Retirement Portfolios E-Book

Michael J. Zwecher

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 465

Veröffentlichungsjahr: 2010

Beschreibung

Retirement portfolio guidance for finance professionals Retirement is one of the most important parts of the financialplanning process. Yet only two percent of financial advisorsdescribe themselves as competent in retirement planning. Constructing a retirement portfolio is viewed as a difficultendeavor, and the demands facing financial advisors responsible forthis task continue to grow. The pressures are particularly intensedue to events such as the financial crisis and oncoming rush ofretiring baby boomers. It is imperative that financial advisors beequipped and ready to create appropriate retirement portfolios.That's why Michael Zwecher-a leading expert on retirementincome-has created Retirement Portfolios. * Examines how portfolios should be prepped in advance so thatthe transition from "working" portfolio to retirement portfolio issmooth and seamless * Outlines how to create a portfolio that will provide income,continue to generate growth, and protect assets from disaster * Details the differences in managing a retirement portfolioversus managing portfolios during asset accumulation years The ability to create retirement portfolios and manage theirrisks are skills you must possess to be an effective financialadvisor. Retirement Portfolios will help you develop theseessential skills and gain a better understanding of the entireprocess.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Preface

PART ONE: FRAMING THE PROBLEM

PART TWO: ADAPTING PORTFOLIOS FOR RETIREMENT INCOME

PART THREE: MANAGING PORTFOLIOS FOR RETIREMENT INCOME

PART FOUR: MAKING IT HAPPEN

APPENDIXES

Acknowledgements

PART One - Framing the Problem

CHAPTER 1 - Portfolio Focus and Stage of Life

A “BALANCED” PORTFOLIO APPROACH MAY NOT LAST THROUGH RETIREMENT

RETIREMENT SAVING VERSUS RETIREMENT INCOME: AN ILLUSTRATION

PRODUCTS VERSUS SOLUTIONS

SUMMARY

CHAPTER 2 - The Top-Down View A Short Primer on Economic Models of Retirement Income

AN OVERVIEW OF ECONOMIC MODELS OF RETIREMENT INCOME

RECONCILING RETIREMENT INCOME PORTFOLIO CONSTRUCTION WITH ACCUMULATION

THE DYNAMICS OF RISK AVERSION

SEPARATION BETWEEN FLOORING AND UPSIDE

FULLY FUNDED VERSUS UNDER FUNDED FLOORING

MONETIZING MORTALITY

TAKING MARKET RISK

RISK IS RISK, IS IT NOT ?

RISK, UNCERTAINTY, AND RISK A VERSION

SUMMARY

CHAPTER 3 - The Importance of Lifestyle Flooring

AMOUNT OF FLOORING: A BALANCE SHEET VIEW

RETIREMENT REQUIRES OUTCOMES, NOT JUST EXPECTATIONS

CONSUMPTION NEEDS

YES/NO PLANNING

THE WINDOW FOR MAINTAINING LIFESTYLE

THE BEDROCK FLOOR

THE ASPIRATIONAL FLOOR

THE FINISHED FLOOR

NOMINAL VERSUS REAL FLOORING

TYPES OF FLOORING

CHOOSING A FLOORING TYPE

SUMMARY

CHAPTER 4 - Monetizing Mortality Annuities and Longevity Insurance

RISK POOLING

PURE LONGEVITY INSURANCE

ANNUITIES

COMPLEX ANNUITIES

CREDIT RISK AND INSURANCE

SUMMARY

CHAPTER 5 - Flooring with Capital Markets Products

GOVERNMENT-ISSUED SECURITIES

CREATING A FLOOR OF STRIPS

TIPS

MUNICIPAL SECURITIES

CORPORATE SECURITIES AND OTHER FINANCIAL PRODUCTS

SUMMARY

PART Two - Adapting Portfolios for Retirement Income

CHAPTER 6 - Building Retirement Income Portfolios

PORTFOLIO SLEEVES FOR RETIREMENT INCOME

PORTFOLIO INTUITION

BASIC PORTFOLIO CONSTRUCTS

GENERAL ACCUMULATION PLANS FOR RETIREMENT INCOME

TAXES AND RETIREMENT INCOME PORTFOLIOS

SUMMARY

CHAPTER 7 - Creating Allocations for Constructing Practical Portfolios by Age ...

