Harold Evensky: Inflation, Asset Allocation, and the Most Important Planning Vehicle for the Next Decade May 27, 2008 Harold Evensky is President of Evensky and Katz, a fee-only financial advisory firm based in Coral Gables, FL. Mr. Evensky is widely recognized for his leadership in the financial advisory industry, having pioneered the retail application of concepts such as the core and satellite approach to investment management. He has served on the Boards of a number of national industry organizations, is a frequent speaker, and is the author of several books, the most recent of which is Retirement Income Redesigned: Master Plans for Distribution: An Advisor s Guide for Funding Boomers Best Years (available via the link to Amazon above). We interviewed Mr Evensky on May 20, 2008. In your letter to your clients at the end of January, you said you believed the economy was not in a recession at that point, but might likely be in one during this year. You also said the market already reflected expectations with respect to a recession. What is your current thinking on these two questions: is there a 2008 recession in the cards, and are the US markets fairly reflecting these expectations? My thinking has not changed. Whether we officially end up in a recession (technically two quarters of negative GDP growth) is moot. We clearly won t know until we are well past the worst of it. It is still iffy whether we will be formally in a recession, but psychologically we are in a recessionary mode. We are fundamental believers in an efficient market. The market today reflects those expectations already. We are not big in believing that we, or anyone, can predict the market. Have you adjusted asset allocations in retirement portfolios in the last year, in response to the sub-prime, commodities markets, or general economic forecasts? Absolutely not. We don t adjust strategically based on a one year period. We have made adjustments in the last few years, mainly to increase international exposure. This was due to the relative poor performance in domestic equities, and, as a result, our clients reaching a greater comfort level with international exposure. We have always been and still are -
under-invested in internationals, with respect to where we see their role as an asset class. Over the long term we expect relatively modest equity returns. We have made some modifications within broad classifications. In fixed income, we have extended out duration exposure, from roughly 3.5 to 4.5 years. Our quality had been A or better, and we are now at AA. We have a small/value bias, which we have slightly decreased, in order to increase our international exposure. We are still biased to small/value, which had a great run last year and we now expect to see a modest regression to the mean. None of these changes were specifically related to the sub-prime or to a fear of recession. By the time these events surface, it is too late to invest. Many investors are worried about inflation, particularly given the rise in oil, food, and other commodities markets. Have you made any adjustments to asset allocations to reflect higher rates of inflation? For advisors that want to be better positioned for higher inflation, what would you recommend? We have made no adjustments specifically with respect to inflation, but we too are concerned. Strategically, over the long term there is major risk of accelerated inflation. We use TIPS extensively. We are talking about using them in all portfolios, in spite of their negative tax consequences. If there is moderate to high inflation, say 5%-6%, then equities are still a good place. But if there is hyperinflation, say 15%, then equities are a disaster. We don t use commodities to hedge inflation. Natural resources are a good high inflation hedge; however, the current pricing has already anticipated a significant inflation hit.. There is no obvious alternative, other than TIPS, for hedging moderate to high inflation. Have you increased your exposure to non-us developed or emerging economies in the last year? Our core allocation is in developed markets, and our increase in international exposure has been primarily in the developed markets. We have used Julius Baer, and have recently added DFA funds that give us a different developed market exposure. In the satellite portion of our portfolios, we have some emerging market exposure, including the PIMCO developing local markets (emerging market money market) and Goldman Sachs International Equity Flex, a 120/20 fund.
