rates and having a safe money buffer in place can have a substantial effect on reducing potential negative sequence of return risk.

Interest Rate Risk

In today’s low interest rate environment, a retiree must look for alternatives to low yielding, high quality bonds that have been the “safe money” component to a traditional retirement portfolio. Historically, high quality bonds have returned a 4-6% rate of return, which in this low interest rate environment may be hard to find in the near future. In addition, our “safe” bonds are susceptible to substantial losses as interest rates potentially rise.  When interest rates rise, traditional bonds lose value. From a historical perspective, current interest rates are at the lowest levels we’ve seen in over 50 years.

More Changes with Safe Withdrawal Rule

The “safe withdrawal rule” is the percentage of a portfolio that can be withdrawn annually (adjusted for inflation) through a retiree’s lifetime. The widely accepted 4% “safe withdrawal rule ” was established by William Bengen’s research in 1994. Bengen based his findings on historical data dating back to 1926 and a portfolio that was invested 50% in S&P 500 stocks and 50% in intermediate term government bonds. Due to current economic conditions and the low interest rate environment, many studies have refuted the 4% rule and Bengen’s finding. A 2013 landmark research report conducted by Morningstar Investment Management entitled, Low Bond Yields and Safe Portfolio Withdrawal Rates belies the 4% rule and adjusts the “safe withdrawal” rate down to 2.4% when investing in a 60% stock/40% bond portfolio with a 30 year retirement time horizon.⁴

Morningstar executive summary states the following: “Yields on government bonds are well below historical averages. These low yields will have a significant impact for retirees who tend to invest heavily in bonds. This is because portfolio returns in the earliest years of retirement have a larger impact on the likelihood that a retirement income strategy will succeed than returns later in retirement; this is known as sequence risk.”

In addition the executive summary states, “We find a significant reduction in ‘safe’ initial withdrawal rates, with a 4% initial real withdrawal rate having approximately a 50% probability of success over a 30 year period.”

In today’s low interest rate environment and the high probability of increasing interest rates, where do we find a viable alternative to “safe money” bonds?

A New “Safe Money” Strategy

In light of this highly probable bond situation, many individual investors and advisors are looking for “safe money” alternatives. Some advisors are offering high yield bonds, convertible bonds and bank loans as alternatives since these bonds typically are not susceptible to interest rate risk. This strategy could ultimately backfire with unintended consequences since these bonds typically have a positive correlation to the stock market, as evidenced in the 2008 economic meltdown. On the surface, these bonds may look attractive, offering high dividend yields with some capital appreciation potential. However, when diving deeper into the research, high yield bonds, convertible bonds, and bank loan bonds all suffered substantial losses of greater than 20% during the 2008 economic downturn. This does not look to be the solution for our “safe money” component to our retirement portfolio. In an attempt to reduce bond losses in an increasing interest rate environment, these bond alternatives actually expose investors to additional risk of portfolio loss. Bonds are utilized in a portfolio to add stability and safety, and the unintended result could be increased portfolio losses and increased volatility, both of which are not good for a retirement portfolio. As discussed earlier, when taking income the portfolio with higher volatility will run out of money sooner than a portfolio with lower volatility.

Bonds are a portfolio’s “safe money” component and are positioned to reduce risk and volatility. Due to this fact, in today’s potential increasing interest rate environment, the only traditional stock and bond portfolio solution is to utilize ultra-short duration, high quality corporate or government bonds.

Enter a New Asset Class: FIAs Offer a Viable Alternative

Fixed indexed annuities (FIAs) can be an exceptional “non-traditional” bond alternative since they offer principle protection with reasonable returns, and they work well as a “safe money” alternative. A 2009 Princeton Wharton School of Economics study suggests, “The fixed indexed annuity may be considered a separate asset class, when compared to taxable bond funds and fixed annuities”.⁵

FIAs are a type of fixed annuity that is backed by some of the largest and most financially solid life insurance companies in the world.  The FIAs interest is tied or “plugged into” an external index like the S&P 500 index, EAFE international stock index or a combination stock and bond index. An FIA credits interest as a percentage of the index return they are plugged into. Typically, the more aggressive the index, the lower the “participation rate” or percentage of gains in the selected the index. Conversely, the lower the volatility of the index plugged into, the higher the “participation rate” or percentage of gain the FIA will credit. Fixed Index Annuity (FIA) product design is unique. Using FIAs, retirees have the potential to receive index interest credits with no risk of loss due to market declines. Returns from FIAs have been steady since 1999. Fixed indexed annuities averaged a 4.63% annualized return for all five-year holding periods from 1999– 2015.

