What a difference a year makes. People entering retirement early last summer had a strong market to boost their nest eggs and cushion any anxiety over their life transition. On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time. To the extent that the subprime crisis had even registered, most observers expected the damage to be contained within the housing sector.
The investment outlook has darkened since then, however, especially for those who may not have decades ahead to smooth the effects of volatility. Regardless of how the markets perform, most retirees count on withdrawing income regularly from their nest eggs, while preserving as much of their principal as possible.
On an institutional level, foundations face a similar task. Congress requires them to give away at least 5% of their assets each year; their challenge is to grow principal to keep pace with inflation, so they can meet commitments to grantees and cover operating expenses. It’s like retirement… in perpetuity. “The problems of the retired investor and of the endowed institution are very closely related,” says Laurence Siegel, director of research in the investment division of the Ford Foundation. “Both seek to produce an income stream that grows with inflation.”
You don’t need to invest your clients’ nest eggs exactly like the Rockefeller or Ford Foundations-to say nothing of Harvard or Yale. In fact, most investors can’t act like Harvard or Yale, despite the books and articles that espouse to teach how-they just don’t have enough money. But foundations and endowments can teach advisors strategies for constructing and maintaining retirement income portfolios. Here’s a look at how.
All-Important Allocation
Retirement income planning didn’t even exist a couple of generations ago. Through the mid-20th century, most people didn’t have a decades-long retirement, for the simple reason that life expectancies were shorter. People stopped working, lived a few years on Social Security and then died. Later on, in the 1980s, retirees could pack their portfolios with double-digit-yielding Treasury bonds and bank certificates of deposit and live comfortably off that income. During the same decade, as inflation cooled, a bull market began that persisted for the rest of the century.
Today, the picture is decidedly more complex. People are living longer than ever. The life insurance industry has adopted new actuarial tables reflecting this: As of January 1, 2009, all policies must be issued with rates that extend through age 121, replacing tables that end at age 100. And the markets are less friendly. Market watchers predict that stocks may languish for years in a range-bound market that provides none of the oomph of the bull market that ended in 2000.
Meanwhile, people’s spending needs haven’t changed-if anything, they’ve risen, as healthcare costs have exceeded inflation-and inflationary pressures have mounted. Yet 30-year Treasury bond yields hover under 4.50%.
Recent research reinforces the importance of asset allocation in retirement as one of the safest, most efficient ways to meet long-term portfolio needs today. Because of compounding, more than half of every dollar that’s withdrawn from a defined contribution plan comprises investment returns generated after retirement, according to a study conducted by Russell Investments and released last month. The study looked at a prototypical 25-year-long retirement of a 65-year-old who dies at age 90. Out of each dollar the retiree withdrew from a defined contribution plan, 10 cents came from contributions made to the plan while working, 30 cents came from investment returns generated prior to retirement, and a full 60 cents came from investment returns generated after retirement. “The pool of assets is so much bigger after retirement,” says Bob Collie, director of investment strategy for Russell. Post-retirement investment returns account for an outsize portion of each dollar withdrawn from a defined contribution plan simply because the asset pool is larger in retirement, and because people’s longer lives are putting their money to work over longer horizons than before.
Today’s long life expectancies mean that an overly conservative asset allocation won’t go the distance for most retirees. Indeed, advisors recognize that only their wealthiest clients can derive a secure retirement from, say, bond ladders. “You can’t do it with bonds alone, because that would erode the assets,” says Thyra Zerhusen, manager of the $1 billion Aston/Optimum Mid Cap Fund and of a New York-based foundation’s portfolio, which she declined to name and which she runs the same way as her mutual fund. When Zerhusen began managing the foundation’s portfolio, it had roughly 70% of its assets in bonds and the rest in stocks. This breakdown mirrors the traditional retirement portfolio. But longer life expectancies, lower bond yields and a potentially stagnating stock market have zapped the effectiveness of this allocation. Zerhusen persuaded the foundation’s finance committee to adopt the inverse allocation, and today the portfolio is roughly 70% stocks and 30% high-quality bonds.
Alpha Alternatives
The foundation portfolio Zerhusen manages is unusual in that it doesn’t have an allocation to alternative investments. “We only buy what we understand,” Zerhusen says. Her expertise in identifying undervalued and misunderstood mid-cap stocks has helped the foundation meet its annual operating goals, which involve withdrawals of 8% to 10% per year, without sacrificing principal.