We are interested in frontier markets, although we have not invested there yet. We are trying to figure out the appropriate vehicle, and are looking at funds and ETFs. The asset class makes a lot of sense. It offers high risk and high return, along with poor correlation to other asset classes. At a fundamental level it is very compelling. For the last five years we have taken a core and satellite approach. Our core assets (80% of total assets) are managed in a cost and tax efficient passive framework. The 20% satellite portion is more actively managed. We established this 80/20 allocation because we expect to be in a low return environment for the next one or two decades. It is too costly to invest any other way. We are implementing a rebalancing software system, which may enable us to add a few new pieces to our core, such as emerging markets. Traditionally, the transaction and management cost of rebalancing and trading overwhelms the profit opportunity. But rebalancing software may solve that. The second piece we look at may be commodities, and after that real estate. We don t know how to invest in real estate. We are not convinced that REITs give us the desired real estate exposure. TIAA/CREF has a great direct real estate investment portfolio, and they are coming out with a product that has access to it. But it is limited to qualified investors, so it does not work for 100% of our clients. The Fed may be forced to keep interest rates low for some time, in order to relieve the pressure on the credit markets and to prevent home mortgages from resetting at high rates. Are we in for a period of sustained low interest rates, and how should this be addressed in retirement portfolios? Check back with me in a year and I ll let you know! I can make a strong argument on both sides. The Fed will keep rates low to protect the economy; the Fed will raise rates to fight inflation and the possibility of hyperinflation. We invest for the long term, and believe that attempting to anticipate short term movements is ludicrous. We ladder fixed income positions, so as to not worry about rate guesses. Nobody can accurately predict interest rates. We d like your opinion on a number of investment categories, specifically with respect to what role they should play in long-term retirement portfolios in the context of today s markets:
TIPS As long as you have thought through the tax issues, they belong in all portfolios. We will continue to add TIPS positions. This is not based on today s market, but based on a 20-30 year outlook. Commodity Funds If it were not for high transaction costs, commodities would be part of our core allocation. As a basic concept, commodities make a great deal of sense as a hedge against inflation and hyperinflation. We have used Oppenheimer and PIMCO funds in the past, and we are now looking at ETFs. We would want a high level of diversification within the commodity sector for any fund we choose. Gold It makes great jewelry. I have never quite understood the rationale behind gold, unless you want to buy Krugerrands and bury them in your backyard in case of Armageddon. I don t understand the argument for gold as an inflation hedge. It is like lead it pays you nothing. It is also unclear how to invest. Many gold funds, including those in the mining industry, have returns that are often unrelated to gold as a metal. If clients want to buy gold, they should buy the metal and not tell anybody. Reverse Mortgages Intellectually and conceptually they are viable and valid as a planning tool, but are too expensive now. If someone is down to the wire and without resources, and they don t want to leave their house, it is a credible planning solution. Over next decade or more, I believe reverse mortgages will become viable and cost-efficient as more people need to tap into residential real estate to maintain their quality of life. The problem now is the cost. Fixed Annuities A number of years ago I told someone that, if I ever recommended fixed annuities, they should wash my mouth out with soap. The story is very different today. Immediate annuities are the single most important planning vehicle for the next decade. In the past, insurance companies took out all the gravy. Today there are low cost providers that offer very competitive products. The real benefit is the mortality return. This is the guarantee that you will be paid regardless of how long you live, and it provides an important psychological benefit to clients. If you conclude that immediate annuities make sense, then it may also make sense to save in low cost deferred annuities. The problem with deferred annuities is the cost drag. Deferred and especially payout annuities are going to be important planning tools. As rates increase and regress to historical norms, advisors need to think about how to incorporate them. When we run an optimization on a client s assets, it is unlikely it will not incorporate immediate annuities.
Variable Annuities If you are saving and expect to use an immediate annuity, a deferred variable annuity is a logical way to do it, especially in a low cost vehicle. It is a credible long term vehicle if there is an expectation that you will annuitize. Ultimately, some balance between fixed, variable, and immediate annuities is the solution. Lastly, many in the boomer generation had been relying heaving on using home equity as a primary source of retirement income. This strategy is obviously under a lot of pressure. What advice would you offer to advisors with clients in this situation? My advice is don t plan on home equity as part of the retirement solution. Historically, the long term return on residential real estate has only been a couple of percent over inflation. The real problem is not that people have been counting on home equity for retirement. It is that they were using it as a checkbook. For some, reverse mortgages may be the only alternative, despite their high expenses. It may be the only way to buy groceries. My advice is to address this early in the retirement planning process. Otherwise it will be too late. www.advisorperspectives.com For a free subscription to the Advisor Perspectives newsletter, visit: http://www.advisorperspectives.com/subscribers/subscribe.php