The Distribution Problem Part 3 – An Alternative Solution

It’s been a busy and exciting fall season at USA Financial with all kinds of projects and opportunities on the horizon.  I’ve finally had a chance to circle back around to some of my musings on social media and in particular the distribution series.

In case you need a refresher, part 1 discussed the unique challenges of the distribution stage for investors.  Then in part 2 we elaborated specifically on sequence of returns risk and how that will present an even greater challenge to investors going forward.  Finally, as promised, I will suggest an alternative solution to this problem that many retirees are facing – a solution that is simple in concept yet profound in effectiveness.

The status quo of portfolio management in the distribution stage can be summarized primarily by two strategies.  Option 1 is a constant proportion method where the portfolio is rebalanced every year to a specific equity/fixed income mix – 60% stocks, 40% bonds as an example.  The other method generally gets more conservative as the client ages so that a 60/40 mix turns into a 40/60 mix over time – age-in-bonds and linear glidepath are a couple variations that take this approach.  The shortcoming of both of these approaches is that neither allocation strategy actually adjusts according to how the market has been performing.  In fact, both of these strategies in the distribution stage actually force equities to be liquidated while they are down in value, locking in those losses, and stunting their ability to ever come back in value.

An Alternative Approach

What if instead we built a portfolio where you didn’t have to liquidate equities while they were down in value, thereby mitigating sequence of returns risk?

Here is an overview of the approach we take with our Summit Series Descent Composites:

Descent Pic

The idea is to start with 3 years of a spending reserve bucket within the portfolio that is allocated to cash.  For example: 12% allocation to cash for a 4% spend rate, 15% for a 5% spend rate, 18% for a 6% spend rate, etc.  All withdrawals come from this cash component within the portfolio.  The remainder of the portfolio is primarily geared toward equities in order to generate the growth needed to sustain the spend rate over the course of a long retirement and to offset the silent risk of inflation.

Every quarter the portfolio will be rebalanced according to what the market has been doing.  If the market is up, then the cash reserve bucket will be replenished from the equity component.  However, if the market is down, the portfolio will not be rebalanced in order to give the portfolio more time to recover losses.

This all sounds good in theory, but I’m a numbers guy.  So how has this type of distribution strategy worked historically?  Our friends at Horizon Investments have put together a detailed research report comparing the effectiveness of an intelligent rebalance to the other prevailing distribution strategies out there.  Here is a summary of their findings:

Blog Pics

Source: Horizon Investments Research, Retirement Planning: Solving for the Major Risks in Retirement

Parameters

What Horizon calls Real Spend in green is the very same concept we are discussing here.  As you can see, probability of success (defined as not running out of money) is dramatically increased when using an intelligent rebalance strategy for distributions.  This objective study looked at all the rolling 20, 25 and 30-year periods going back to 1926, so as to not cherry pick any specific time period.

There are other income distribution strategies out there that are not discussed here (annuities, insurance, alternatives, etc.) and every strategy has pro’s and con’s that need to be considered, but for those investors and advisors seeking to utilize a more traditional mix of equities and bonds to generate income, this is a strategy that should be considered.  Feel free to reach out to me for more information regarding anything discussed in this series or to request a copy of the full research report or information on our composite models.

The strategies discussed do not guarantee a profit or prevent against a loss. Investing carries an inherent element of risk, and it is possible to lose money while utilizing any strategy that includes equity or bond investments. Past performance is no guarantee of future results.

The Summit portfolio may seek to allow more time for the portfolio to recover and postpone rebalancing, increasing the duration of market exposure and potential for loss.

Summit Portfolio Series is offered through USA Financial Exchange. A Registered Investment Advisor. Eric Gritter is an Investment Advisor Representative of USA Financial Securities. USA Financial Securities and USA Financial Exchange are affiliated companies.

The Distribution Problem Part 1 – Clarifying the Unique Challenge of the Descent

During the Q&A session of the recent June market update, I answered an open-ended question on fixed income.  Part of my answer centered around the distribution challenge that advisors and retirees are facing today.  Due to the complexities and nuances of this topic, I am going to break this up into a three-part series.

Today, my goal is to set the stage for the challenge that retirees are facing in the distribution phase.  Part two will then take a deeper dive into some of the risks pertaining specifically to distribution and shed some light on the dangers of how some advisors are setting expectations for income in retirement.  Finally, part three will present an alternative way to approach the challenge of income distribution compared to the prevailing strategies used by many advisors and investors currently.