It’s very important to understand that FIAs are a “safe money” alternative to bonds offering absolute guarantees. This means that if the index loses value, the FIA will receive a 0% interest credit in that year, but will not suffer a loss of the original principal value/investment. FIAs are NOT an alternative to the stock market since ALL FIAs calculate interest based upon either a participation rate or a cap rate that will limit the return based upon the index selected.

A recent research report entitled, The Role of FIAs in an Optimized Portfolio completed by WealthVest concluded; “Investors who want to avoid losses in the years immediately before retirement or during retirement, may be able to reduce overall portfolio risk and optimize performance by adding FIAs to their portfolios. During periods of rising interest rates the value of outstanding bonds usually falls.” The report continues; “During periods of rising interest rates, adding FIAs and reducing or eliminating bond exposure helped improve risk-adjusted performance. The study found that adding indexed annuities to a portfolio and reducing the percentage of bonds helped improve Sharpe ratios. We may be on the cusp of a period of rising interest rates.”⁶

FIAs vs. High Quality Government Bonds

Relationship to interest rate movements:

• Bonds have an inverse relationship to interest rates:
• As interest rates rise, bonds lose value
• As interest rates decline, bonds gain capital appreciation potential
• FIAs have a positive relationship to interest rate movements
• As interest rates rise, FIA renewal rates increase
• As interest rates decline, FIA renewal rates will also decline

Surrender charges (FIAs) & Market Value Adjustments (bonds):

• Treasuries have Market Value Adjustments (MVAs) unless held to maturity
• 10 year treasuries must be held for 10 years or could lose or gain value based upon the interest rate movements
  • Increase in interest rates = Bond principle value will decrease
  • Decrease in interest rates = Bond principle value will increase
• FIAs have surrender charges of 10-15 years unless held to maturity
• If surrendered early will be subject to a surrender penalty
• Most FIAs offer 10% “free out” at any time, meaning the annuity owner can withdraw 10% of their principle value at anytime without any penalty
• Most contracts have a decreasing surrender charge schedule that reduces to 0% after the maturity of the contract
• Above the “free out” amount the annuity owner would be subject to a penalty for early withdrawal

In summary, if interest rates hold at the 2.42% level (as of 3/20/17) or increase over the foreseeable future, FIAs will offer value over high quality bonds. If interest rates reduce over the foreseeable future, bonds will pick up capital appreciation and will be a viable “safe money” alternative. In this low interest rate environment, coupled with the high probability of an increasing interest rate environment, FIAs are a viable “safe money” alternative to bonds.

Not Many FIAs Make the Grade

Many FIAs pay high commissions which ultimately reduce the effectiveness and the return potential. Additionally, it’s important to utilize high quality, low-cost FIAs that are “consumer friendly”. FIAs have many moving parts and are fairly complex. It’s extremely important to understand the nuances between the many contracts and company products available. As with any investment (stocks, bonds, mutual funds, ETFs or annuities) there are the good, the bad and the ugly, and proper due-diligence and analysis is essential to optimal performance.

 The Unconventional Portfolio Design offers LESS (which is MORE in retirement)

When in retirement and taking withdrawals, LESS is MORE…LESS risk brings MORE portfolio value. The truth is in the research that backs a Multi-Disciplined Retirement Strategy (MDRS) to create an unconventional 36/24/40 portfolio design as validated in the Nationwide/Morningstar study. A Multi-Discipline approach includes both guarantees for safety and security, and globally diversified stocks for growth and inflation protection. Rational retirement solutions backed by research and retirement analysis are what retirees need, NOT fear. The combination of low-cost, high quality FIAs (from the Insurance Discipline) and a globally diversified stock portfolio (from the Investments Discipline) offers the best combination for the best possible retirement outcome.

As concluded in the research, a combination of stocks, bonds and FIAs can potentially offer better risk-adjusted returns than a traditional stock and bond portfolio alone. Reduced portfolio volatility can lead to longer portfolio life expectancy when taking income from the portfolio, which in turn could offer retirees a better retirement outcome.

But Who’s Promoting the Unconventional Portfolio?

