FMD Capital Management

Retirees Face An Asset Allocation Conundrum

Written by David Fabian, May 19th, 2015

One of my clients recently sent me an article from CNBC on the big shift in thinking for retirees with the need for an income plan. The story essentially centers on the conundrum of how to generate an acceptable yield without taking an inordinate amount of risk.

All of the usual concerns were cited:

  • Historically low interest rates.
  • People living longer and thus extending amount of time they survive off their retirement savings.
  • Rising health care costs.
  • Hunt for yield pushing investors to riskier alternative asset classes.

While none of these factors are particularly groundbreaking, they do bring into question the historical doctrine of asset allocation decisions from initial retirement years through later stages of life expectancy. Most investors have been told to shift additional money to bonds and cash as they grow older to ward off stock volatility and enhance their income streams.

One popular method involves using your age to determine your bond allocation – i.e. if you are 75 years old, you should have 75% of your portfolio in bonds and the remaining 25% rest in stocks or cash. That logic may have worked for decades of falling interest rates and rising bond prices. However, faced with the potential for a cyclical or secular rising interest rate environment, this strategy may not seem all that attractive.

The natural conclusion is that retirees should be shifting more money to stocks with less emphasis on bonds in order to make up the income shortfall in their portfolio and avoid rising rates. That will certainly allow you to sidestep a meaningful dip in the bond market. Nevertheless, what is not mentioned is the additional volatility this will introduce through the natural ebb and flow of stocks.

Bear markets can have devastating consequences for your wealth, which seem to be marginalized by the fact that we haven’t experienced one in the last six years. The 2008 financial crisis seems pretty dim in the rear view mirror, especially in the context of reduced volatility in broad-based stock indices such as the SPDR S&P 500 ETF (SPY). It seems like we have become conditioned to expect every 2-4% dip in SPY is going to be bought.

So how do we overcome these challenges while keeping an eye towards income and capital preservation?

In my opinion, the concept of a successful retirement outcome should not be based on generalized investment strategies. It is first and foremost a highly individualized process that involves a significant number of moving parts. Each investor needs to evaluate their retirement income sources, living expenses, goals, and risk tolerance to determine how they will attack the problem. There is no “one size fits all” solution that you can count on with certainty to meet your needs.

Setting asset allocation targets can be a useful exercise in making sure your portfolio is well balanced to meet your income goals and reduce overall volatility. However, I believe that those targets should have some built-in flexibility to shift in response to specific threats or opportunities as markets change over time.

For example, one component of attacking the rising interest rate demon is making sure you aren’t overly exposed to that specific risk. If the majority of your bond allocation is made up of the Vanguard Total Bond Market ETF (BND) or iShares Investment Grade Corporate Bond ETF (LQD), then you certainly have cause for worry if rates move meaningfully higher.

Instead of passive indexes, I prefer holding core positions in actively managed bond funds such as the PIMCO Income Fund (PONDX) or SPDR DoubleLine Total Return Tactical ETF (TOTL). Both funds offer a risk-managed approach with veteran management teams that have the flexibility to shift their sector, duration, credit, and interest rate exposure as needed. This can reduce overall volatility and produce superior yields than many funds with heavy treasury or investment grade corporate bond exposure.

For the equity side of the portfolio, I think it’s important to use low-cost ETFs to get direct access to dividend generating stocks. The Vanguard High Dividend Yield ETF (VYM) and Vanguard Dividend Appreciation ETF (VIG) are two examples that we employ for clients in our Strategic Income Portfolio. Each ETF owns a unique and diversified basket of stocks with a historical penchant for high yields or increasing dividend payments. These are also paired with a risk management plan to reduce the position size or exit the holding entirely if we see a significant downtrend in develop in stocks.

In addition, I think that it can be advantageous to utilize alternative investments in preferred stocks, REITs, convertible bonds, and MLPs when appropriate. These asset classes can offer higher yields and non-correlated returns to traditional stocks and bonds, which make them attractive under various conditions. The key is keeping your exposure to these alternative themes relatively small and in line with your risk tolerance.

The Bottom Line

The debate will rage on whether 60% stocks and 40% bonds or vice versa is the best way to play the market over the next decade. Instead of trying to find the perfect ratio, give yourself some flexibility to adjust your asset allocation mix as conditions dictate. In addition, further analysis of your current holdings may unearth some weaknesses that should be addressed with respect to interest rate risk or high beta stock exposure.

With the stock market near all-time highs, it certainly makes the transition to a heavier equity allocation a precarious decision at this juncture. Any shifts should be gradual and taken with a balanced mindset that blends the need for capital preservation and low volatility.

Challenging long held assumptions on portfolio construction may ultimately lead you to make strategic changes that improve your long-term results.   If you don’t have the time or tools to properly evaluate your portfolio, you may be well served in working with an advisor who can recommend an individualized income strategy to meet your needs.

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