When most people think about investing and their personal financial plan, they tend to view it as a fairly linear progression.  They take a snap shot of where they are today, financially speaking, and project what their goals are 20-30 years down the road.  Some investors will break that path up into two distinct phases – the accumulation phase and the distribution phase.  Regardless if they view their financial life as one long continuum or two distinct phases, most investors assume that the risks in investing remain constant and similar no matter where they are on the path.

Our approach to investing is quite different.  We view investing more like a mountain trek that has three distinct phases, each with its own unique challenges and risks – Ascent (Accumulation), Acclimate (Risk Mitigation), and Descent (Distribution).

During the Ascent phase, the investor is accumulating assets during their earning years.  The primary risk inherent in this phase is volatility.  Volatility in and of itself is not a bad thing despite what media often portrays.  In fact, without a certain level of volatility it would be impossible to earn more than the risk-free rate that cash or treasuries are paying over the long term.  The key is to appropriately gauge the investor’s appetite and ability to handle volatility and mirror that same level of risk within their portfolio.

Once the investor nears retirement, they enter the Acclimate phase.  The primary risk at this point during the investor trek is loss.  This is not to be confused with volatility.  Absolute loss, or drawdown, at this stage can have a permanent negative effect on an investor’s financial goals.  One reason is that they are much closer to the point in time that they will begin to take distributions from their accumulated assets to live on during retirement.  Related to that issue, negative investor behavior (i.e. panic selling after losses) becomes more acute.

The final phase of the trek is the Descent, otherwise known as the distribution phase where investors begin to convert their accumulated assets into a replacement paycheck after they stop working.  This is the phase that I will focus on for the remainder of this blog post and the two follow-up posts.  The primary risk that investors face here is longevity – at its core, this is the risk of running out of money.

Before I move on, our friends at Horizon Investments recently issued a whitepaper detailing this redefinition of risk based on the investor stage.  I would encourage you to check that out if you are interested in more information on the rationale for this investment philosophy.  Here is a visual of what we’ve discussed so far:Mountain

Longevity as a risk can be a bit abstract to think about.  I find it easier to grasp when breaking it down into the two core risk components:

  • Sequence of returns risk – experiencing early losses in the distribution phase increases the probability of running out of money due to liquidating assets that are down in value, thereby locking in those losses permanently.
  • Inflation – the loss of purchasing power over time.

The difficulty here is that these are competing risks.  On the one hand, you need conservative assets within your portfolio to mitigate sequence of returns risk.  On the other, equities are a better hedge against inflation than fixed income over time.

Hopefully that clarifies for you the unique challenge that investors are facing in retirement.  Over the course of the next couple weeks I will shed some light on how advisors are attempting to solve this distribution riddle and also present a viable alternative.

A New Stock Market Era has Begun (actually its already 5 years old)… Yet Almost Everyone Missed It

Here’s the Skinny,

The popular 1st Quarter 2018 USA Financial Trending Report has been released along with the January 2018 USA Financial Trend Tracker.

Here’s an except from the report…

On January 4, 2018, the Dow Jones Industrial Average (DJIA) closed above 25,000. Just eight trading days later, on January 17, 2018, the DJIA closed above 26,000, sprinting through the fastest 1000-point growth milestone ever. Many may remember years ago when I first introduced the stark visual differences of “your father’s stock market” (1980-1999) in contrast to “your stock market” (2000-2012).

The visual distinction for the S&P 500 for the 20 years of 1980-1999 compared to the 13 years of 2000-2012 is shocking. In fact, in my opinion, it changed everything. It ushered in the age of risk-management as king, unseating passive buy and hold investing as the logical approach. However, we are now dealing with a whole new era that began in 2013. (Note: I consider 2012/13 as the transition point for the next era, as 2013 was the year the market surpassed its previous highs, finally recapturing gains from both 2000 and 2007).

Once again, we see a very distinct contrast from the previous era, even with the performance flatness from late 2014 to early 2016. If we string all three eras together on a single chart, you can quite literally see and feel the “tone” of the market change as we progress through time (the RED vertical lines separate the eras).

chart.PNG

Continue reading the 1st Quarter 2018 USA Financial Trending Report.

See the most recent  trending updates and the accompanying explanatory video.  

That’s the Skinny,

Risk Managed Accounts May Subdue Sequence of Returns Risk (Part II)

As a follow up to the previous post: Here’s the skinny

Risk Managed Accounts May Subdue Sequence of Returns Risk (Part II)

Risk managed accounts are my first line of attack (my second will be discussed in Part III) against the sequence of returns risk for investors withdrawing retirement income from their accounts.