FLOORING ALLOCATIONS

LONGEVITY ALLOCATIONS

PRECAUTIONARY ALLOCATIONS

DISCRETIONARY EQUITY ALLOCATIONS: ASSETS WITH RISK

SUMMARY OF ALLOCATIONS

SUMMARY

PART Three - Managing Portfolios for Retirement Income

CHAPTER 8 - Rebalancing Retirement Income Portfolios

REBALANCING THE DISCRETIONARY WEALTH SUBPORTFOLIO

REBALANCING THE FUNCTIONAL COMPONENTS

RAISING THE FLOOR

SUMMARY

CHAPTER 9 - Active Risk Management for Retirement Income Portfolios

STATIC EXAMPLE

THE VIEW FROM THE CAPITAL MARKETS LINE

RISK MANAGEMENT AND EXPECTED RETURNS

SIMPLE RULES: FOR PASSIVE AND ACTIVE RISK MANAGEMENT

AN INELEGANT BUT SIMPLE PLAN

HIGH-WATER MARK FLOORING

THE CUSHION

RISK RULES—PERIODIC REBALANCING

RISK RULES—MORE ACTIVE REBALANCING

CPPI AND VOLATILITY

TAXATION AND ACTIVE MANAGEMENT

LOCKING IN FLOORING: LONG END VERSUS SHORT END

A QUICK NOTE ON USABILITY, SCALABILITY, AND APPROACHES OTHER THAN LIABILITY MATCHING

PLAYING WITH FIRE IN A RETIREMENT INCOME PORTFOLIO

SUMMARY

PART Four - Making It Happen

CHAPTER 10 - The Transition Phase

WHAT THE TRANSITION IS ABOUT

THE ORDER OF TRANSITION

A DIFFICULT TRANSITION

WHEN TO TRANSITION

MAKING THE TRANSITION SEAMLESS

CREATING A BUSINESS MODEL THAT INCLUDES A NATURAL TRANSITION

SUDDEN TRANSITIONS

SUMMARY

CHAPTER 11 - Putting Together the Proposal

LAYING OUT CLIENT’S ASSETS TO SHOW CURRENT STATUS

MINIMALLY INVASIVE SURGERY: RECONFIGURATION PROPOSAL

LIFESTYLE AND FLOORING TYPES

ACCUMULATION PLAN TYPES

ALLOCATIONS

PASSIVE VERSUS ACTIVE RISK MANAGEMENT

SUMMARY

CHAPTER 12 - Market Segmentation

SEGMENTATION FOR TRADITIONAL PORTFOLIOS

SEGMENTATION FOR RETIREMENT INCOME PORTFOLIOS

SUMMARY

CHAPTER 13 - Products and Example Portfolios

OVERVIEW OF PRODUCTS OFFERED

MANAGING EXPECTATIONS AROUND OUTCOMES

EXAMPLE PORTFOLIOS

SUMMARY

CHAPTER 14 - Preparing Your Client for a Retirement Income Portfolio

KNOW YOUR RESOURCES

LIFESTYLE AND LIFE CYCLE

RISKS TO YOUR RETIREMENT LIFESTYLE

LIFESTYLE AND FLOORING TYPES

WHAT THE ADVISER NEEDS FROM THE CLIENT

SUMMARY

CHAPTER 15 - Salvage Operations, Mistakes, and Fallacies

MISTAKES AND FALLACIES

HOW TO DIG OUT OF A HOLE

SUMMARY

APPENDIX A - History of Theoretical Developments in Life-Cycle Planning

APPENDIX B - How Professionals Can Maximize the Usefulness of this Book

Notes

Glossary

References

Index

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Copyright © 2010 by Michael J. Zwecher. All rights reserved.

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Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Zwecher, Michael J., 1957-

Retirement portfolios : theory, construction, and management / Michael J. Zwecher.

p. cm.—(Wiley finance series)

Includes bibliographical references and index.

eISBN : 978-0-470-58562-7

1. Retirement income-Planning. 2. Portfolio management. I. Title.

HG179.Z94 2010

332.024’014-dc22

2009031706

This book is dedicated to my daughters, Olivia, Maia, and Zoe,three children who make every day the best day everbut guarantee that I will never be able to retire.

Preface

Life in 2009 and Beyond

“What was I paying you for?”

Whether asked in a civil or angry tone, that is the question that many advisers hear explicitly or implicitly from their clients. It’s a valid question. The business model of retail financial services has been based around creating high expectations but devoid of defined milestones or goals; in the jargon of the MBA, the business model has been built around selling hope without offering the client any explicit deliverables.

For nearly 25 years, beginning in 1981, selling based on expectations and hopes was enough to build a business. As the affluent classes expanded, portfolios were created and markets boomed. Retail advisers could sell expectations and the market generally delivered the outcomes for accumulators and retirees alike. The few storm clouds and squalls that did appear could all be managed—and the manageability of those small storms seemed to justify a business model with expected performance as its linchpin. As in any business model an arms race inevitably develops around the selling linchpin. In financial markets expectations of performance begat expectations of outperformance. Built around raised expectations of performance rather than delivery of outcomes, this business model left clients—and the model itself—vulnerable to the financial hurricane.

The first dark clouds appeared with an unexpected mortgage write-down by HSBC Holdings in early 2007. The clouds were followed in June with the lightning bolt forced liquidation of two Bear Stearns hedge funds. Credit markets soon began to blow apart leaving corporate borrowers unable to roll debts, particularly those funded with short-term paper. Asset-backed commercial paper, auction rate securities, variable rate debt obligations, and the entire repo market foundered. The Fed cut rates and injected liquidity, yet Bear Stearns and AIG still failed. Lehman failed, Merrill almost failed. Morgan Stanley looked to be in a death spiral.

The events of 2007-2009 were a double blow. The softening of the housing market was impacting the balance sheets of clients and putting a drag on the economy, but the failures within the financial system nearly sent the economy over a cliff. Not only did the markets for all asset classes deflate with suddenness and violence as if it were a case of financial “Ebola,” many of the mainstay firms that proffered advice to retail clients were destroyed. They were largely responsible for the debacle, inept at handling the crisis, and unconcerned about the damage wrought. It is hard to sell your advice as wise when your firm is blowing itself to kingdom come and the CEO is mismanaging nearly every utterance, including public testimony before Congress. For clients, it meant that plans, built on thrift and deferred consumption were destroyed. For advisers, the impact has been, and is being, felt at both the personal and career levels.

In the aftermath of the panic, with its damage to both client portfolios and client relationships, some have been quick to declare the retail model dead. Selling based on expectations and fair-weather investing may not be dead, but it will certainly be tempered for a while, perhaps even for a generation. Clients are reevaluating their strategies and tactics for building portfolios, which means that the business model will, if nothing else, evolve.

Selling expectation-based portfolios based on concepts promising risk-free enhancement of yield such as alpha1 are great for raising client’s expectations of higher return per unit of risk. Unfortunately, what was often sold as alpha was really either just a liquidity premium or a premium for non - linear risk; in normal markets these premiums accrued to the holder. In markets such as the one of 2008, however, illiquidity acted as a lead weight on a struggling swimmer and events that previously seemed like remote possibilities came to pass. For the most part, alpha-promising products are great for selling on aspiration but poor for resiliency in meeting future needs. Advisers need to have a business model that allows them to sell based on expectations that meet both client’s aspirations and future needs.

In spite of all that has happened, the news is mostly good. Portfolios can be constructed to withstand market turmoil, and they can be constructed out of familiar components. The “sleeves” might feel a little different, but the feel is familiar. For many people, this means keeping the type of portfolio that they know and are comfortable holding. For the adviser, the change in business model is substantial, but the change in day-to-day operations will feel natural. To be sure, there are some things to think about and do differently. For most people there’s no need to take a “sledgehammer” approach. Saving for retirement doesn’t become any easier, but you can build portfolios that are sensible, robust enough against market cycles to protect lifestyle and still provide opportunities for aspiration to a better lifestyle.

