Structuring a Retirement Portfolio Using an Endowment Approach

Transcription

1 Retirement Planning Structuring a Retirement Portfolio Using an Endowment Approach We should have known it would come to this. The baby-boomers are ready to retire and the financial services industry is in disarray. Products created to provide retirement income haven t worked as advertised. Events of the past year have raised questions about annuity products provided by insurers. Investment vehicles employing naive asset allocation models have underperformed. Now, the federal government is getting into the act. Policymakers at the Department of Labor, regulators at the Treasury Department and congressmen are considering ways to fix the system. We can hope for progress. Repairing the Social Security program by matching revenues with spending seems pretty easy compared with reforming healthcare. Measures that encourage increased savings (requiring opt-out rather than opt-in), promote transparency and educate the consumer are in the works. These will be welcome improvements. Our suggestion is to utilize an endowment investment approach to structure a retirement portfolio. This message is aimed at the 60 year-old who is confronting retirement in a highly uncertain world. It may be modified for use by others. Endowment Model In the financial world, endowment usually describes assets that have been given to an academic, religious or cultural institution in support of the institution s purpose. Most endowment funds are intended to provide regular payouts in perpetuity. To meet this need, the funds are often structured as a balanced portfolio that holds a mix of stocks, bonds and cash. Returns come in the form of income (dividends and interest) and capital gains (because stock prices tend to appreciate over time). Since the necessary return is not earned by dividends and interest alone, this is called total return. Appropriately invested balanced portfolios are expected to generate annual returns of about 7%. Here is the underlying math: Long-Term Asset Class Returns: Expected Portfolio Returns: Equities 8% Bonds 5% Cash 3% Portfolio 8%(.70)+5%(.25)+3%(.05) = 7% Portfolio 8%(.60)+5%(.30)+3%(.10) = 6.6% With its higher weighting of equities, the portfolio will provide a higher total return if stocks do well. This higher expected return is accompanied by a higher level of risk that the portfolio could lose value over brief or extended time periods. The trustees overseeing an endowment typically distribute 4 or 5% of the endowment s value annually (private foundations are required by law to pay out 5% each year while public charities usually have no such requirements). With 2 or 3% of each year s expected return retained in the account, the endowment stands a reasonable chance of holding its value in inflation-adjusted terms. Under this assumption, future payouts may grow at a pace equal to or greater than inflation. What distinguishes many plans from other types of balanced accounts is a flexible spending policy. Spending levels are determined in reference to the value of the account. While the simplest approach is

2 to calculate current year spending as a percentage of the previous year s closing value, many trustees smooth the payouts by using a percentage of average account values over the last three or four years (or the past 12 or 16 quarters). While the flexible spending policy does introduce uncertainty regarding the level of the payouts, using an average of account valuations minimizes the changes over time, and facilitates the preparation of budgets. Retirement Portfolio A 60-year old contemplating retirement is not concerned with perpetuity. He or she is wondering how to structure his or her investment portfolio for a potential lifespan of thirty or more years. In retirement planning, a set amount is often desired and withdrawn regardless of the account balance. Many retirement projections include annual adjustments for an increased cost of living. Such plans do not address the possibility that a period of negative investment returns, combined with fixed or escalating payouts, can deplete an account to the point that it might not recover. In particular, periods of high inflation may be accompanied by weak investment returns, leading to disastrous results for the retirement program. Nor does a set payout policy address the possibility that above average returns might allow for higher distributions. The flexible spending policy allows the retiree to stick with the investment strategy in good markets and bad. Knowing that the worst-case scenario is a reduced payout rather than a depleted account gives the retiree the confidence to keep cool during sell-offs. Example To compare the results obtained from fixed and flexible payout schemes, we present a $100,000 retirement account funded on December 31, We assume that the more conservative allocation is adopted with an initial payout of 5%, and we ignore transaction costs. Under the fixed payout, annual distributions (blue bars), rise with inflation (as measured by CPI), reaching $6,253 in Because of adverse market results, the account value has fallen to $57, 402 by the end of 2009 (blue line). With a planned 2010 distribution of $6,422, the account must earn at least 11% in 2010 just to maintain Fixed Payout Flexible Payout its value. If future Fixed Value Flexible Value $100,000 returns remain at the $6,000 historical level of 6.6%, we project that the account will be depleted in $5,000 $4,000 $90,000 $80,000 $2,000 With a flexible policy $1,000 that ties the payout to the account value, $ $70,000 $60,000 $50,000 2

