Co-written by Marie DeCaprio CFA®, CFP® and Jeremy Rhen, CFP®

Working with an investment advisor to develop a comprehensive financial plan BEFORE you decide to retire is one of the best ways to identify what investment path best suits your personal goals and retirement needs.  However, many people decide to retire without following through with the proper planning or analysis and then often find themselves wondering if they are invested properly and whether the longevity of their nest egg is secure.  Obviously, part of the retirement planning process is determining an “appropriate” spend-down strategy for your portfolio (see our last article Nurturing Your Nest Egg for more details), but another important factor to retirement success is the selection and management of your portfolio allocation and investment strategy.

 

Ultimately, the overall balance between equities and fixed income investments, along with the mix of assets, determines how we expect a portfolio to perform over the long haul.   Yet, we often find that retirees are either too aggressively invested because they feel they must “make up for lost time” or are “playing it safe, so they don’t lose a penny” by investing almost entirely in fixed or high-income investments and products.

Investment Income vs. Total Investment Return

At this point we often encounter one of the most common misconceptions we face as financial advisors – the difference between investment income and total investment return.  Most people do not understand that there is a difference between the income that an investment pays out to them (whether via a stock dividend, bond coupon or distribution) and the overall return that they have experienced by holding that investment (income plus the change in underlying asset value, less taxes and fees, etc.)   Many people wrongly assume that since they are living in retirement they are finished with saving and investing for growth and should collect the income from their investments to live on.  This might be a mindset that was passed down from prior generations, or may be a false sense of security found in the idea that assets will not be depleted by only spending the income they produce; either way, this philosophy does not hold up in the current retirement landscape.

Consider that in previous generations, most people had some form of pension in retirement, they received a reasonable social security check (relative to their salaries or cost of living), and usually only lived 5-15 years after retiring.  Under those circumstances, many people did not need to extensively save to build a large nest egg to supplement their retirement income, nor did they run a great risk of running out of money before they passed away.  Much of their income was paid in the form of fixed income payments to them by their pension, an annuity, bank CDs or social security.  Some would say that the dependence on this “check-cashing” retirement model has led to the propensity for retirees to seek out income producing investments to replace these familiar sources, rather than taking a harder look at the total investment return of their investment portfolios.

Many of us now face a retirement that could last 15-30 years, with far fewer fixed retirement income sources, and almost all the responsibility to save, invest and spend appropriately now falls on us as individuals.  For these reasons, most retirees should be investing their portfolios for an expected total return that allows them to accomplish their goals and live full, long lives in retirement, rather than focusing on finding enough income to cover their current needs.

Income Generating Strategies

Often, we come across retirees who have investment portfolios concentrated in a handful of large domestic blue-chip stocks that pay higher dividends.  They receive the dividend checks in the mail and use the funds to supplement their other retirement income with little understanding or concern of the underlying composition of the stock portfolios they own.  Typically, the price of a stock adjusts to account for the fact that a company is paying out a dividend.  So, often on paper, the value of what you own hasn’t changed whether you receive income in the form of a dividend or had to sell some of the stock to realize the same value.  In one case YOU decide when you realize the income, in the other case the COMPANY dictates if, when, and how much the dividend will be.

Other retirement investors have a large portion of their assets invested in REITs (real estate investment trusts) which are often touted for their high-income yields, diversification from equity markets, and the perceived strength of their underlying real estate holdings.  Unfortunately, REITs are notoriously tax inefficient, sometimes illiquid (meaning they can’t be sold at will) and can have drastically uneven cash flows from year to year.  Over the last several years there have been numerous lawsuits against certain REITs and the financial firms who target selling them to elderly retirees.

Another income-based product we commonly find in retirement portfolios are variable annuities.  These are often sold as investments that participate in market appreciation and then can be annuitized to “guarantee” a certain amount of income for the rest of the owner’s life (similar to a pension or social security benefit).  Annuities, especially variable annuities, are often riddled with high fees and commissions that can cause under-performance in the longer term.  Many people do not realize that they can take a portion of ANY investment account and later decide in retirement to purchase an immediate annuity to fix a portion of their income if need be.  Having all, or most, of your retirement income annuitized and limited to fixed income payments can restrict access to additional funds needed to pay for unforeseen one-time expenses.  Furthermore, over-reliance on these types of products can also impact how much of a legacy you leave to your heirs (you generally can’t inherit the “unpaid” part of an annuity once it’s been annuitized).

As if these drawbacks weren’t enough, there are often tax disadvantages to all three of these strategies and other income-based retirement solutions.

The Right Retirement Strategy For You

So, how should a portfolio allocation be structured and what retirement investment strategy should be pursued given that these conventional, income-centered approaches all seem to have pitfalls?  In working with a financial planner, retirement planning or portfolio stress-testing software can be used to help identify a retirement strategy that is expected over the long-term to keep pace with the retirement spend-down amount that is needed.  By focusing on total investment return, rather than just income, these types of analysis help to quantify the likelihood of different portfolio allocations sustaining a given drawdown rate.  When compared to spending income or dividends alone, this often gives the investor more flexible access to their funds when they want or need them.

Many retirees fear that selling even a portion of their underlying investments will accelerate the depletion of their portfolio.  However, working with an experienced advisor to responsibly and strategically utilize assets in retirement gives them an unbiased 3rd party to oversee and coordinate the process.   By managing a portfolio for total return, an advisor can focus more on what is important to the client: maximizing tax efficiency, planning for future goals, managing realistic expectations, and wealth transfer or estate planning.