Clients defer consumption and save their money for a reason. A portfolio is not a flower garden designed for purely aesthetic value, but a means to prepare for future needs. While willing to take risk, clients maintain an expectation that enough of the money will be there when it is required to meet future needs. For the adviser, it means that creating outcomes is important. It doesn’t mean, or have to mean, risk avoidance. But it will mean that alert risk monitoring will be required for some and risk compartmentalization for others.

This is a good time to reflect on what advisers can do that is both viable in a business sense and valued by their shell-shocked clients. Advisers offer more than market knowledge, product knowledge, transactions, and advice. Advisers have a comparative advantage as service providers for clients. This book focuses on helping advisers—and individual clients—utilize that advantage and ensure value -additive portfolio creation and proper management.

In the traditional model, advisers combine product and market knowledge with sales acumen to create a book of business. Here we show how to extend beyond the simple lens of risk-return to create a scalable business model that allows for most of what you are used to doing but simultaneously meets the customized needs of clients. We also cover other ways an adviser adds value, particularly as a delegate: Someone who can take action without the conflicted passions of trying to manage one’s own emotions and portfolio simultaneously. Whether the relationship allows for discretion or not, the adviser’s monitoring of markets means that the adviser can act faster and without waffling when conditions are met (nondiscretionary) or deemed warranted (discretionary).

Retirement is the most opaque, costly, and angst ridden part of financial planning that most people face. The good news is that it doesn’t have to be that way. The bad news is that, as of 2008, only a small percentage of financial advisers describe themselves as competent when it comes to creating portfolios designed to meet retirement needs. Clients can’t look to 401(k) administrators for solutions; they’ll probably receive a nice pamphlet with lots of bromides for the “average” retiree, but it will be next to useless for your client. For the most part, they are neither properly registered to be allowed to offer investment advice nor, as plan administrators, able to provide tailored advice; asking for information about something not on the menu would be a complete waste of time. For some, the last two sentences are a problem, for you and for me they’re an opportunity.

When properly explained, understanding how to structure portfolios for retirement income is an easier problem than most advisers realize. Saving for retirement may be difficult, but, with the proper understanding, you can analyze the circumstances of your clients and from there show them what to do without feeling lost yourself. By knowing where they are, and where they want to be, you will better understand how you can take actions to improve outcomes.

Much of what advisers and clients need to know is straightforward and intuitive—its stuff that makes sense. Most of the material is geared for the financial professional; if you’re an individual whose goals are simply to understand what needs to be done and be able to converse intelligently with your adviser you may want to skim the more technical sections. Each chapter is designed to (1) enhance understanding, (2) enhance competence, and (3) enhance expertise. At the very least, you should finish this book with a better understanding of what needs to be done, even if you skip the sections on how to do it or how to do it really well.

Most parts of the book are not technical but expository. However, some parts will require—and reward—those with patience and concentration. There is a workbook accompanying this book for those who want to implement the portfolios discussed here. I make no apologies for the segments on allocations and active risk management being technical in nature. On balance, I’ve attempted to minimize the abstract and maximize concrete examples. Most of the mathematical concepts are found in the accompanying workbook or moved to the appendix of this one. There are a few background areas where I get into the assumptions and theory underlying the methods used, but I keep those for exposition that will be of most use to those who want to implement some of the ideas discussed in the book for a varied client base.

In reading this book, you will spend most of your time learning how to reframe your existing practice to provide more value to clients. Much will focus on what to ask and how to act to protect your client’s retirement and aspirations. You’ll also be given a menu of alternatives that you can undertake in concert with your clients. All of the alternatives presented here conform to best practices. Your job will be to understand your client’s preferences and pick which alternative works best for him or her. For an individual, you can choose between going it alone or conveying what you want your financial adviser to do on your behalf.

In writing this book I have received no funding or payment from any firm. It is not my intention to sell anything but rather educate so that you can do the selling. For that reason, this book is aimed at helping professionals understand how to manage a portfolio of assets to protect a lifestyle without changing the desirable features of current practice and bridging them to the emerging thought on best practices. Some intrepid individuals may find this book useful, but it is not meant as a simple guide for average readers. For professionals, I have sought to provide a framework of solutions that can be scaled across their client base. These professionals can be:

• Transaction-oriented salespeople

• Asset gatherers

• Portfolio managers

• Insurance planners

• Financial planners

PART ONE: FRAMING THE PROBLEM

Part One (Chapters 1-5) provides the setup, the thematic underpinning for viewing retirement income needs. These first chapters are designed to focus your attention on framing the retirement portfolio problem in a way that can be solved. If you think back to your days of doing word problems, Part One is designed to help you understand the important aspects of the portfolio problem and set up the problem to be solved in Parts Two through Four.

Chapter 1, Portfolio Focus and Stage of Life, shows you how tools and techniques used in the accumulation phase of your client’s life don’t work well or are inappropriate for both planning for and living in retirement.

Chapter 2, The Top-Down View: A Short Primer on Economic Models of Retirement Income, provides a capsule summary of the last 40 years of economists’ work in the areas of consumption planning and lifetime portfolio selection relating to retirement. This provides a useful way of framing the issues and splitting up the problem into two parts: meeting your client’s lifestyle needs and meeting your client’s need to aspire. Our focus for the remainder of Part One is on the lifestyle needs and we defer the aspirational needs to Parts Two through Four, where we discuss allocations, portfolios, and risk management for retirement.

Chapter 3, The Importance of Lifestyle Flooring, is all about understanding lifestyle (flooring) needs and the classifications of product types that help to safeguard lifestyle during retirement. We delve a little deeper to see how what is considered a need will be funded. By matching needs against resources, and the options available for securing lifestyle needs.

