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Money & Policy

Your Retirement: In Better Shape Than You Think?

This adviser says: focus on income, not the size of your accounts


(This article appeared previously on MarketWatch.)

A lot of time is spent on telling retirees and those who are rapidly approaching retirement that they haven't saved enough. It’s a gloomy future for those who don't get their fiscal house in order.

 
These statements are based on very sound, but conservative, estimates of growth. They’re also looking at the entire retirement picture the wrong way.
Focus on Cash Flow Not Size of Portfolio
 
The Harvard Business Review recently published an article on the subject, and it really got me thinking. Robert Merton, the author of the piece, is a Nobel Laureate and professor of finance at MIT, so he knows a thing or two about finance. Here's the gist of the argument: retirees should focus on the cash flow their portfolio will generate, not the size of their retirement savings.

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Of course, there’s a correlation between how much you can get in cash flow from your portfolio and its size. However, by focusing on cash flow and not being fixated on market gyrations and their impact on your portfolio, you gain peace of mind and reduce the probability of making investment mistakes driven by emotional overreactions — which have ruined more than one portfolio.
 
We had the opportunity to interview Merton on our weekly radio program recently about the crisis in retirement planning.
A Case Study in Overcorrection
 
Sadly, there is a large portion of Americans — 19 percent of those age 55 to 64 — who haven't saved any money for retirement. Unfortunately there isn't much help for them. But let's take a look at a much more common scenario, a husband and wife who have saved $500,000 in various 401(k), IRA and other accounts for retirement. We'll call them Mr. and Mrs. Jones.
 
Mr. and Mrs. Jones diversified their portfolio into a variety of exchange-traded funds, no-load mutual funds and a hand-full of blue chip stocks. If the Joneses behave like most investors, they’ll check their statements and account values frequently and might determine that they can withdraw between $20,000 and $25,000 a year from their portfolio without depleting it. (Additionally, they will receive Social Security payments, which adds another $20,000 in annual income.) The problem is that this income stream is subject to market risk.

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If the market corrects by 20 percent — a risk that cannot be ignored — the amount of income these types of investments can produce will be cut and their withdrawals will likely have to be reduced to avoid further depletion of the nest egg.

 
A death spiral can follow. In many cases, once pinched by a correction, investors tend to become more “conservative” and reduce their exposure to stocks. This emotional reaction will reduce the potential for a rebound in the portfolio when the market recovers, so paper losses become real losses.(Just think back to your own behavior in 2009 — many investors retreated and have still not returned to being fully invested and their portfolios still languish below their 2007 values).
Keeping Up with the Joneses
 
Here is my solution, based on Merton's wise observations: Don't worry about the size of the portfolio and avoid some of the effects of market volatility. Focus on the income-producing qualities of the investments in your portfolio. Put yourself in a position where a chunk of the income stream is protected by insurance company guarantees.
 
If the Joneses were my clients, here is what I would tell them: Put $250,000 ($125,000 each) into a managed variable annuity with a guaranteed minimum withdrawal benefit (income for life). Many of these policies have ratchets that allow for appreciation of the income benefit event if the market declines. A word of caution — these can be complex so always read the prospectus before investing.
 
Put the other $250,000 in high-quality dividend paying stocks that have a history of raising their dividends annually — so-called Dividend Aristocrats. Our portfolio of such stocks has consistently generated an income stream between 4.5 percent and 5 percent after dividend hikes. Investors who held the portfolio for the past four years (since we launched the strategy) are now earning over 8 percent on their initial principal.

While the income stream from this portfolio is very similar to the income stream from the Jones' original portfolio, it is more reliable and less susceptible to volatility.This income stream is consistent, predictable and has upside. (For example, the dividend aristocrats found in the State Street High Dividend ETF have raised their dividends by an average of over 11 percent annually over the past two decades; that's an 11 percent raise each year.)

Also Consider Annuities
 
In addition to income protection, variable annuities can have death benefits that return the full value of the original principal even if the value of the underlying subaccounts are reduced due to market decline.*
 
By focusing on income-producing qualities instead of the current market value, investors will see the dividends increase providing a nice offset against inflation with part of their nest egg and see a consistent and insurance-company guaranteed income stream from the balance of their nest egg.
 
In the event of a sharp or prolonged market correction, the income will be there — guaranteed by the insurance company and growing, thanks to the Dividend Aristocrats.
 
*DISCLOSURE: Variable Annuities have risks and costs, request a prospectus before considering an investment.

Amit Chopra is a Certified Financial Planner who has been working with clients at Gary Goldberg Financial Services since 2006, focusing on investors who are nearing or have entered retirement. Oliver Pursche assisted in the writing of this article.

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