Most large foundations and endowments (foundations are mandated to give away a minimum of 5% of their assets per year, while endowments are not) have at least a quarter of their assets in investments outside of traditional, long-only publicly traded equities and bonds, Siegel says. “Alternative investments are, in principle, a more efficient way of generating alpha (if the manager has skill) than traditional, long-only investments,” he writes in an email message. “This is because short selling, the ability to leverage and use derivatives, the ability to lock up funds for long periods of time, and other features of alternatives each contribute in various ways to portfolio efficiency (the expected return per unit of risk taken).”
The Harvard and Yale endowments have about 50% of their portfolios in alternatives such as private equity, hedge funds, real estate and commodities, according to Frontier Capital Management, a Boston-based investment management firm. At $34.6 billion and $22.5 billion, respectively (as of the end of fiscal year 2007), Harvard and Yale’s endowments could weather any liquidity challenges that this high alternative allocation presents. But less-capitalized funds and private foundations without access to new money from alumni or other contributors (and whose circumstances are more analagous to those of retirees) could face trouble in a bear market if they allocate such a high percentage to alternatives, Siegel says. Margin calls or forward commitments on private equity can force the selling of assets, and there are fewer liquid assets to choose from if a large chunk of the portfolio is in real assets. Similarly, your clients will have less flexibility in their income withdrawals if they have too much allocated to real assets.
Some advisors have embraced the use of alternatives. “In portfolio design, the ultimate goal is to have investments that are not correlated,” says Greg Plechner, principal and senior wealth manager at Greenbaum and Orecchio, a fee-only advisory firm in Old Tappan, N.J. “With alternative investments, you’re able to attain that.” Greenbaum and Orecchio allocates an average of between 15% and 20% of their clients’ portfolios to alternatives. Retired clients have a slightly smaller allocation to alternative investments, he notes, since their fixed-income portion is higher.
The firm’s clients with more than $1.5 million to invest have access to private investment partnerships, while those with less than $1.5 million can access similar strategies through exchange-traded funds and notes, and institutional share mutual funds. For example, the firm uses PIMCO CommodityRealReturn Institutional, Vanguard Energy ETF, and Rydex Managed Futures Fund for market-neutral exposure.
Choosing private equity and hedge fund opportunities requires considerably more due diligence than does selecting investments sold on an exchange, as the former have far fewer reporting requirements. Greenbaum and Orecchio employs three full-time professionals whose sole job is to evaluate private investments and do the related legal work.
Endowment Products for the Rest of Us
Over the past year, the financial services industry has introduced new products to help consumers generate retirement income and to capitalize on the wave of retiring baby boomers. Endowments inspired the design of at least one of the new retirement income mutual funds on the market: The Vanguard Managed Payout Funds, launched in early May. The three funds of funds target payout rates of 3%, 5% and 7%, respectively, while maintaining capital, and in this approach function something like a university endowment, Vanguard executives say. The underlying funds are Vanguard stock and bond funds, and other investments, including REIT and TIPs (inflation-protected Treasury bonds) funds and commodity-linked investments.
Vanguard’s approach contrasts with that of Fidelity Investments, whose new payout mutual funds are designed to liquidate an investor’s principal by a target date. Vanguard chose its approach because “there was a sense generally that there’s a strong desire among retired clients to preserve their capital in liquid form for the duration,” says John Ameriks, a Vanguard principal and economist. Vanguard’s research among the company’s mutual fund shareholders reveals that many older people continue to save in retirement. “It’s very hard for people to turn on a dime in retirement,” Ameriks says. “They’ve been saving their whole lives.” In other words, even if your clients aren’t saving enough for retirement, their saving habits are nonetheless ingrained.
According to the Vanguard funds’ prospectus, the 3% payout fund is expected to appeal to investors who want to see their capital and payouts increase over time and seek only a modest current payout from their assets; the 7% payout fund, on the other hand, is expected to appeal to those who need a greater payout to satisfy immediate spending needs. While the payments and capital on the 7% fund are not expected to keep pace with inflation, Vanguard will seek to preserve the fund’s original value. The 5% fund is designed to provide long-term inflation protection and capital preservation. The funds could function as the investment vehicle of a small endowment, and in fact, Vanguard has fielded a few inquiries from such institutions, Ameriks says.
The funds’ payout rates are targets, not guarantees. “These products are not annuities,” which offer a guaranteed income stream for life, Ameriks notes. “There are positives and negatives to that.” The company believes that positives, such as liquidity and flexibility, outweigh the lack of a guarantee. Indeed, annuities have failed to gain widespread acceptance in the marketplace largely because consumers are loath to relinquish access to their principal.