Chapter 4, Monetizing Mortality: Annuities and Longevity Insurance, looks at risk pooling, how longevity-based products work, and an individual’s ability to monetize one’s own mortality. Roughly 15 percent of all retirement assets are held in insurance-related retirement products such as annuities. For many, it is the only retirement product that they own. There are many classes of these insurance-related products and most individual products seem difficult to understand. The goal of Chapter 4 is to simplify the understanding of insurance products and, when coupled with Chapter 3, help your clients decide if insurance products are right for them.

Chapter 5, Flooring with Capital Markets Products, is a brief look at using capital markets products to help secure a floor under a lifestyle. It is not meant as a comprehensive guide, but in tandem with Chapter 4, meant to provide a perspective on the possibilities for creating lifestyle security with standard products such as stocks and bonds that can be used to construct a retirement income portfolio. When coupled with Chapter 3, Chapter 5 helps to crystallize the notions of a protected floor.

PART TWO: ADAPTING PORTFOLIOS FOR RETIREMENT INCOME

Part Two is designed to move you from understanding to action. The theme is to start with the subtle changes that make big differences. This part is dedicated to taking your ingredients and combining them in a recipe to meet outcome-oriented goals. In Part Two, we start with some simple retirement income constructs that dovetail with traditional accumulation portfolios. The objectives are twofold. Our first objective is to show advisers and individuals that there are straightforward ways to prepare for the act of retirement, naturally transitioning from an accumulation to a retirement income focus. Our second objective is to show that the changes to portfolios are not drastic; conceptually, they make sense to clients and they are as scalable as traditional constructs.

Chapter 6, Building Retirement Income Portfolios, walks through the basic portfolio construction for retirement income. For those still working or in the preretirement accumulation phase, this chapter offers simple construction types for building retirement income portfolios. The portfolio constructs offered are straightforward for individuals and scalable for professionals to offer to multiple clients. The last section of Chapter 6 offers a list of 11 common pitfalls regarding the use of taxable versus tax-advantaged accounts for assets. To paraphrase Nigel Tufnel, most books only offer 10 pitfalls, but this book has 11.

Chapter 7, Creating Allocations for Constructing Practical Portfolios by Age and Lifestyle Needs, provides some information and examples of functional asset allocation useful for conceiving complete retirement income portfolios. This chapter provides guidance on allocations to lifestyle security, longevity risk, precautionary needs, and risky assets. We also discuss the impact of having lifestyle security on an individual’s risk tolerance. Chapter 7 helps to clarify the line between those who are more natural candidates for insurance products versus standard capital-markets products like bonds.

PART THREE: MANAGING PORTFOLIOS FOR RETIREMENT INCOME

All portfolios need to be monitored and occasionally they need attention. This is as true of a passive portfolio as an actively managed one. For passively managed portfolios, the goal is to keep the portfolio on a predetermined track. For actively risk-managed portfolios, the goal is to seek the higher returns that come with higher risk without letting the risk threaten to endanger lifestyle.

Chapter 8, Rebalancing Retirement Income Portfolios—even if you set up a passive portfolio for retirement income, it requires periodic rebalancing to raise what it provides for the client’s lifestyle and to avoid increases in risk. There is a difference between rebalancing as used in the normal context of accumulation portfolios and portfolios that are set up to protect a lifestyle. In our case, rebalancing is a more delicate, but not more difficult, problem. There is a role for traditional rebalancing within the aspirational segment of the portfolio that is also discussed.

Chapter 9, Active Risk Management for Retirement Income Portfolios, shows how to actively risk manage around a lifestyle floor, without ever losing sight of the need to maintain the floor. We show how portfolios can be set up to take a little more risk, attempting to gain higher return, and be prudent at the same time. Remarkably, using historical returns we see that a little risk can go a long way in helping to raise lifestyles. Fortunately, historical returns also teach us that taking a lot of risk, even if coupled with diligent risk management, can pay off but is more likely to lead to no net gain in lifestyle.

PART FOUR: MAKING IT HAPPEN

By the time you get to Part Four, you should have a solid understanding about the important considerations for retirement portfolios, the methods for constructing retirement portfolios, and the techniques for managing the portfolios. What comes next? This part is about adapting a traditional business to encompass retirement portfolios. The emphasis here is on having a process that is backward compatible with your existing business model. To that end, we emphasize making the transition feel natural, working within current infrastructure, understanding the subtle changes in client segmentation, and how product sets fit into our framework. We cover a large number of examples that can be considered as outlines of portfolios targeted for the different segments. Information that speaks directly to clients is included in Chapter 14. The last chapter of the book is focused on final thoughts about myths and fallacies that are dangerous for portfolios and some helpful ways to rehabilitate the still viable portfolios that may have suffered a setback.

Chapter 10, The Transition Phase, moves from a focus on accumulation of assets to a focus on lifestyle protection. The goal of this chapter is to have the transition fit the natural evolution of a portfolio so that clients feel comfortable in the undertaking. This chapter shows the best time to begin the transition and constructs that make the transition natural.

Chapter 11, Putting Together the Proposal, combines the ideas of the book and focuses on putting it all together for a proposal to a (new) client. Here we show how to take an ordinary accumulation portfolio and provide a makeover to create a retirement income portfolio—all in an intuitive and straightforward manner.

Chapter 12, Market Segmentation, synthesizes the material of earlier chapters regarding the segmentation of clients. As you will see, there are subtle but profound differences between traditional segmentation and effective segmentation for retirement income. The goal is to show how producers, marketers, and investment managers can create offerings targeting relevant market segments.

Chapter 13, Products and Example Portfolios, provides several case studies and sample portfolios that can be used for various client types. Though there are no specific product “endorsements,” these portfolios are meant not as theoretical constructs but as prototypes.

Chapter 14, Preparing Your Client for a Retirement Income Portfolio, helps you provide something to the client and with the client in mind. It is designed as a tool to help you frame the issues to clients in a way that they can understand.

Chapter 15, Salvage Operations, Mistakes, and Fallacies, is meant to provide guidance for climbing out of the hole that has swallowed so many client portfolios. As a prelude, we first discuss common mistakes and fallacies in retirement income planning. We then move on to salvaging what is left in 2009 and the more general problem of helping clients who suffer a financial setback.