In Part I, we analyzed a scenario in which investors had a nest egg of $1,000,000 and were attempting to take annual withdrawals beginning at $60,000 and increasing each year by 3% adjusting for inflation.  The problem was, depending upon the sequence of their returns, (1) one ran out of money, (2) another had a declining balance, and (3) the third maintained their $1,000,000 nest egg after withdrawals.  Mathematically these are all accurate and true.  That’s the unusual challenge with sequence of returns risk – it depends on the luck of the draw.

So, do we just throw up our arms and pray the sequence of returns works in our favor?  Of course not.

The looming retirement planning question is “How may we prepare in real life?”  Can we do anything to combat this risk besides simply withdrawing less money?  Well, let’s address the ultimate stress-test…  Let’s hypothetically look at what would have occurred to investors in the midst of the 2008-09 financial crisis.

We will compare and contrast relevant numerics for the S&P 500 Index alongside a risk managed account from USA Financial Portformulas, using the Sector Bull-Bear Strategy.

Here’s what performance and accumulation look like if we simply assume that both the S&P 500 and the Sector Bull-Bear Strategy have $1,000,000 invested and are allowed to accumulate with no withdrawals from 2004 through 2016:

Sector Bull Bear

I’ll attach a PDF brochure for the Sector Bull-Bear Strategy if you would like to know more details specifically about how the model functions.  Suffice it to say here, the Sector Bull-Bear is a formulaic trending risk managed model that uses specific criteria to select amongst 11 sector ETFs for the S&P 500 via “sector trigger scores,” but then also calculates an overall “master sector trigger” to formulaically dictate when the model will shift entirely out of equities to a conservative bond/gold ETF blend.

The chart above illustrates the S&P 500 (the GREY line) versus the net fee performance of the Sector Bull-Bear (the BLUE line) from the beginning of 2004 through 2016.  Take particular note of how the Sector Bull-Bear would have responded during the 2008-09 financial crisis by automatically shifting out of equities – revealing the popularity of using risk management.

But remember, we are discussing the perils of the sequence of returns risk and the difficulties it creates when distributing retirement income withdrawals from a portfolio.

So next, we will extract withdrawals just as we discussed in Part I of this write-up.

In the chart below, we will use the identical investment of $1,000,000 and identical performance from the chart above.  However, now we will assume that the investor begins to immediately withdraw $60,000 per year, via monthly income checks, increasing each year by 3% to adjust for inflation.

Sector Bull Bear 2.png

In this chart, the GREY line still represents the S&P 500 with ZERO withdrawals, just so you have a point of reference.  But our real focus is now on the green and orange lines.  The GREEN line represents the S&P 500 less the withdrawals (again, beginning withdrawals at $60,000/year paid monthly and increasing 3% annually for inflation).  Notice the severity of the decline during the 2008-09 financial crisis and the fact that by 2016 the GREEN line is running consistently below the initial investment of $1,000,000.

The ORANGE line represents the Sector Bull-Bear less the same withdrawals (again, beginning withdrawals at $60,000/year paid monthly and increasing 3% annually for inflation).  Once more, focus your attention on the reaction of the ORANGE line during the 2008-09 financial crisis.  Also, follow the ORANGE line movement through 2016 as it remains significantly above the initial investment of $1,000,000 through the duration.  This is the value of using risk management to combat the sequence of returns risk!

Unfortunately, all I ever read about the “acceptable retirement withdrawal rate” and/or the “sequence of returns risk” is that one must reduce their retirement income.  It’s as if everyone forgot what investment planning was all about.  Risk management is why we exist!  Anyone can simply identify a 60/40 portfolio allocation and reduce income payments from 6% down to 3%; there’s no need for a financial advisor in a relationship based on that math.

But financial advisors exist to deliver value to their investors.  And risk management is one of the primary ways that such value may be delivered…  Especially to an investor in need of withdrawing retirement income.

That’s the Skinny,

 

 

 

Mike Walters, CEO

 

 

 

2017.09.14 sector-bull-bear-strategy

Risk Managed Accounts may subdue Sequence of Returns Risk (Part I)

Here’s the Skinny…

Risk Managed Accounts may subdue Sequence of Returns Risk (Part I)

For simplicity, I’m going to start this explanation with data published by BlackRock used to illustrate a basic understanding of sequence of returns risk.

Stated simply, during accumulation and/or savings years, sequence of returns has zero impact.  Meaning, if you start with a lumpsum, the order of identical annual returns (positive or negative) has no bearing on the end result.

However, the opposite is true during the distribution and/or retirement income years.  If you are making withdrawals and/or extracting income then the sequence of returns is crucial.  In fact, it can make or break your retirement.  Negative annual returns experienced early during one’s distribution years may spell disaster.

