Forty years ago most retirees could rely on pension income from a former employer for the bulk of their retirement, with supplemental income coming from Social Security and/or personal savings. Back then, personal savings could be invested in government bonds yielding 10%, mitigating the need for exposure to more volatile asset classes like the stock market. Those days are long gone. Today’s landscape is entirely different.
When you consider the current environment -- increased life expectancies, disappearing pensions, an economy in turmoil, interest rates at historic lows, rising health care costs and the possibility of higher inflation and income tax hikes -- the fear of running out of money is completely justified. With the current 10-year government note yielding 2.0% and the 30-year government bond yield at 2.8%, retirees are being forced to reallocate their portfolios into more aggressive and riskier asset classes (exposing them to sequence risk) in search of return and ultimately more retirement income.
Enter sequence risk, also known as sequence-of-returns risk. This is the volatility (rise and fall) of asset prices. Of course, a rise in asset prices is a good thing for someone invested in the stock market, but a fall in asset prices at the wrong time could be devastating. A portfolio in the beginning of the drawdown stage might be depleted by a market plunge much sooner than it would after a similar drop many years later. Today, those near or in retirement are more exposed to sequence risk, because today’s portfolios have more demands.
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Unlike retirement portfolios 40 years ago, which were primarily allocated toward high-quality, high-yielding bonds, today’s retirement portfolios generally have three requirements: to preserve capital (cash), to produce income (bonds) and to continue growing (stocks). This is known as the bucket approach to investing, as each bucket serves a specific purpose (cash is used for immediate income needs and to preserve money, bonds are used to satisfy intermediate cash flow needs, and stocks are used to grow the portfolio). Because portfolios are being forced to take on more stock exposure (in search of returns) due to the Federal Reserve’s low interest rate policy, retirees are more subject to the whims of the market and sensitive to the timing of market corrections.
Imagine nearing retirement, or being retired in 2008 and watching your portfolio, which you depend on for income, get decimated in the largest financial crisis since the Great Depression. All of a sudden, your income-generating ability decreases 30%-50%, and the probability of outliving your assets (longevity risk) increases dramatically. Many were forced to postpone retirement, or those already enjoying retirement were forced back into the workforce.
With the extinction of pension plans, Social Security, private savings and defined contribution plans (401(k), 403(b) and 457 plans) have become the primary sources of retirement income. The days of relying on just pension and Social Security income in retirement are long gone. Now it’s the individual’s responsibility not only to save and invest for retirement, but also to structure withdrawal strategies to mitigate sequence and longevity risk. In essence, everybody is expected to become a pension manager unless they outsource this function to a competent wealth manager focused on retirement income strategies.
The bucket approach is an effective way to mitigate sequence and longevity risk. The general idea is to set up three or more distribution “buckets,” with different asset classes and different time horizons for liquidation. These should be in place well before retirement, when an investor is more detached from distribution issues. The first bucket is all the cash needed to live for the next one to two years. It should include monthly expenses as well as a cushion for unexpected events. If a bear market hits at the beginning of withdrawals, the investor usually will be more comfortable using the cash distribution bucket and sleep better on the expectation that the bear market will not lead to ill-advised investment liquidations.
The second bucket should cover the costs of living years three through 10. Ideally this money would be invested in high-quality, individual bonds customized to match your annual expense needs. This bond strategy helps protect an eight-year time horizon; your portfolio will be able to generate the income that you need even if there’s a market collapse. The premise of this strategy is that the bonds are held to maturity.
The reason behind using individual bonds as opposed to bond funds is because bond funds don’t mature. Bond funds trade based on their net asset values (NAVs), so if you hold bond funds and need to liquidate them for income you may be selling them at a NAV below your purchase price. Interest-rate risk is a concern, especially in this low-interest-rate environment, because when interest rates rise (which they inevitably will) bond prices will fall.
Owning individual bonds whose maturities are timed with your annual cash flow needs eliminates this risk, because you won’t be forced to sell a bond at the wrong time. In this low-rate environment, it’s advisable to invest in bonds with shorter maturities, as rates will eventually begin to rise, making longer bonds less attractive. Holding shorter bonds also allows you to roll maturity proceeds into higher-yielding bonds (once rates begin to rise) if the cash is not needed for spending purposes.
The third bucket, which covers years 11 and on, should be invested 100% in equities for long-term growth and possible legacy assets for heirs. This doesn’t mean making predictions (bets), trying to pick companies or managers or trying to time the market, but rather getting broad exposure to the global marketplace at a very low cost. A recommended approach is to own 10,000-12,000 companies across the globe and across various asset classes. Harnessing the returns of capitalism in tax-efficient funds while keeping costs low and staying disciplined is a recipe for investment success. An investment time horizon exceeding 10 years is a good amount of time for a well-diversified equity approach to generate a respectable return, and the idea is to harvest gains from this bucket over time and to extend the income portfolio’s time horizon with the proceeds.
Along with an appropriate mix of portfolio assets, you should consider the type of account that the assets are held in. The combination of taxable, tax-deferred and tax-exempt accounts will make withdrawals more tax-efficient (tax allocation). Since 1870, safe withdrawal rates for a retired investor's portfolio with 60% stocks and 40% bonds have ranged from 4% to 10%, with the median around 6.5%. These withdrawal rates are highly dependent on a retiree's investment experience in the first 10 years of retirement.
Using the bucket approach to engineer your retirement portfolio will reduce the potential damage from sequence risk, lessen longevity risk and provide the predictable streams of income necessary for a financially secure and enjoyable retirement.
Woodring is founding partner of San Francisco Bay area Cypress Partners, a fee-only wealth consulting practice that provides personalized, comprehensive services that help retirees and busy professionals to enjoy life free of financial concern.