It's Time to Reconsider Retirement Income Models

It's no secret that advisors have embraced model portfolios, having chosen them for more than 50% of their clients' assets, according to a 2019 Broadridge study — and for good reason. A FlexShares study, "Race to Scalability 2018," found that the majority of advisors who outsourced investment management grew their client base and realized a 30% revenue increase.

But not all models are created equal, especially when it comes to retirement income.

Given that 75% of workers and retirees prioritize income over maintaining or growing wealth in retirement, according to the Employee Benefit Research Institute, it's not surprising that traditional retirement solutions focus primarily on income.

But clients also need growth. In fact, EBRI finds that 40% of Americans aged 35 to 65 are expected to run out of money in retirement. The industry's one-dimensional focus on income has historically tilted client portfolios to lower returning asset classes, like investment-grade fixed income, and hindered the ability to sustain sufficient growth rates over extended periods of time.

When you couple this tendency with the current lower rate and slower growth market environment that we expect to last for many years, it's clear that advisors may need to rethink their retirement income solutions.

A Possible Solution?

A better option lies in dynamic multi-asset class portfolios that diversify across more nontraditional sources of both return and income.

For instance, models incorporating outside-the-box asset classes improve the likelihood that a client's savings will grow enough to fund spending and last through retirement.

While the majority of retirement income models designed to grow over time are traditional 60/40 global stock and bond portfolios, we forecast that these models will earn less than a 4% annual return over the next five years (far less than the 7% of the past 10 years).

Furthermore, we see increased risk on the horizon, as we believe the stock market isn't factoring in reduced earnings expectations due to COVID-19. Plus there's uncertainty around the looming U.S. presidential election and tensions are escalating between the U.S. and China.

High-yield bonds and real assets are two key asset classes that should be considered as a way to further diversify your risk-generating assets while increasing the potential for growth and income.

The expected return of HY bonds is better than that of equities, according to our five-year forecast, and such bonds have historically experienced only a third of the stock market's drop.

Real assets, such as listed infrastructure, also present healthy return prospects and have historically been used by investors looking for inflation protection.

It's important to dynamically or tactically allocate among these asset classes, especially during volatile markets.

Models featuring more asset class diversification may also solve investors' income dilemma. Investors have historically relied upon investment grade bonds to fund the "rule-of-thumb" 4% spending rate for retirees. But their yields are less than 2% today. As of June 2020, however, significantly higher yields could be found from HY bonds and infrastructure.

Dividend-paying stocks also can generate more income, but similar to model portfolios, not all dividend-paying stocks are created equal. For example, the recent COVID-19 crisis caused more than 130 Russell 1000 companies to cut dividends to some extent through Q2 2020.

Applying more stringent quality screens for stocks with efficient management, higher profitability and stronger cash flows would have helped investors avoid almost all of those stocks. Advisors also should avoid dividend strategies with large sector concentrations since poor performance in it could have a huge negative impact on investment return.

An advisor's job is never easy, especially in rapidly changing market conditions. But choosing the right portfolio and staying fully invested remains critical.

By missing just the five best performance days in global stocks over the past 10 years (through June 2020), investors would have missed out on nearly half of the 95% return they would have realized if they remained invested. Fortunately there are model portfolios that can choose from a wide array of assets and make tactical adjustments to meet clients' retirement needs.

Nadia Papagiannis, CFA, is the practice leader of Multi-Asset Class Solutions at Northern Trust Asset Management.