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November 14th, 2011 | Forbes

Beyond Income Investing: A Total Return Approach to Funding Your Retirement

For retirees getting by on lifetime savings, these are challenging times. Interest rates on Treasuries, municipal bonds and other high-grade paper are so low as to be insulting. The Federal Reserve Board has telegraphed its intent to maintain microscopic short-term interest rates for at least two more years. The interest rate regime is what it is, but what concerns us is that these distortions are encouraging investors to take excessive risk for which they are unlikely to be rewarded. Worse, this form of investor behavior can wreak havoc on the important goal of maintaining purchasing power during retirement.

Don’t be a Yield Hog

I speak, of course, of the hunt for yield. Take the example of the retiree who pulls 4% out of his account each year to meet living expenses and mistakenly believes that a low-risk investment strategy is to run a portfolio with a 4% yield that perfectly matches his liabilities (in fact, many working people also pursue a strategy of meeting monthly bills such as mortgage and utility payments with investment income). This is quite likely the way his parents invested. Since interest rates on high-quality bonds are pathetically low, he pumps up income by investing in high-yield stocks and bonds, REITs, and hybrid securities such as preferred stocks and convertible bonds. Moreover, he perceives this as a prudent strategy since it “preserves capital” by not forcing him to sell assets to pay the bills.

There are two problems with this income approach. First, in reaching for yield in a low-interest environment, the investor is unwittingly putting his principal at risk. The siren call of monthly income is blinding him to the risks embedded in the high-yielding assets. For instance, during the market crash of 2007-2009, the prices of REITs and preferred stocks (80% of which are financials) collapsed along with those of common stocks. If a company decides to cut or eliminate a lush dividend on its common shares, in all likelihood the share price will plunge. Morever, a portfolio laden with higher-yielding fixed income securities of long maturity will be squeezed if interest rates embark on a long march upwards, as many analysts are forecasting (for more on the portfolio implications of secular interest- rate cycles, see graph below).

Second, a pure income strategy leaves a portfolio vulnerable to inflation, which is generally the largest risk to investors over decades of retirement. A portfolio that yields 4% will almost certainly struggle to maintain purchasing power over an extended time frame. Especially since we are living longer and longer, investors typically underestimate the long-term ravages of inflation. For instance, consumer price inflation has recently been running at 3.9%. At that rate, a couple with a lifestyle that costs $100,000 today would see the cost of that same lifestyle rise to $146,600 in 10 years.

Total Return vs. Income

So what’s the solution? We prefer a total return approach to one that is narrowly focused on yield and income. To the extent that investments provide the main source for expenditures, capital appreciation and dividends are among the most effective methods of generating cash. Distinguishing the need for cash rather than “income” helps us to craft an optimal investment program.

Here’s a bit of history. Traditionally, investors have separated income and growth, meeting current spending needs with interest and dividends and pursuing growth with stocks and other equity-like investments. Since the 1970s, many institutional investors such as foundations and endowments (which typically have annual distribution rates of around 5%), have adopted a total return approach of blending income and capital appreciation. We believe this is a sounder approach for coping with unanticipated inflation and preserving long-term purchasing power. In fact, the investment strategy was codified into law with the Uniform Prudent Investor Act of 1994, which tasks fiduciary trustees with developing portfolio strategies that meet current and future distributions for trust beneficiaries and defines safety of capital as preserving the real—not nominal—value of the portfolio.

There’s obviously more than one way to implement a total return strategy. Here’s one approach. Let’s say we have a recently retired couple, Jim and Jane Parker, who are in their mid-60s. The Parkers have a $2 million nest egg, a combined $48,000 a year in social security and pension income and an estimated (pre-tax) cost of living of $120,000 a year. Thus, the couple will need to withdraw $72,000 a year from their account, a 3.6% withdrawal rate.

Let’s say the Parkers invest their assets in a globally diversified 50/50 mix of equities (and other risky assets, such as gold and commodities) and bonds. A portfolio such as this would currently yield about 2%. The Parkers reinvest all of the dividends and interest coupons. Over the long run, global stocks and commodities have been a good hedge against inflation. In a doomsday scenario, if the stock market crashes and doesn’t recover, the Parkers will be able to survive for nearly 14 years ($1 million/$72,000) without dipping into their bombed-out stock portfolio. In a normal environment, stocks fluctuate by about 20% each year. The Parkers would embrace market volatility in funding their $6,000- a- month withdrawal requirement and rebalancing their portfolio. In other words, they generate cash from sale of securities, not from dividends or interest. For instance, through much of 2009-10, when stocks and gold sparkled, the Parkers would have sold part of these holdings to generate cash flow and to recalibrate the portfolio. In recent months when stocks fell and bond prices surged, the Parkers would have trimmed bonds to meet withdrawals and to reset allocations. Essentially, they are taking what the market gives them: harvesting gains from equities in good times and from bonds during equities’ bad times. By the way, do not underestimate the value of a disciplined rebalancing program, which can add up to half a percentage point to annualized returns of a 50/50 portfolio.

Conclusion

We believe that a total return approach will provide a smoother ride for investors than an income-oriented investment strategy. By addressing the challenge of maintaining purchasing power in the teeth of inflation, total return can provide retirees with income today…and income tomorrow.

As Published On: Forbes

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Gerstein Fisher
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