APPENDIXES

This book also includes two appendixes. Appendix A, History of Theoretical Developments in Life-Cycle Planning, features the more technical aspects of the material covered in Chapter 2. It is more technical and goes a little deeper into the material than the main text while still being accessible to nonacademics.

Appendix B, How Professionals Can Maximize the Usefulness of this Book, answers this question, whether your business model is transaction based or fee based, institutional or retail. This appendix explains the relevancy to maximizing the usefulness of retirement portfolios in your business.

Acknowledgments

This book was written between September 2008 and July 2009. For most of that period, it was a good time to be focused on something other than the day-to-day spasms in financial markets. But out of the mix doesn’t mean that I worked alone, in a vacuum, or without the generous help of others.

Many people contributed to the book intellectually, thematically, and stylistically. Many contributed to helping research, frame, or tighten the arguments that appear within. Still others helped provide impetus to write this book.

Much helpfulness came from members and affiliates of the Retirement Income Industry Association (RIIA), including François Gadenne (Chair, RIIA), Steve Mitchell (COO, RIIA), Bob Powell (Editor, Marketwatch), Elvin Turner (Turner Consulting, LLC), Greg Cherry (RIIA Research Committee, Chair), and Rick Miller (Sensible Financial).

Among those whose contributions were the most insightful and interesting were Zvi Bodie (Boston University), Ravindra Koneru (Endowment of the Institute for Advanced Study, Princeton), Larry Kotlikoff (Boston University), John Lambert (Bank of America), Fong Liu (Barclays), Annamaria Lusardi (Dartmouth University), Moshe Milevsky (York University), Armando Rico (Merrill Lynch), and Nevenka Vrdoljak (Bank of America).

In helping to hone and frame the arguments to fit within the body of practice of financial advisers were John Carl (Retirement Learning Center), Elizabeth Chen (Merrill Lynch), Keith Heyen (Wells Fargo), Michael Higuchi (Merrill Lynch), Tom Latta (Merrill Lynch), David Musto (JPMorgan), Keith Piken (Bank of America), Bob Rafter (Retirement Learning Center), Jim Russell (Merrill Lynch), George Wilbanks (Russell Reynolds), Bruce Wolfe (Allianz), Joe Zidle (Merrill Lynch), and Jeff Zorn (Northwestern Mutual).

Many others helped to push me along in writing the book including Kazi Ariff (Bank of America), Harvey “Skip” Brandt (Starwood), Glenn Worman (Morgan Stanley), Jim Gatheral (Merrill Lynch), Laura DiFraia (Wachovia), Doug Manchester (Goldman Sachs), Gloria Nelson (Afton Marketing), Stacy Schaus (Pimco), Bob Triest (Federal Reserve Bank of Boston), Dabin Wang (Barclay’s), and Lainie Zwecher.

I also want to mention the people at John Wiley & Sons who were very helpful in taking this book from concept to reality, including Pamela van Giessen, Emilie Herman, Kevin Holm, and Kate Wood.

PART One

Framing the Problem

CHAPTER 1

Portfolio Focus and Stage of Life

Objectives

Why retirement income planning differs from accumulation The danger of drawdown plans

In the same way that saving for a child’s wedding is different from actually planning the wedding, planning to live in retirement is different from planning for the far-off act of retiring. Every few years a new financial panic ushers in a series of stories about retirees and those nearing retirement having their fears raised and their hopes dashed because their portfolios are not set up to protect their lifestyle during retirement. The goal of this book is to help you transition and manage your client’s (or your own) portfolio from a generic retirement fund to a portfolio that will see them through to the end. So let’s get to it.

For most of your clients, retirement isn’t just another stage in the evolution of their portfolios. It is a main reason why they saved part of their incomes and created their portfolios. The point of this brief chapter is to introduce you to some of the reasons for rethinking the construction of such portfolios so that they meet this objective and other objectives your clients desire. At some point, the client’s priorities will begin to shift from accumulation of assets to maintenance of lifestyle. As you will see, switching the focus of the portfolio may utilize familiar products but requires changes in portfolio management. In later chapters, we’ll discuss methods for transitioning clients and building “normal” looking portfolios designed for maintenance of lifestyle without foregoing aspiration. In this chapter, we focus on reasons that retirement requires a different approach from that of shifting the accumulation portfolio into reverse.

In this first chapter, we walk through examples to sow the idea of why a “balanced” portfolio may not last through retirement; how retirement saving differs from creating retirement income; how fixing the spending level (variable weights) of a typical portfolio can leave the client vulnerable to running out of money too soon; how fixing the depletion weights (variable spending) in a typical portfolio can lead to undesirable swings in the client’s lifestyle; a section on retiring at the wrong time—which I call the Murphy’s Law of timing retirement.

We also discuss the production industry’s tendency to focus on single products that are supposed to act as magic bullets but usually only appeal to a narrow segment of the client base. In brief, we will contrast products with solutions. Clients want solutions, products may enable or be part of solutions, but it is rare that a product is the solution.

A “BALANCED” PORTFOLIO APPROACH MAY NOT LAST THROUGH RETIREMENT

Balanced portfolios are great for accumulating wealth within one’s comfort level, but eventually collecting assets must give way to deploying assets. Much of the inadequacy of maintaining balance as the goal will be fleshed out in later chapters. What I mean by this section’s provocative heading is that most of Modern Portfolio Theory (MPT), and the portfolio advice that flows from it, is geared toward an arbitrary accumulation portfolio. An accumulation portfolio is unconstrained by the need for meeting drawdown cash-flow needs. For an accumulation portfolio, the main concern is maintaining a portfolio’s balance of risky and safe assets to let the portfolio grow at a rate and risk level at which the client is comfortable. In accumulation, the problem is how to make the client’s portfolio grow while letting both of you sleep at night. In retirement, the game is to enable the client to meet or exceed lifestyle needs each and every year, while making sure that the money and aspirational goals will survive. Sports metaphor: Saving for retirement is largely an offensive game and retirement income planning is a combination offensive-defensive game.1 We show you how to implement both static and active accumulation plans and provide you with the means to defend them not just for the average retirement, but for every retirement.

