The financial services industry is in a period of substantial change. Low interest rates, new regulations and additional scrutiny are changing the landscape. Perhaps the biggest change is the transition of the first wave of Baby Boomers from working to retirement. Not only is this generation huge, but its also the first “401(k)” generation. The introduction of self-directed retirement accounts, such as 401(k) plans, coincided with the “Baby Boomer Generation” (people born between 1946 and 1964) entering their peak saving years.
Beyond the 401(k)
The 401(k) plan was first introduced in 1980. In 1980, the oldest Boomers were 34 years old and entering the age range at which people really start to save. Not surprisingly, the financial services industry created a multitude of new financial products to pitch to these people. Thus began the era of the mutual fund. Mutual funds held $370 million in total assets in 1984. By 2010, the total assets in mutual funds in the U.S. were more than $10 trillion.
While mutual funds have many excellent features for investors during their peak savings years, they may not be as optimal for investors as they retire and start to draw income out of their portfolios. Today, there are a range of products and services that help investors as they move from saving up to drawing down their assets. There are also many people across academia and the financial services industry who are trying to figure out what types of products and services to provide as investors shift into the de-cumulation phase of their financial lives.
There are three broad categories of income-generation strategies that are the focus of the work that I am aware of:
1) Managed withdrawal
2) Income investing
Now, none of these are new, but we are likely to see new hybrid investment offerings that either combine the features of these three, package them to be more attractive, or add new features to match what investors want.
A managed withdrawal solution is quite simple and is the most similar to the way that investors have been taught to build up their assets. Rather than saving a specific percentage of your pay, you simply draw a percentage of your portfolio in the form of income. This draw is a combination of dividends or interest generated by your portfolio and when needed, you can sell assets to bring the total income draw up to your target level.
There are a few variations of this approach. The simplest (and most common) is establishing your income draw based on the value of your portfolio at the time of your retirement, and then planning on withdrawing that same amount every year (with an adjustment for inflation). There is a large amount of literature out there on how much you can draw and be confident that your assets will sustain you for the rest of your life. These studies generally determine a safe withdrawal rate (referred to as the “SWR”). The original SWR studies are the source of what has become known as the “4% rule” which basically states that investors can plan on expecting a “safe” income equal to about 4% of their retirement assets saved at the time of retirement. For example, this means that a $1 million portfolio should be able to provide approximately $40,000 in inflation-adjusted income. Now, there are many variations on this type of approach, and research suggests that the most effective way to safely draw a higher level of average income is to have the flexibility to increase or decrease income levels depending on portfolio performance. In other words, you may have to prepare yourself to live on less income in the years when your portfolio poorly performs.
Income investing is the “old school” solution to retirement income where your portfolio is focused on assets that generate income via dividends, interest payments, or other distributions.
Traditional income portfolios tend to be heavily weighted towards fixed income (bonds) and dividend-paying stocks. Other assets classes favored by income investors include Master Limited Partnerships (MLPs) that usually own gas pipelines and related assets and Real Estate Investment Trusts (REITs). With income investing, you only draw on income generated by your portfolio thus preserving your retirement assets. However the challenge with income investing is that you’ll need to ensure that the income generated by your portfolio is reasonably stable and keeps pace with inflation. An income investing strategy has become more challenging in recent years as bond yields have plummeted to historic lows. Additionally, while the official inflation rate is low (which should offset the lower bond yields) many costs that retirees face have gone up substantially in recent years (i.e., medical care, gasoline heating oil and food).
Annuities are a form of insurance policy in which you invest a specific amount of money with the policy provider who then promises to provide you with a stream of income for the rest of your life.
There are many types of annuities. Some promise a specific income level (known as a Fixed Annuity) and some have an income level that varies based on mutual fund performance or other investment performance. The key feature of annuities is that you can never run out of money. In formal terms, this means that annuities are perfect to offset “longevity risk,” the risk of outliving your assets. Investors need to keep in mind that annuities do have a certain level of inflation risk and while you can buy an annuity with an “inflation rider”that ratchets up your income as inflation rises, these are not very commonly sold in the marketplace today. Also, annuities have a default risk and the guaranteed stream of income is only as good as the company selling the annuity. States do have insurance plans that back annuities, but they vary in terms of coverage.
What Can We Expect To See in the Future?
Having covered the three most common approaches for funding retirement, let’s take a look at what we should expect to see as more and more Baby Boomers retire and start to look for better retirement income solutions.
First, we can expect to see financial advisors designing hybrids of these approaches for their clients. Moshe Milevsky, a thought leader in this space, describes this transition as moving from thinking in terms of asset diversification to thinking in terms of product diversification. His research suggests that people will be well served by combining annuities and other insurance products with other asset classes.
Zvi Bodie, a Boston University professor and influential voice in retirement planning, believes that our entire framework for retirement planning is terribly flawed and that we essentially need to start from the ground up. (In fact, Bodie recently published a new book with Rachelle Taqqu titled, “Risk Less and Prosper” which I reviewed on the Portfolioist back when it was first published). Bodie starts from the premise that we need to focus our attention on a “safety first” approach to guarantee their basic financial security. At least for the portion of total savings that provide for your required cost of living, Bodie believes that investors need certainty as to the future value of their savings and certainty with regard to income in retirement. Treasury Inflation-Protection Securities (TIPS) are the dominant (and perhaps only) asset class to hold during an investor’s working years in his approach. As you age, Bodie recommends that you should gradually transition from TIPS to inflation-protected fixed annuities. For assets beyond those required to guarantee a basic standard of living, Bodie has proposed investing in assets that provide leveraged exposure to market upside with limited downside. I have researched Bodie’s approach to retirement portfolio planning and I expect to see financial products that apply his thinking in the future.
In place of more traditional managed withdrawal portfolios, I expect to see more products that emphasize income investing in place of the current dominant paradigm of “total return” investing, which is the current standard of practice across the financial services industry. Financial theory suggests that investors should be indifferent as to whether they get their returns from income or price appreciation. There is, in fact, surprisingly little academic research to date that investigates how an income-focused approach would serve retirees vs. a total return/ systematic withdrawal approach. In my own research, I find that there are reasons to prefer an income-focused approach, but my work here is far from exhaustive or complete, and I believe will not see a marked shift in this direction until there is more academic research on this problem.
There are few problems more pressing for an individual with most or all of his assets in a self-directed retirement plan than determining what to do as the retirement date approaches. During the crash of 2008, many investors with high exposure to stocks saw their retirement assets decline in value dramatically. The big challenge for investors and for financial services professionals is to create better alternatives for people close to, or in, retirement.
- Retirement: Demographics and Destiny
- Retirement Services for the Masses
- Dr. Andrew Lo: ‘Buy and Hold” Does Not Work Anymore
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