It has been a long time since retirees have
faced such perplexing decisions concerning how to manage their
retirement nest eggs. Yields on fixed income instruments are at
lifetime lows for most and economists have even dusted off an old term
called deflation. One of the most important questions retirees
are asking is, “How do I get adequate income from my portfolio?”
Most experts agree that an annual withdrawal
rate of no more than 5% should be used in a retirement portfolio.
However, this rate of return in bonds or CDs is not realistic in the
current interest rate environment. And although it is far from our
thinking in recent years, inflation will continue to be a major factor
to consider when positioning a portfolio for maximum income. If you
doubt this, ask yourself: “Will I pay more or less for a postage stamp,
a car, or a house 10 years from today?” The answer is invariably
‘yes.’ It is only a matter of how much more. Because of
the perceived ‘safety’ of fixed income investments such as utilities,
preferred stocks, and even high yield bonds, most will pursue yield
rather than total return when they are considering their
income from a portfolio. This can be detrimental.
In order to get an adequate yield in a low
interest rate environment, longer-term securities are usually required.
The eventual direction of rates must be up. This means the value
of long term fixed income securities must be down. This creates
two problems: 1.) Liquidity. You cannot sell unless you are willing to
forfeit principal because as rates go up, values go down. You will have
the equivalent of long-term certificates of deposit paying very low
yields. Do you like the prospect of owning CDs that are paying 3 to 4%
for 15 or 20 years? 2.) Because of the liquidity problem you have
created with fixed income securities, you will likely not sell and
therefore miss out on any opportunity to reinvest in higher yields or a
rising stock market. This would be a very frustrating experience and
could even jeopardize your retirement nest egg’s long-term viability.
By taking a total return approach
to this problem, a retiree can effectively avoid this situation. By
maintaining an adequate amount of the portfolio in ultra short
bonds (less than one year average duration) the loss of principal
problem is eliminated because ultra short bonds can react quickly if
rates climb. Additionally, by holding an adequate portion in stocks
this will allow a hedge against inflation and also help with income
taxes at capital gains rates of 20% (with stocks) vs. nearly 40% in the
top bracket as ordinary income (with bonds).
When retirees are told to employ a total
return approach to managing their money they always ask the question:
“What if I need money to live on? I don’t want to have to sell stocks
if they are down.” Good point. By having 3 to 6 months cash on hand
and then liquating ultra short bonds, you will never likely be in a
position of selling a security when it is “down.” When this methodology
is utilized, a rebalancing of the portfolio should occur every six
months to get the portfolio back in line with your Investment
Policy Statement. (Don’t have an IPS? Shame on you.) The
beauty of this automatic rebalancing is that it virtually ensures that
you will always sell high and buy low.
Think about it. Say the
large U.S. portion of the portfolio has done well for six months and the
large International has lagged behind. By automatically chopping off
the top of the U.S. large and moving it to the International large asset
class you are selling high – that which has done well – and buying low –
that which has not done as well and is therefore cheaper to buy. This
is the type of systematic discipline that allows any investor, but
especially retirees, to have a consistent and enjoyable long term
investing experience.
(5/03)
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