But Then Again…
As much as retirees and foundations share similar challenges, there are some noteworthy differences between the two. For starters, individuals die. No one needs to produce income in perpetuity, as foundations endeavor to do. Retirees need to plan for at least 30 years in retirement, and annuities can insure they won’t outlive their assets. Amid the general unpopularity of these insurance products, advisors and their clients often overlook the benefits provided by risk pooling. “Annuities produce a much higher income than bonds or TIPs because the people who die help pay for those who survive,” Siegel explains in his email. In fact, you need 25% to 40% less capital to provide for yourself in retirement using risk pooling than you would structuring an investment portfolio on your own, according to a study by David F. Babbel and Craig B. Merrill of the Wharton Financial Institutions Center, co-sponsored by New York Life.
Annuity companies have introduced cash refund options that have increased their products’ popularity. This popular feature insures that investors’ heirs will receive money back after they die, yet it eats into the benefits of risk pooling. A 65-year-old male would receive 8% less income and a 75-year-old man 13% less from an immediate annuity with a cash refund than he would from one without, says Mike Gallo, senior vice president for retirement income at New York Life.
Another approach is to deconstruct the traditional annuity by layering a low-cost insurance guarantee on top of a separately managed account. In March, Pershing LLC launched such a hybrid retirement income product, which pairs a managed account solution with a lifetime income guarantee offered by The Phoenix Companies. The product, known as Lockwood Investment Strategies Longevity Income Solutions, or LIS2 for short, will ensure that investors won’t outlive their assets, says Len Reinhart, the former president of Lockwood who worked on the product design and now consults for Pershing Managed Account Solutions.
LIS2 features a 5% annual payout, after fees, which begins when an investor is 65 years old. The 5% rate is applied to the initial investment for a fixed dollar amount that stays the same each year. For example, an investor who puts $1 million into the product would get $50,000 each year for the rest of his or her life. The Phoenix Companies buys 10-year puts as hedges for the guarantee, which assures consumers of their fixed payout regardless of the underlying funds’ performance.
This structure will ensure that investors don’t become too conservatively invested in retirement, Reinhart says. “The whole point is for the client to be in an aggressive growth strategy,” he says. In other words, ensured of a guaranteed income stream through LIS2, retirees can invest the rest of their portfolios more aggressively. This argument is frequently applied to annuities as well.
Another major difference between retirees and foundations lies in their tax treatment. Private foundations pay an excise tax of 1% to 2% on investment income and realized capitalized gains, and endowments pay nothing. Needless to say, individuals don’t enjoy such favorable treatment at the hands of the Internal Revenue Service.
Furthermore, many retirement income strategies are not designed for their tax efficiency. For example, investors in Vanguard’s Managed Payout Funds receive a 1099 tax form each year stating how their monthly payments were generated for the previous year, whether by a combination of income, capital gains or a return of capital. This complex tax treatment means investors would benefit from holding these funds in a tax-advantaged account. If Lockwood’s LIS2 product is able to generate income payments through income or capital gains, then investors will be taxed at the 15% capital gains rate, Reinhart says. But if the account balance plunges and the insurance company must make the payments, the investor will be taxed at regular income rates. Investors who open an IRA account managed by Lockwood Capital Management and hold the LIS2 offering inside it would enjoy tax-deferred treatment on the income.
Advisors at Greenbaum and Orecchio actively work to minimize their clients’ tax burdens. If a client needs income, the firm uses iRebal rebalancing software to quickly determine how to use principal, income and rebalancing proceeds to generate the income in the most tax-efficient way, Plechner says. Clients with more than $1.5 million to invest may choose the firm’s ETF and mutual fund-based alternative investment strategy for tax purposes, he notes. Clients with alternative investments including hedge funds, private equity, venture capital and real estate receive a K-1 tax form that state the investor’s share of the partnership’s taxable income. The forms often come late, requiring clients to file an extension on their taxes, Plechner says, a hassle some wish to avoid.
Despite the most careful planning, many institutions and individuals will fail to meet their income goals at some point. Following a year of poor returns, a foundation can simply cut the size of its grants. Your clients’ bills, however, won’t disappear in a bear market. When clients fail to meet their income goals, they can cut their spending or increase their equity allocation, says Deena Katz, chairman of Evensky & Katz in Coral Gables, Fla. The choice, as her partner Harold Evensky puts it, is clear: “Do you want to eat less well, or sleep less well at night?”
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