3 Fixed Payout Fixed Account Value Flexible Payout Flexible Account Value , , ,000 93,678 5,000 93, ,170 84,207 4,842 84, ,253 71,042 4,637 71, ,379 77,838 4,168 80, ,481 78,122 3,944 82, ,662 75,352 3,909 81, ,854 77,315 4,071 86, ,001 75,465 4,172 86, ,247 55,035 4,246 65, ,253 57,402 3,981 72,628 only $3,981 was distributed in 2009 (red bars). However, the account is valued at $72,628 at the end of 2009 (red line). If future returns remain at an annual 6.6%, then the account will slowly recover in value, and future distributions will increase accordingly. Further assumptions: Portfolio is rebalanced annually on 12/31. Benchmark portfolio is 60% S&P 500 Total Return, 30% Barclays Aggregate Bond, and 10% 90-day T-Bill. Flexible payout is 5% of the average end-of-year account value over the previous 3 years. More examples are provided on page 5. Filling Your Retirement Buckets When discussing the rationale behind a balanced approach with trustees or directors of endowments, an investment advisor might say, Look at it this way, with a portfolio and 5% payouts, in the event of a stock market decline, you can maintain the current payout for 8 years, waiting for stocks to return to long-term trend lines. The 10% in cash would provide the first two years of payouts, and the 30% in bonds would cover the following six years. While such an observation serves to illustrate a risk-limiting feature of a balanced approach, it is too simplistic, and it ignores the benefits of rebalancing. A board faced with a market decline would instead endorse reduced payouts as dictated by the flexible spending policy and encourage the investment manager to restore the allocations. Thus, the down-and-out asset class may be purchased at favorable prices, improving the likelihood of favorable returns in the future. In contrast, someone retiring in 2000 with an experience similar to the fixed payout plan presented in Example 1 might feel compelled to liquidate assets at an inopportune time. One can think in terms of buckets to help visualize how an endowment model actually functions within a retirement program (see diagram on following page). The stock portfolio is the largest bucket. Dividends and a portion of the proceeds from stock sales flow into the fixed income or cash buckets on both a regular and as-needed basis. Likewise, interest and a portion of maturing bonds from the fixed income bucket pour into the cash bucket. The cash bucket replenishes the retiree s checking on a monthly or quarterly basis. The likely existence of IRAs or other tax-deferred accounts do not impinge upon this approach. If possible, distributions from these accounts will not begin until the required age of 70½. From a tax efficiency standpoint, retirement accounts should hold as much of the fixed income assets as possible. While illiquid assets such as rental property, closely-held stock or collectibles can be considered in this framework, what is important is that each retiree understands how his or her plan works. A flexible spending policy is designed to ensure that the plan will survive the direst financial scenarios, and its requirements must be consistently observed. Payouts should be recalculated each year, and asset classes rebalanced regularly if the plan is to function as intended. 3

4 Bucket Diagram Equity Investments provide growth that may offset inflation. Dividends flow to the cash bucket, and a portion of sales will periodically be moved to Fixed Income or cash to maintain the desired allocations. Equity Fixed Income Investments provide steady, highly predictable income that helps balance the volatility of the equity assets. Interest payments and proceeds from maturing bonds replenish the cash bucket. Fixed Inc Cash Investments hold assets for recurring distributions to the checking account. Moneymarket funds, Treasury bills and other short-term interest-bearing securities provide modest returns and high liquidity. Cash Checking Account holds sufficient funds to pay bills until the next distribution arrives from the cash bucket. For those who wish to preserve the value of their retirement portfolio for the benefit of heirs or charity, this plan may serve as a valuable framework until death. The approach does not tell the retiree how safely he may spend down the principal as the years go by (there are calculations and simulations that can offer valuable insights for those decisions). A higher fixed (and indexed to inflation) payout commitment - say 6 or 7% - will increase the risk of account depletion. A flexible payout of 6 or 7% of the account value will tend to front-load payouts to earlier years, and will leave the plan more exposed to the effects of inflation. A lower payout of 4% will have a beneficial effect on future account values. For the 60 year-old, preserving principal, even if it means accepting lower annual payouts for a few years, is a primary objective, just as it is for the endowment trustee. Rock Point Advisors offers a balanced investment product, so this may be considered self-serving commentary. In viewing the alternatives offered by Wall Street, or solutions that may be forthcoming from Washington, we believe that retirees should consider combining a balanced portfolio with a flexible payout policy, regardless of their choice of manager. The structure and discipline provided by this time-tested approach can sustain the retiree through difficult markets. 4

5 Example A $100,000 balanced ( ) account started in 1990 would have been worth over $220,000 by 1999 under either payout scenario. Flexible payouts began to exceed the inflation-indexed fixed distributions around 2000, causing diverging account valuations. For the flexible approach, the 2010 payout of $8,566 would represent 5.2% of the account's value. While the market declines of 2002 and 2008 were certainly alarming, the accounts have survived, and for 2010, both scenarios would see distributions of about $8,500. Fixed Payout Flexible Payout Fixed Value Flexible Value $11,000 $250,000 $10,000 $9,000 $225,000 $8,000 $200,000 $7,000 $175,000 $6,000 $5,000 $150,000 $4,000 $125,000 $100,000 $2,000 $1,000 $75,000 $- $50, Example Similar to the 20-year history, the strong returns posted by both stocks and bonds lead to higher payouts under the flexible payout approach, and higher account valuations where the fixed payouts are limited by reference to the initial account value and adjusted for inflation. The flexible payout for 2010 would be $22,306, just 5.2% of the account value. $27,000 $24,000 $21,000 $18,000 $15,000 $12,000 $9,000 $6,000 $- Fixed Payout Fixed Value Flexible Payout Flexible Value $980,000 $880,000 $780,000 $680,000 $580,000 $480,000 $380,000 $280,000 $180,000 $80,000 5