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