Phill Rogerson, Managing Director, AIS Consulting & Product

Fundamentally, building a sustainable retirement income strategy isn’t a product challenge, it’s a planning challenge—a highly complex and sophisticated one that must balance the needs of today with those of tomorrow.  Many of today’s retirees are anxiety driven, rather than long-term focused.

In Russell’s fourth quarter Financial Professional Outlook (FPO) survey, which was fielded in October 2015, just 25 percent of advisors reported that their clients are optimistic about the markets, while 53 percent said clients are “uncertain.” Even more worrisome, nearly one-third of advisors (30 percent) believe that a notable portion of their clients will not be able to maintain enough assets to support their preferred lifestyles without making significant changes.

Retirees are increasingly demanding yield from their investment portfolios, hoping that this might make the difference in helping to meet their long-term goals, while not always fully understanding the potential consequences of chasing yield to their retirement lifestyles.  This can be a difficult demand to counter for advisors.

The frequent client default to seek yield is a seemingly simple investment solution that could jeopardize their future. While the approach may appear to protect a retiree’s purchasing power, it often has hidden risks.

Why is building a sustainable retirement so hard?

At the macro level, the biggest change in retirement planning in the last three decades has been the marked shift from pension plans to individual retirement plans. Instead of a large pool of money that was managed by employers, or their proxies, many of today’s retirees are increasingly relying on themselves or advisors to create and manage their own, much-smaller, individual pools of money. Such smaller pools of retirement funds can limit the capabilities of retirement portfolios to mitigate risk and harvest potential income.

Further complicating this new retirement planning landscape are each retirees’ unique variables (e.g. income, liabilities, time horizon) that offer a mix of potential upsides and downsides. For instance, one issue that is only growing in importance is lifespan. Advances in healthcare, for example, has resulted in people living longer.  So, while current mortality tables are a starting point, individual lifespans are beginning to change faster than statistical data can catch up.

Additionally, each retiree’s unique goals for life in retirement are also variables that must be a part of the planning process. Does the retiree want to fund education expenses for grandchildren? Are family members moving in and needing financial assistance? Are healthcare costs a significant factor? What lifestyle expectations are anticipated?

While the financial services industry has made progress in helping workers save for retirement, the majority of its solutions for helping individuals navigate effectively through retirement seem formulaic and two-dimensional.  They do not adequately factor in retirees’ unique variables, nor the trade-offs many often make to balance dueling needs: present versus future, self versus others. All too often the solutions presented are yield-seeking products that don’t take the variables we’ve mentioned above into account.

What are the dangers behind the yield-seeking approach?

As I’ve mentioned above, while a bias towards yield in a portfolio provides an easily understandable solution for investors, seeking yield is much more complex than it appears. Many investors believe they are protecting their future by spending only income and leaving their nest egg (aka principle) untouched. But, that’s not necessarily true.

Yield-seeking strategies introduce risks into an investment portfolio that may not be obvious to the traditional end-investor. For example, there is the inherent risk associated with higher yield assets. Probably the most obvious is high-yield debt. There is a reason this asset is referred to as high-yield bonds during good times, but junk bonds during bad (high default) times.

Likewise, many investors prefer dividend-paying stocks for their combination of dividends and growth. But investors need to remember that companies generally pay dividends when they don’t see better opportunities for reinvestment in their operations. As a result, there is an opportunity-cost consideration. Also, dividend-paying stocks tend to be concentrated in certain types of industries, which can be an added risk (too many eggs in one type of basket).

Such investments, from certain types of bonds to those assets that that pay dividends can also have unintended tax consequences that need to be expertly mitigated (and that can’t always be done in straight yield-investing approach). Of course there are ways to diversify a yield-seeking strategy to help mitigate some of these risks, but many investors tend to prefer to maximize income at the expense of diversification.

Additionally, another important risk lie in reaching for yield in order to maximize short-term income at the expense of capital appreciation (growth).  Our extensive research concludes that reaching for yields higher than 3.5 percent erodes a portfolio’s principal.1 This research reinforces our view that balancing growth and income is critical to helping investors meet their long-term goals for retirement.

Taking control: Understanding client motivation

While no single product or formula can be used to create a sustainable retirement strategy, a diversified strategy can help provide the necessary balance between short-term and long-term goals.

Given each client’s unique situation, advisors may find it more effective to start the process with a conversation. Asking retirees the right questions is critical. Here are some suggestions:

  • What do you want to achieve with your investments?
  • How much annual income do you think you need in retirement?
  • Do you expect the amount to change over time?
  • What other goals do you want to support in retirement − paying for a grandchild’s education, helping family buy a home, special medical needs, etc.?
  • How much time do you have to reach those goals?
  • Are you open to a variety of ways to generate income or do you have a specific preference?

Once a retiree and an advisor focus the conversation on the investor’s unique goals, circumstances and preferences, a disciplined investment approach can be established.  Yield-seeking retirees and their advisors may find new solutions when retirees are prodded to understand their total situation. This kind of approach can help both advisor and retiree find a more, balanced, sustainable approach for their retirement investing plan together.

Finding the right investing approach: Balance, diversity, risk and adaptability

Still, even with the right questions and expertise, as reflected in the December 2015 FPO, 46 percent of advisors said they struggle to develop diversified investment strategies for retirees that balance income and growth.

While no single product or formula will solve this complex problem, we believe it is possible to build the right solutions for individuals to help create responsible yield. This needs to be done through a well-diversified, multi-asset structure that includes:

  • Balance: Current income needs and longer-term objectives must be balanced.
  • Diversification: A mixture of strategies, asset classes and globally diverse investments should be considered.
  • Risk: Appropriate risk should align with an investor’s individual tolerance. (Beware of overreaching for yield.)
  • Adaptability: Yield-producing assets must be subjected to dynamic asset-allocation adjustments at appropriate frequencies.

A total portfolio approach with the above qualities that balances the desire for yield with the long-term goals of an individual will help to provide investors with more flexibility that can help manage some of the risks associated with yield-seeking strategies.

Given the complexity of the retirement landscape, it’s impossible to create one-size-fits all solution for retirees.  Trying to do so often means trading in one set of risks for another. Through talking to and understanding their retired clients’ situation more clearly, advisors can provide more informed and effective investment solutions that balances retirees’ conflicting needs.  While it’s impossible for advisors to take out all the uncertainties that their clients face, they can still help retirees manage them.    

See the full December 2015 FPO report.

1 “Financial Professional Outlook,” Russell Investments, December 2015.

Disclosures

Russell Investments conducted the Financial Professional Outlook survey between October 6, 2015, and October 21, 2015. The survey was sent to a broad group of U.S. financial advisors. Having a financial relationship with Russell was not part of the criteria for being included in the survey. In total, 297 survey responses were received representing 213 firms. The sample size of 297 is sufficient to provide 95% confidence that the results will be within plus or minus 5.8%. In other words, if we repeated this survey 100 times we would expect to find similar results in 95 of the 100 trials.

Russell Financial Professional Outlook is a product of Russell Investments, produced independently of Russell’s investment and manager research services.

The information, analyses and opinions set forth herein are intended to serve as general information only and should not be relied upon by any individual or entity as advice or recommendations specific to that individual entity. Anyone using this material should consult with their own attorney, accountant, financial or tax adviser or consultants on whom they rely for investment advice specific to their own circumstances.

This material is not an offer, solicitation or recommendation to purchase any security.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets.

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First Use:  March 2016
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