In retirement, the problem is to maintain a lifestyle; a lifestyle that must be funded and defended. It can be funded partially from Social Security and defined benefit pensions, but also from the client’s portfolio. The idea of risk versus return is not wrong; however, in retirement, the probability of outliving one’s money becomes a very serious issue, especially when markets are stressed. Drawdown plans are very sensitive to down-market conditions early in retirement. Defending a lifestyle against unforeseen liabilities such as health or personal injury problems will be discussed, but the focus of this book is on things within your control as a financial adviser and having flexibility designed into the portfolio for the things that are out of your or your client’s control.

Fixed Spending Levels (Variable Weights) and Shortfall Risk

Why worry so much about the defensive game? If the market tanks right before or just after retirement (as in 1973, 2000, or 2008), then your client may end up in a big hole and forced to eat “seed corn” in order to maintain lifestyle. On the other side, if the defensive stance is too rigid, you will be unable to adjust for contingencies and opportunities. To harp on the downside for a moment: Depending on how and how fast the market and portfolios recover determines whether eating the seed corn was merely a dangerous or a fatal mistake. Improperly defended, your client risks what is termed a shortfall. Shortfall risk can become an existential problem once your client stops generating outside income.

Consider the lucky, the unlucky retiree, and the average retiree who each need the money to last for 20 years (Table 1.1). A string of positive returns during the first 10 years of retirement means that this lucky individual is able to withdraw $50,000 per year without running out of money.

Table 1.1 shows the lucky retiree who gets a ride on a bull market early and is able to make the money last with plenty of room to spare. Note that in the remaining amount, after taking a withdrawal at the end of the year, is the amount with which you begin the next year. Table 1.2 shows the unlucky retiree who attempts the same drawdown strategy but retires into the teeth of a bear market. Here, a string of negative returns at the beginning of retirement means that this unlucky individual runs out of money after 11 years. This performance is worse than having put the money in a mattress. It begs the question that if keeping cash would work with certainty, what would it take to secure the lifestyle but keep open the opportunity for upside?

In both cases (Table 1.1 and Table 1.2), the average return was zero and only the ordering of the returns differed. In a later chapter, we’ll return to this individual who started with $1 million and needed $50,000 per year for 20 years. We will show that this individual’s retirement was fully funded and that making it work should have been a no brainer.

Suppose now we consider the “average” retiree. For this person, we assume that the rate of return is always the average return. In this case, with an average rate of return of 0 percent, starting at $1 million and taking out $50,000 per year will last exactly 20 years. Although the returns data are contrived, these examples demonstrate clearly that a standard drawdown strategy has potentially large risks for a retiree. In any drawdown strategy, it is not sufficient to look at the average case; the order of returns will matter, and it will matter a lot.

TABLE 1.1 The Lucky Retiree Whose Funds Will Last

TABLE 1.2 The Unlucky Retiree Whose Funds Run Out Too Soon

Another way of saying what I’m trying to get across is that modern portfolio theory creates good portfolios that work on average. For retirement income, however, the problem switches to ensuring that the income generating capacity of the portfolio works regardless of the path taken by the market but still has almost the same upside potential. There are both simple, passive methods for ensuring sufficient yearly income and methods that require more activity and thereby put more at risk that may or may not provide greater upside. The best approach for a particular person requires knowledge about that person; but we’ll go through a variety of approaches that you and your client may want to use.

Making your client’s money last does not mean putting everybody in bonds or annuities. It means managing their funds in a way that has them prepared for each year’s needs. In many cases, it merely means taking advantage of the fact that bonds don’t just dampen portfolio volatility, but they are generally scheduled to pay fixed amounts on set dates plus their face value on maturity.2 Throughout the book, we explore both passive and active ways to take and maintain control of a portfolio throughout retirement. Advisers should come away with a firm grasp on how to help their clients, and frankly, sell the proposition. If you’re not an adviser and not the type to do it yourself, you’ll come away knowing how to interact more productively with your adviser, so that your adviser can act as an agent able to understand and meet your goals.

Here’s the key concept: Once your client begins thinking of retirement, you want to help them to understand what they need as a lifestyle floor (the minimum amount of funding required for the client to keep their lifestyle viable) and begin to shift their portfolio’s focus from pure accumulation, with its emphasis on maintaining balance, to a stance that protects their lifestyle while still offering the potential for upside. This floor isn’t necessarily what they want to spend to maintain a lifestyle; it is what they need to spend to maintain their lifestyle. Protecting a lifestyle floor means changing the rebalancing rules that are used in accumulation to ensure that floor’s protection.

Fixed Depletion Weights (Variable Spending) and Lifestyle Risk

There is an alternative that some of you may have already considered. It is possible to take a fixed proportion each year, while letting the amount vary depending on market conditions. If you think of someone starting out with 100 shares and they want to make the funds last for 20 years, then you could sell 5 shares per year. In such a case the fund will last, but they may end up with a few lean years and a few fat years along the way. For example, we consider our lucky, unlucky, and average retirees using this approach. With an average return of zero, our average retiree will take out $50,000 per year. But our lucky and unlucky retirees will end up with the consumption paths shown in Table 1.3.

A string of positive returns during the first 10 years of retirement means that except for the final year this individual supports a lifestyle greater than $50,000 per year.

Having the bull market at the beginning of retirement, “Lucky” was able to maintain a lifestyle that provided little in the way of income stability for planning but did provide a few fat years along the way. However as with drawdown plans, for the unlucky retiree of Table 1.4 who follows the same rule but gets hit by very different market dynamics, the scheme does not work nearly as well.

With the first 10 years of Table 1.4 sporting negative returns, this individual supports a lifestyle that can only be described as grim relative to sticking the money in a mattress.

