Baby boomers continue to impact our nation. The generation that fought for free speech and civil rights is now forcing financial services to re-evaluate investing and retirement planning. They are the first group to transition from traditional pensions to the 401(k). Boomers will increasingly have to look to their own accounts to support them in retirement. Essentially, they have to treat their 401(k) and IRA accounts as their personal pension.
Clients approaching or in retirement can build a personal pension using a hybrid approach that combines the best of pension-like predictable cash flows and higher long-term returns of a total return approach. A personal pension needs to be engineered specifically to each client's financial goals that are uncovered through the financial planning process. By linking to the financial plan, clients can balance the sometimes competing goals of predictable cash flows and portfolio longevity.
To generate both predictable income and long-term returns, we advocate splitting a portfolio into two sub-portfolios—income and growth. Each sub-portfolio uses asset classes that best suit its purpose. Individual bonds are used to generate the predictable pension-like cash flows in the income portfolio, while stocks and other long-term-growth-oriented assets make up the growth portfolio.
The income portfolio delivers predictable cash flows in the near term, usually eight to 10 years, regardless of what is happening in the stock or bond markets. It also provides a time buffer for the growth portfolio to ride through down markets. The growth portfolio is tasked with driving long-term total return to replenish the income portfolio as it is spent down.
From Accumulation to Decumulation
Up to now, most of the research and industry focus has been on investing in the accumulation phase. The main objective has been to grow clients' portfolios so that they would have enough to retire—hitting their "number." As clients transition to retirement, they shift their focus to generating predictable income out of portfolios and making sure they don't run out of money.
With more boomers retiring every day, we are starting to see weaknesses in using accumulation strategies like pure total return for clients who now have to look to their portfolios to replace their paychecks. Traditional income approaches, like dividends, also face challenges when equity markets break down.
Spending needs, however, are not driven by market returns. Mortgage payments don't change if the markets are up or down. Neither do car payments or utilities and grocery bills. Income from pure total return and dividend strategies, however, is impacted by market functions, causing retirees to either take pay cuts or sell assets in declining markets.
The effectiveness of an income strategy isn't revealed in calm or rising markets. Strong market returns can hide a multitude of sins. The true test of a strategy comes when markets are melting down like we experienced in the crisis of 2008. We will see that building a personal pension to fund a client's retirement will help them fare better than accumulation-centric total return approaches or traditional income strategies like dividends and annuities.
An Institutional Strategy for Individuals
Liability-driven investing (LDI) is an institutional investment strategy that has been used for decades by pension funds looking to match a stream of payments to retirees. For a pension fund, the liabilities are the benefit payouts owed to the pool of retirees. In the age of the 401(k), retirees are challenged with the same liability, but rather than being part of a pool of beneficiaries, individuals have to look to their own portfolio to replace their paychecks.
Income-matching, based on dedicated portfolio theory, is the most appropriate form of LDI for individuals. An income-matching portfolio can be characterized as a "smart bond ladder" where the portfolio matches a target income stream through a combination of coupon interest and bond redemptions. This approach integrates well with the financial planning process because the target spending needs flow directly from the capital needs analysis in the client's plan.
To build an income-matching portfolio, individual bonds are laced together to match the target spending needs. Using a mathematical programming technique to minimize the cost, a series of certificates of deposit and government agency bonds deliver cash flows in the most efficient manner.
Downside Protection for Cash Flows
Unlike bond funds that face low or negative returns in periods of rising interest rates, an income-matching portfolio will deliver the target income stream, regardless of changes in value of the underlying portfolio. The bonds in the portfolio are intended to be held to maturity, and the combination of the coupon payments and bond redemptions make up the cash flows that fund the client's spending needs. The cash flows are perfectly predictable (barring default on CDs and agency bonds) and are not affected by rising interest rates. In fact, the worst-case returns for a bond held to maturity are known the day it is purchased: its yield to maturity.
