Middle-class retirees have always faced a tricky trade-off to achieve decent returns without too much risk. But with today’s ultra-low interest rates, that challenge is tougher than ever.
Retirees have traditionally managed risk by upping bonds and reducing stocks as they age. But with rates so low, you give up a lot of return to get that extra stability. Is there a better way for retirees to manage their risk/reward trade-off? Consider three alternative approaches to generate reliable cash flow that don’t involve loading up on bonds: Income investing, the “bucket” strategy and annuities.
Going long: Before diving into the three strategies, let’s first examine the unique investment risks you face in retirement. In “Do you need more stocks?” we discussed investment risks and asset allocation more generally. You realize you can potentially go for a greater mix of stocks with less bonds if you’re a “long-term investor.” To do that, you need to be both willing and able to wait out market declines without selling off your stocks. But that’s hard to do for many middle-class retirees, because they typically need to draw from their portfolios to generate money to live on. This can make you vulnerable to a threat known as “sequence of returns risk.” If your portfolio is heavy on stocks and there’s a market meltdown soon after you retire, then you may be forced to keep selling stocks at beaten-down prices to provide money to live on. That can deplete your portfolio so much that it may never recover even when stock prices eventually go back up.
Having a big bond allocation has been the traditional means to help insulate portfolios from this risk, but there are other ways to do it. These alternatives generate reliable cash flow through other means—even in the face of a market meltdown—so you won’t be forced into selling stocks at the wrong time to cover spending needs. The alternatives can work well if your priority is generating decent amounts of reliable cash flow, but not so well if you’re intent on preserving capital at all times. The value of your stocks will still suffer in a downturn, so you need to be okay with waiting out down markets and giving stocks a chance to recover.
Income Investing: The idea behind income investing is to provide most or all of your cash flow needs through reliable dividends from stocks and reliable interest from investment grade bonds. With interest rates so low, that probably means more stocks and less bonds than in the past. Of course you need to be able to distinguish in advance dividends that are “reliable” from those that aren’t, which isn’t always easy.
Look for profitable, well-managed, blue-chip companies with sound balance sheets. The proportion of profits paid out in dividends should be reasonable. The companies should have strong competitive positions in stable industries that are also growing. Canadian blue-chip dividend stocks of this type maintained their dividends through the worst of the 2008-2009 financial crisis with only a few exceptions. “It’s a lot more important to look for the quality of the business than to be drawn in just for the dividend yield,” says Mark Allen, vice-president equities at RBC Wealth Management. These stocks typically pay moderate dividends of 3.5% to 5% with moderate dividend growth. But don’t overlook dividend growth stocks that yield less but grow dividends faster. Be skeptical of the highest-yielding stocks because they’re often at risk of a dividend cut.
“Bucket” strategy: The “bucket” approach protects you from sequence of returns risk by separating your portfolio notionally into at least two buckets. You draw your day-to-day cash flow needs from a bucket composed of cash and high-quality short-term bonds. You keep your risky assets in a separate long-term bucket and avoid selling them when markets are down. U.S. financial expert Harold Evensky advises that you should maintain at least five years’ worth of cash flow needs covered by cash and short-term bonds. That way, in a downturn your long-term investments would have at least five years to recover undisturbed. As your short-term bucket gets depleted, replenish it with medium-term bonds coming closer to maturity or by selling long-term assets when prices are favourable.
Annuities: Annuities provide regular cash payouts that last as long as you live. The downside is annuity pay-out rates are impacted by meagre interest rates and are much lower than historical norms. But annuity pay-out rates get better the longer you wait. The sweet spot, these days, is to wait before buying them until your early 70s, or possibly longer.
When you buy an annuity, the money used in its purchase is no longer visible in a conventional asset mix. But generally, with the annuity’s assurance of reliable cash flow for life, you should be able to up the equity in your remaining portfolio to try for a little more return.
Takeaway: In the right circumstances, income investing, the bucket strategy and annuities can help retirees stay the course as long-term investors. They help create reasonable amounts of reliable cash flow to cover spending needs without loading up on bonds. That way you can pursue decent returns without undue risk to your retirement.
3 strategies to help retirees generate reliable cash flow
Notes: (1) Wealthy retirees may earn sufficient dividends and interest that they can live off without touching their capital. But most middle class retirees will probably need to supplement dividends and interest by drawing from capital to some extent. Potentially they can use the bucket strategy or annuities to help do that. Creating a bond ladder is another option to help cover remaining spending needs. (2) U.S. financial expert Harold Evensky’s version of the bucket strategy calls for maintaining two years worth of spending needs in a highly liquid “cash flow reserve account” and at least three years of spending needs in high-quality short-term bonds. The separation of short-term bonds from long-term investments can be notional, so you don’t necessarily need to create separate investment accounts. (3) Annuities generally are less well-suited for you if you are: Low-income (government ensures minimum retirement needs), rich (annuity protection is not needed), intent on leaving a big bequest (payments generally end at your death), or you have low life expectancy (you get few payouts).