TABLE 1.3 The Lucky Retiree Enjoys a Well-Funded Lifestyle

TABLE 1.4 The Unlucky Retiree Lives a Constrained Lifestyle

Fixing the depletion weights and allowing the amount consumed to vary each year will always stretch the funds as far as needed, but is not always a satisfying approach. When returns are constant and without volatility, flexible withdrawals provide stable consumption. However, for portfolios having elements of risk, anyone who is even moderately risk averse will prefer a smoother, more predictable consumption path.

Falling for Murphy’s Law of Timing Retirement

For most people, retirement isn’t a spur of the moment act but part of a premeditated plan. Often the premeditation is colored by the current state of the economy as a whole and portfolio performance in particular. When markets are booming, people have a sense of financial well-being. That may lead some to underweight the probability or suddenness of a market downturn. This sense of well-being may make some more prone to choose early retirement after a long period of prosperity and near a market peak. This would be Murphy’s Law of retirement: People tend to retire just before a market downturn and are thus more likely to be unlucky. We want to show you how to protect their gains in a way that allows for participation in opportunities for growth while managing against the risk of degradation in lifestyle. This further helps avoid the blame game and the potential for questions about suitability.

Drawdown Plans Are Sensitive to Longevity

All drawdown plans, whether fixing spending levels or fixing portfolio weights, are sensitive to longevity. The more that an adviser tries to optimize a drawdown plan to cover a retirement span, the greater the sensitivity of the plan’s likelihood of success to living past the expected span’s terminus.

For the fixed spending level plans, the longer the stream of income is expected to flow, the greater the probability that any depletion rate will fail. Few people want to constrain their lifestyle needlessly. That means that there is an incentive to seek the highest rate of drawdown that will be expected to work. But the rate that ought to work for a 10-year span is unlikely to be successful for a 30-year span. Advisers run the risk that the higher they try to manage or optimize a drawdown plan’s cash flows, the greater the probability that the plan will run out of money if the client is blessed with longevity.

For the variable spending plans, there is also a danger in longevity. In a mathematical sense, the risk here can be somewhat mitigated by adjusting the drawdown rate to reflect conditional life expectancy at each point in time. However, what works mathematically is not necessarily sensible. The level of spending that falls mathematically out of a variable spending plan may not be high enough to sustain lifestyle. The likelihood that a variable spending plan will yield cash flows that are too low to sustain lifestyle is greater when the plan is adjusted for longevity.

RETIREMENT SAVING VERSUS RETIREMENT INCOME: AN ILLUSTRATION

Conceptually, the retirement saving problem is a problem of growing as big a pot as possible given a client’s level of risk aversion. Once retired however, each client needs to maintain a lifestyle that works for him or her. Instead of thinking of the metaphor of the pot that keeps growing, what you want to do is begin to think of a problem where you create a floor amount of income for each year of retirement and your goal is to never let the client fall below the floor. As shown in Figure 1.1, accumulation eventually gives way to decumulation. It is useful to lay out assets and match desires against abilities, recognizing that some of their income may come from external sources and that the client may anticipate a slowing down of their lifestyle.

FIGURE 1.1 Growing the Portfolio and then Protecting the Lifestyle

If your clients have been contributing to Social Security, or have other forms of social income such as veteran’s benefits, then they will be eligible to receive benefits that can defray some of their lifestyle costs. In addition, although the participants of defined benefit retirement plans have become rare outside of governmental employment, some clients may get such income. Social Security and defined benefit plans aside, it’s all up to remaining financial and human capital sources.

PRODUCTS VERSUS SOLUTIONS

Retirement income is a multifaceted problem. The objectives include securing a lifestyle, having the ability to meet contingencies, and being able to aspire to an improved lifestyle. The difficulties that people face include risks that the adviser can control and risks outside the adviser’s control. The adviser can help mitigate market risks, credit risks, longevity risks, inflation risks, some of the risks associated with changing tax laws, and certain health risks. But he or she cannot control spending risks, public policy risks, and uninsurable catastrophic events. The focus of this book is on managing for and through the difficulties and finding solutions that help prevent difficulties.

Products are not solutions, but they help to effect solutions. With different segments for lifestyles relative to wealth, risk aversion, health, and longevity, there will be different solutions. Quite often products are touted as solutions. In a few cases, products exist that meet the needs of a particular slice of a segment. This book, however, does not endorse individual products. There are no products that offer solutions for all segments. Products have pros and cons for particular segments. For some segments, annuities are perfect, for others capital markets products are a better choice, for still others a hybrid approach combining capital market products with insurance-related products can be appealing.

This book weighs product types for their ability to help effect solutions for individuals. We show how to build portfolios and, where necessary, manage the risk within the portfolios. In most cases, the right solution is static or, with occasional rebalancing, nearly static. There are solutions where the risk needs to be actively managed.

SUMMARY

This chapter showed that traditional portfolios, built for accumulation of wealth, frequently fail during withdrawal in retirement. In a nutshell, the problem is that traditional portfolios are designed around the principle of finding what is, on average, the best alternative—and finding the best portfolio for an individual client out of those that will not fail. These first few examples are designed to reinforce the notions that drawdown plans suffer from major weaknesses.

• When making withdrawals the order of returns matters

• The timing of retirement can have a significant impact on the likelihood of success or failure

• Unexpected shocks, even one-time shocks, can destroy a plan

• Outliving ones assets becomes a more acute risk for an “optimized” withdrawal strategy

CHAPTER 2

The Top-Down ViewA Short Primer on Economic Models of Retirement Income

Objectives

Understanding the framework for retirement portfolios Securing minimum needs Creating upside above the minimum Understanding funding and the need to take risk Capital markets and capital markets risk Risk pooling: Monetizing your mortality and its risks

While many financial professionals are well schooled in the dynamic nature of asset markets and asset prices, most of the practical literature geared toward financial professionals gives short shrift to the basic point that clients are saving and investing for a reason. Even less guidance is provided to advisers on the dynamic nature of how the actions required for achieving the client’s portfolio objective change through time. The standard framework in which most advisers operate treats the client portfolio as separable from desired future consumption. Separating out consumption and ignoring the reason that portfolios are created may make the material easy to teach, but reduces the material’s relevance.