Certainly not insurance agents and certainly not the Ken Fisher’s of the world. Why? Because they aren’t properly licensed and/or don’t understand the intricacies of each other’s discipline (insurance vs. investment). Your only chance for implementing the new, unconventional portfolio is to: 1) do it yourself…which is quite complex and requires a deep understanding of many disciplines, portfolio and investment strategies; or 2) work with a “hybrid” retirement advisor who understands how each discipline interrelates together to develop a proper retirement portfolio. It’s important to make sure that he/she is experienced not only with this type of portfolio strategy, but also in retirement planning and in the use of sophisticated retirement and investment planning software. Hybrid advisors don’t have the biases that you’ll find with pure stockbrokers or pure insurance agents. They also follow fiduciary standards that require them to put the best interests of the client first.

We strongly suggest that you consult a hybrid advisor to help you project your current state of retirement income readiness. He/she can also use the sophisticated software tools available today to help you design a new “unconventional” 36/24/40 portfolio to include proper tax optimized withdrawal strategies, and the integration of all the retirement risks your portfolio may be exposed to. Your Retirement Advisor has affiliate advisors available for complimentary income and portfolio assessments.

You can read more about the importance of working with a Hybrid Advisor in our blog post, Why Financial Advice is Like Religion & Politics and Why the Middle Way Leads to Wisdom.

Sidebar:

Two Competing Disciplines: Insurance vs. Investments

The retirement industry has two competing disciplines vying for a retiree’s money; Insurance, which offers absolute guarantees, and Investments, which are based on probabilities and statistical analysis. Typically, you hear both camps utilizing some sort of “fear tactics” to try to gain a competitive advantage over the other.

We recently saw an online banner ad that caught our attention. It read, “I would rather die and go to hell before I would ever sell an annuity.” The advertiser, Fisher Investments, is a stock market bigot who obviously doesn’t sell insurance. They make their money investing people’s money in the stock market. Fisher’s erroneous claims have been refuted by retirement research backed by some of the industry’s greatest academic researchers. As explained by John H. Robinson’s article, Why Annuities Hate Ken Fisher. And You Should Too, Advisor Perspectives magazine, 2014, “Fisher’s claims are at odds with a growing body of empirical research published in peer-reviewed academic and professional journals.”  He continues, “Empirical research has found that variable annuities can be useful in protecting investors from the twin retirement threats of sequence of return risk (the risk of sharply negative market returns early in retirement) and longevity risk.”⁷

On the flipside, we found a book that promotes the use of Index Universal Life (IUL) insurance as the single solution to ALL retirement issues. As a “fear tactic”, the book’s authors issue several warnings about the dangers of stocks with the ultimate warning on page 34 stating, “All my savings were in the stock market and I had no control over how that market performed. In fact, there was a very real risk that I could lose all my money“.  The book, Wealth Beyond Wall Street, written by two insurance brokers is the epitome of misinformation and half-truths.⁸ The book attempts to convince retirees that an insurance-only solution is the only way to retirement success. The rhetoric continues throughout the book warning readers that the government, Wall Street and the entire investment industry is robbing retirees of their wealth. It’s a sad testament of what some individuals will do to try to build their own wealth through half-truths while ultimately hurting retirees and their retirement outcomes.

References:

1. Shift Away from Potential Risk and Toward Potential Return, Nationwide (Morningstar), 06/16
2. Why You Must Care About Volatility In Retirement, Sure Dividend , Oct 14, 2014
3. There’s no Need To Fear Stock market Corrections, Wealthfront, 1/11/2017
4. Low Bond Yields and Safe Portfolio Withdrawal Rates, Morningstar Investment Management, Jan 21, 2013. David Blanchett, CFA, CFP® Head of Retirement Research Morningstar Investment Management. Michael Finke, Ph.D., CFP® Professor and Ph.D. Coordinator at the Department of Personal Financial Planning at Texas Tech University. Wade D. Pfau, Ph.D., CFA Professor of Retirement Income at the American College

5. Wharton Financial Institutions Center, October 5, 2009,
6. The Role of Fixed Index Annuities in an Optimized Portfolio, Wealthvest, 11/23/15
7. Why Annuities Hate Ken Fisher. And You Should Too, John H. Robinson’s, Advisor Perspectives magazine, 2014
8. Wealth Beyond Wall Street, Brett Kitchen & Ethan Cap, 2015

Sources:

-The Retirement Killer: Volatility , Frank Armstrong III, Forbes Magazine, Dec 6, 2013

-Does Your Portfolio Have Too Much Interest Rate Risk?, Allianz, 9/2013

-Low Bond Yields and Safe Portfolio Withdrawal Rates, Morningstar, 1/21/2013

-Jack Marrion, Geoffrey VanderPal, David F. Babbel, Index Compendium

-The 18 Risks of Retirement Income Planning, American College of Financial Services

-Investopedia