Pretend for a moment that the year is 1980. You have a portfolio of $1 million you are planning on retiring in ten years, and you follow a simple investment strategy in which you hold 100% U.S. stocks until retirement, then switch to 100% five-year Treasury bonds and live off of the income from the bonds. You would end up with an annual income of nearly $400,000 in retirement. If you used the same strategy ten years later, retiring in 2000, you would have an annual income of nearly $350,000. However, if you used the same strategy starting in 2002, retiring this year, you would have an annual income of … $12,000, far less than you would have if you were retiring 10 or 20 years ago. The reason for the drastic reduction in investment income for current retirees is two-fold – the low accumulation of equity wealth in the years leading up to retirement, and the low bond yield prevalent in today’s market.
Investors typically allocate their investments across two “buckets” of investments - bonds and stocks, and allocate between them in such a way as to meet their overall risk tolerance and generate any income needs. While these two buckets makes sense for investors before retirement, such a strategy will fall short in generating sufficient income to meet most retirees’ needs. We are currently in an unusual time in that bond yields are lower than the yields on common stocks. It is difficult for an investor to plan on generating any more than 1%-2% in income for a classically allocated portfolio.
It is for this reason that we introduced a High Income Strategy that will help alleviate the income shortfall for many retirees. Along with the classic bond and stock strategy, a third “high income” bucket can be created with four main objectives: 1) a yield between 6% and 8%, 2) risk in between that of bonds and stocks, 3) broad diversification within the bucket, and 4) relatively low correlations with bonds and stocks. The high income bucket is comprised by six groups of investments: high yield bonds, preferred stocks, master limited partnerships, high dividend stocks, a tactical strategy, and a strategic income strategy. There is good statistical diversification between all of these six groups, and the resulting portfolio has relatively low risk. It is very important to choose a variety of money managers to implement each of the six strategies – manager diversification is highly important.
Beyond having three distinct risk and return profiles, and having low enough correlations with each other to provide diversifications, the bond, stock, and high income buckets each provide a separate role in the planning for retirement income. The role of bonds is to provide stability, a small amount of income, and a potential source of future cash flow should the portfolio not provide overall income sufficient to meet the needs of the retiree. Stocks also provide a small amount of income to the portfolio, but their main role is to provide some growth to the portfolio. That growth can be used in the future to help hedge against increases in inflation, and to help replenish bonds in case they are needed to be sold to provide additional cash flow. The high income bucket, by definition, is designed to provide most of the income needs of the retiree. For this bucket, stability is essential, but it is more important to focus on stability of income instead of stability of asset values. Because this bucket is the income generator for the portfolio, every effort should be made not to touch the principal.
To see how the three buckets can be used to help an investor meet their cash flow needs, consider the following example -- bonds and stocks are assumed to provide an income return of 2% per year, and the high income bucket is assumed to provide an income return of 6%. The investor has a $2 million portfolio, with an income need from portfolio of $120,000, or 6% of the portfolio value. Our solution is to invest 50% in the high income bucket, 30% in bonds, and 20% in stocks. In this case, the income will fall short of the needs by $40,000 per year. This shortfall will be alleviated by selling off a portion of the bond portfolio, which is why the stability of bonds is a critical portion facet of the strategy. The $600,000 of bonds provide a minimum of 15 years of additional income supplement. Stocks can occasionally be sold to replenish the bond portion of the portfolio, lengthening the amount of time that bonds can supplement the income from the portfolio.
The low bond yields in today’s capital market require innovative thinking for retirees. We believe our High Income Strategy offers a unique opportunity for investors in retirement to support their income goals.
Scott Lummer, Ph.D., CFA
Chief Investment Officer
For more information on this strategy, please contact your Savant advisor or firstname.lastname@example.org.