Assume the following:

Scenario 1: Accumulation or Savings Years

  • Three investors made the same initial hypothetical investment of $1,000,000 at age 40 with no additions or withdrawals.
  • All had an average annual return of 7% over 25 years. However, each experienced a different sequence of returns.
  • At age 65, all had the same portfolio value, although they had experienced different valuations along the way.

Scenario 2: Withdrawal or Distribution Years

  • Three investors made the same initial hypothetical investment of $1,000,000 upon retirement at age 65.
  • All had an average annual return of 7% over 25 years, which followed the same sequences as during the savings phase example.
  • All made withdrawals of $60,000 (6%), adjusted annually by 3% for inflation.
  • At age 90, all had different portfolio values after the same annual withdrawals.

Accumulation ReturnsAccumulation Withdrawals

Please refer to disclosures at bottom of post.

As you can see in scenario 1, the changing order for the annual returns has no impact on the end result.  All three investors finish with exactly the same end accumulation value.

On the other hand, scenario 2 illustrates why historically the generally accepted “safe” withdrawal rate has been considered 4%.  However, in current times as we’ve experienced significantly lower interest rates, the dot-com bubble and bear market of the early 2000’s, plus the 2008-09 financial crisis, many now contend that a 4% withdrawal rate is no longer safe – and that withdrawal rates should be dialed back to 3% or lower.

You see, this is not an exact science, as it depends on so many investment variations and factors.  In scenario 2 for example, a 6% withdrawal rate was assumed and Mr. White ran out of money, while Mr. Rush may be in trouble depending upon how much longer he lives and what his future annual returns may be, yet Mrs. Doe appears to be in good shape financially.

 

When such “acceptable” or “safe” withdrawal rates are researched and calculated they are done so assuming static traditional investment allocations.  Therefore, they assume, for example, that one simply must withstand and absorb declines from significant market downturns – yet the entire purpose of risk management is to mitigate downturns!  And if one can mitigate downturns, the impact on the research and income calculations is significant (more on that in Part II)

However, unfortunately, investors are generally taught that accumulating a certain sized nest egg will solve all their retirement woes.  But obviously, that is not the case.  It helps, don’t get me wrong, more is always better than less when accumulating toward retirement.  But scenario 2 shows very clearly that the accumulation amount isn’t the only important factor.

Yet most investors think that’s all there is to worry about – “I just need to save until I hit my magic number.”  Again, it’s not that simple.  Crafting a retirement income plan requires more knowledge, more sophistication, and different tools then does simply saving and accumulating toward retirement.

That’s the Skinny,

Mike Walters, CEO

 

 

 

Chart 1

Source: BlackRock. This graphic looks at the effect the sequence of returns can have on your portfolio value over a long period of time. Other factors that may affect the longevity of assets include the investment mix, taxes and expenses related to investing. This is a hypothetical illustration. This illustration assumes a hypothetical initial portfolio balance of $1,000,000 with no additions or withdrawals and the hypothetical sequence of returns noted in the table. These figures are for illustrative purposes only and do not represent any particular investment, nor do they reflect any investment fees, expenses or taxes.

Chart 2
Source: BlackRock. This graphic looks at the effect the sequence of returns can have on your portfolio value over a long period of time. Other factors that may affect the longevity of assets include the investment mix, taxes, expenses related to investing and the number of years of retirement funding (life expectancy). This is a hypothetical illustration. This illustration assumes a hypothetical initial portfolio balance of $1,000,000, annual withdrawals of $60,000 adjusted annually by 3% for inflation and the hypothetical sequence of returns noted in the table. These figures are for illustrative purposes only and do not represent any particular investment, nor do they reflect any investment fees, expenses or taxes. When you are withdrawing money from a portfolio, your results can be affected by the sequence of returns even when average return remains the same, due to the compounding effect on the annual account balances and annual withdrawals.

Using Donor Advised Funds

The following blog post was originally published in The Wall Street Journal:

Using Donor Advised Funds

As we draw close to the end of the year, a lot of clients are thinking about charitable giving. What charities a client gives to is often a subject near and dear to them. For an adviser, helping a client make those donations in the best way possible is a way to strengthen the adviser-client relationship.

One technique for charitable giving that doesn’t get near enough attention from the advisory community Read more

Five Reasons Why Every Advisor Should Know About Donor Advised Funds

The following blog post was originally published in the National Christian Foundation:

If you’re a professional advisor or know someone who is, you’ll want to read and share this great article on the benefits of using NCF Giving Funds.  AdobeStock_62762114.jpeg

It’s no secret that mutual funds catapulted stock market investing. Mutual funds provided an easier way for the average consumer to participate in and manage their stock investing. They served as a catalyst for the stock market boom of the 80s and 90s. And many will argue Read more