A half-century of literature exists that links investing to consumption. As you’ll see in this chapter, a simple and subtle tweak to the standard framework provides substantial practical insight. We’re not after an academic exercise, but in showing how recognizing a seemingly small change in framework provides enormous insight into how to build a business.

We start this chapter with a short primer on economic models of retirement income—pay special attention to the simplicity of the results and their business implications. We then reconcile accumulation portfolios with retirement income portfolios. Of practical interest is how the degree of client risk aversion evolves. When the client has an interest in lifestyle maintenance, the portfolio construction separates between lifestyle flooring and creating the potential for upside. We discuss client goals, the ability of clients to meet their goals, the role of taking market risk, and the role of insurance against risks by risk pooling.

AN OVERVIEW OF ECONOMIC MODELS OF RETIREMENT INCOME

Almost all structural models of lifetime consumption and portfolio selection yield strikingly similar results. It helps that the results are pretty intuitive. What is even more helpful is that we can take the important implications of the approach without being constrained by a particular parameter. To be technical for a moment, all members of the standard class of utility functions1 yield optimal consumption plans implying optimal consumption in any period is given by an individually specified minimum consumption floor amount plus a fraction of wealth in excess of the present value (PV) of all future floor amounts (discretionary personal wealth). The salient differences between optimal plans for different preferences manifest themselves by differences in the drawdown fractions (x).

The English translation is this: Every model commonly used by economists takes you to the same place: An individual’s optimal consumption is given by their specified minimum lifestyle plus some fraction of discretionary wealth.

This allows us to characterize “optimal” portfolios as floor plus upside.

The primacy of securing a floor under lifestyle holds for all models. Some models leave the floor unchanged if wealth and consumption rise and others that are more elaborate allow the floor to rise when there is a bump up in lifestyle. All of the models emphasize the importance of some type of floor. The results of optimizing the remainder of the portfolio for alternative preferences are nuanced and subtle. Different preferences imply differences in portfolios and rates for drawing down from discretionary wealth:

1. Differences in risk tolerance will lead to discretionary wealth portfolios that have degrees of risk corresponding to where the individual sits along the aggressive-conservative risk-tolerance spectrum.

2. Those whose relative risk aversion is unchanged as wealth is drawn down will consume discretionary wealth in straight-line fashion while those whose risk aversion increases as they draw down total wealth will be more frugal with their resources and be less tolerant of risk as their wealth shrinks.

RECONCILING RETIREMENT INCOME PORTFOLIO CONSTRUCTION WITH ACCUMULATION

At first glance, the rationale and equation in the previous section may not look like the standard Markowitz (1952, 1959) model or the Modern Portfolio Theory (MPT) framework that we normally work with. In fact, the standard MPT framework is a special case of the more general life-cycle framework of Samuelson (1969) and Merton (1969, 1971) which we use here. Modern portfolio theory began with Markowitz, but it didn’t end there. There are two main features that distinguish the life-cycle framework used here from the Markowitz special case. The first is that this framework is explicit in its acknowledgment that consumption has physical and psychological minimum requirements. By itself, this difference seems small but has a profound impact on portfolio construction. The second is that this framework takes into account the dynamic features of a lifetime portfolio problem rather than the single-period framework used by Markowitz.

The lifestyle floor recognizes that most people would seek to avoid outcomes if their basic lifestyle was in jeopardy. Security and fear are powerful emotions that drive behavior in virtually every financial model. The floor is a statement that there is an outcome where fear overwhelms the desire for potential gains. In brief, the floor is part of a total portfolio, but it is a subportfolio where safe, time-dated cash flows are desired.

The fraction of the portfolio that encompasses discretionary personal wealth—that is, wealth in excess of the amount needed to lock in a floor—is close in spirit to the standard framework. One important difference here is that the model is dynamic, linking the individual’s desires and sense of well-being across time. This dynamic feature embeds a desire for smooth consumption that would not be captured in the standard model. That means that even in this Markowitz-like subportfolio, as wealth is drawn down, the risk aversion of the client will probably be changing and the optimal portfolio will change commensurately.

To give a little better feel for why the portfolio construction differs for retirement income and accumulation, we now go through the abstract setup for a two-period problem followed by a simple example of the way that the problem is changing.

Suppose that we are in a Markowitz world with two periods today and tomorrow. We’ll make it even simpler by assuming that today’s consumption has already been chosen so that the only decision is how to allocate the amount of unspent wealth among different assets. Formally, the investor/consumer’s problem is to choose a portfolio to maximize the expected utility of next period’s consumption subject to limited wealth and the characteristics of available assets. To put it in symbolic form the investor/consumer’s problem is the following:

maxE[U(Ct+1)]

subject to and

max E[U(Ct+1)]

In this equation E[] represents the expectation operator, C represents consumption subscripted by time period, W represents wealth similarly subscripted, Rt,t+1 represents the return on the portfolio of assets. The individual returns on the assets are given by ri and the weights of the assets in the portfolio are given by wi. As always, the weights sum to 1.

Since we’ve already chosen today’s consumption the problem is equivalent to choosing the optimal set of portfolio weights wi. If the utility function is quadratic, or if returns follow a normal distribution, then the preceding problem is a standard mean/variance optimization problem.

The retirement income problem can be seen as an almost identical problem, but with the addition of a constraint that next period’s wealth must be above some floor level. The portfolio weights are still the choice variables in the problem, but the resulting portfolio will now reflect the imposition of the flooring constraint. subject to and

In this simple model a greater proportion of the portfolio will be dedicated to a risk-free asset to ensure that the floor is achieved.2 The complications for modeling are trivial but the implications for portfolio construction are profound.

To see how profound the implications of the change, consider a very simple numerical example with two portfolios:

Portfolio 1

ProbabilityOutcome0.522%0.5-6%

Portfolio 2

ProbabilityOutcome0.0890%0.920%

We can calculate the expected return and volatility of the portfolios as follows:

Portfolio 1Portfolio 2Mean8.0%7.2%Variance0.01960.0596